Given that policymakers seldom if ever experimented with forward guidance this far in the future, there is little data to guide them. The problem, however, is that these DSGE models appear to deliver unreasonably large responses of key macroeconomic variables to central bank announcements about future interest rates.In English, the report is saying the Fed's models must be wrong because they predict "explosive inflation" 2 years out. Interesting that Philly Fed president Charles Plosser recently came to the same conclusion.
Carlstrom et al. show that the Smets and Wouters model would predict an explosive inflation and output if the short-term interest rate were pegged at the ZLB (Zero Lower Bound) between eight and nine quarters. This is an unsettling finding given that the current horizon of forward guidance by the FOMC is of at least eight quarters.
Wednesday, October 3, 2012
Fed Econ Models Predict "Explosive Inflation"
In a staff report published today by the New York Fed (.pdf), economists Mark Del Negro, Marc Giannoni, and Christina Patterson came to the shocking conclusion that key Fed economic models must be wrong...because they predict severe consequences (extremely high inflation 2 years from now) as a result of manipulating the monetary system. From the report, discussing the challenge of predicting economic performance 8 quarters out: