Reconsidering the Fed's Inflation Forecasting Advantage

Previous studies show the Fed has a forecast advantage over the private sector for inflation, either because it devotes more resources to forecasting or because it has an informational advantage. We evaluate the Fed's forecast advantage to determine how much of it results from the Fed's knowledge of future monetary policy. We develop two tests -- an instrumental variable encompassing test and a path-dependent encompassing test -- to equalize the Fed's information set with the private sector's. We find that Fed forecasts do not encompass those of the private sector when the latter has knowledge of the future of monetary policy. Further, we find that between 20 and 30 percent of the difference between the Fed's and the private sector's mean squared forecast error can be explained by monetary policy.