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Bias in Federal Reserve Inflation Forecasts: Is the Federal Reserve Irrational or Just Cautious?

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Carlos Capistrán

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Abstract

Inflation forecasts of the Federal Reserve seem to have systematically under-predicted inflation from the fourth quarter of 1968 until Volcker's appointment as Chairman, and to systematically over-predict it afterwards until the second quarter of 1998. Furthermore, under quadratic loss, commercial forecasts seem to have information not contained in those forecasts. To investigate the cause of this apparent irrationality, this paper recovers the loss function implied by Federal Reserve's inflation forecasts. The results suggest that the cost of having inflation above an implicit time-varying target was larger than the cost of having inflation below it for the period since Volcker, and that the opposite was true for the pre-Volcker era. Once these asymmetries are taken into account, the Federal Reserve's inflation forecasts are found to be rational.

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Paper provided by Banco de México in its series Working Papers with number 2006-14.

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Date of creation: Dec 2006
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Handle: RePEc:bdm:wpaper:2006-14

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Related research
Keywords: Inflation forecasts; Forecast evaluation; Monetary policy;

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Find related papers by JEL classification:
C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Other Model Applications
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Kim , Insu & Kim, Minsoo, 2009. "Irrational Bias in Inflation Forecasts," MPRA Paper 16447, University Library of Munich, Germany. [Downloadable!]
  2. Elliott, Graham & Timmermann, Allan G, 2007. "Economic Forecasting," CEPR Discussion Papers 6158, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  3. Stanislav Anatolyev, 2006. "Dynamic modeling under linear-exponential loss," Working Papers w0092, Center for Economic and Financial Research (CEFIR). [Downloadable!]
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