The Fed’s Forecasting Inertia
Is Powell & Co. wrong about the Long Run?
The Federal Reserve’s forecast of our economy’s long run growth is stuck in place, and has been so for ten years. That might be a problem.
The latest forecast from the Fed was published last month, publicly available here (the forecasts are published for all to see four times year, and have been so since 2009). The screenshot below displays the summary information from that forecast. I’ve circled in red the item of interest for this post: the “Longer Run” forecast for real GDP growth.
As explained in this Macrosight post from 2022 (“Hacking the Fed’s Forecast of GDP”), the “longer run” value the Fed publishes represents their best guess on the growth path for the U.S. economy.
This long run value is very important when it comes to setting monetary policy. Conceptually, this number represents the “stable” growth rate the U.S. economy is following.1 Anything above that value implies a strong if not booming macroeconomy; anything below that value implies a sluggish to an oh-no-we-are-going-into-a-recession-economy.
If the economy is booming, we expect inflation to be increasing and the unemployment rate decreasing. If the economy is slowing, we expect inflation to slow and the unemployment rate to rise. Given that basic juxtaposition, the Fed decides whether or not they are going to adjust their target interest rate (as part of their job setting monetary policy—a job explained in multiple Macrosight posts, summarized here).
Policy Problems
Okay, so what is the problem? Well, the U.S. economy, in the view of this macroeconomic observer, appears to be out-pacing the Fed’s long run forecast. Here, for example, is the Fed’s “longer run” forecast from every published forecast since 2015:2
Notice the forecast has hardly changed since December 2015. And, curiously, the forecast has not changed in the past four years.
Why is that curious? Well, because the economy certainly appears to have changed. In the least, the labor market has been remarkably stable and real GDP growth has been persistently above 1.8 percent for the past four years. With respect to the former, the unemployment rate has hovered between 3.5 and 4.2 percent for three-plus years (see here), while total employment is the highest its ever been (see here).3 With respect to GDP, Figure 1 displays quarterly real GDP growth since 2000 (“real” meaning the data is adjusted for inflation).
As annotated on the figure, the average quarterly growth rate over this 25-year time period is 2.2 percent. Over the four plus years spanning 2021Q1 through 2025Q, the average rate of growth has been 3.7 percent—or, since 2022Q1, 2.7 percent.4
3.7 percent is pretty remarkable, especially so given that average growth from 2000 through 2019 was a little less than 2.2 percent. In terms of economic growth, 3.7 percent is dramatically different than 1.8 percent. Even if we ignore the anomalous growth in 2021, the average of 2.7 percent since 2022 is also well above 1.8 percent.
As a macroenthusiast that plays with forecasting models, I find it a bit odd that the longer run value from the Fed’s has not budged in so long. That long run value is very important for assessing the state of the economy and the subsequent decisions policy-makers make in regards to the economy.
As mentioned above, that long run value is a weather vane of sorts—the Fed assumes that if real GDP growth is running above 1.8 percent, there may be “inflationary pressures” lurking about. As such, they are less-inclined to lower their target interest rate.
But, what if the true value of long run growth is higher than 1.8 percent—say 2.7 percent? That implies that the economy can run “hotter” without those inflationary pressures actually manifesting. Or to put it another way: if the Fed sees real GDP growth is 2.5 percent—above their 1.8 percent estimate—they would label that as an “expansionary” or “getting hotter” economy. Yet, if the true long run value is 2.7 percent, that implies the economy is actually below trend, not above it. The latter implies a very different policy response.
Too cautious?
I suspect the Fed’s forecasting inertia is due to (at least) a couple of factors. First, forecasting is ultimately a tricky business. Forecasting models are inherently backward-looking, in spite of the “fore” in forecasting. If the economy is changing in a permanent way, that will only become apparent with enough hindsight. Hence, it is the natural response of the forecaster to not make dramatic updates or changes to the the inputs they use for their models.
Second, the Federal Reserve is a government institution. By that I mean, like most (if not all) bureaucracies, they are not going to make dramatic changes to how they make decisions, especially if those decisions come from the deliberations of a 12-member committee (like the Federal Open Market Committee). Like forecasting models, large institutions are also, for the most part, backward-looking. That means the decision makers tend to be cautious or conservative in their decision-making processes.5
Unfortunately, that tendency-towards-caution may be affecting the Fed’s forecasts, and in turn, the effectiveness of their policy choices.
This “stable” value is related to the concept in macroeconomics called “Potential GDP,” explained in this Macrosight post, “A Potential GDP-Explainer”.
While the labor force participation rate is still below pre-Covid-19 levels, that is not necessarily surprising. A fall in that statistic would be happening with or without Covid-19 (given the on-going retirements of the Baby Boomers). If you look instead at the labor force participation rate for 25 to 54 year-olds, the rate is above pre-Covid-19 levels.
These averages are based on averaging over the quarterly year-over-year percent changes. If one calculated quarterly growth using annualized quarter-to-quarter percent changes, the averages for these time periods are as follows: 2000 to 2025Q1 = 2.14 percent; 2021Q1 to 2025Q1 = 2.9 percent; 2022Q1 to 2025Q1 = 2.2 percent. The latter is at least a bit closer to the Fed’s 1.8 percent.
The Fed’s caution is pretty easy to see in their public statements. While those statements recently have emphasized a “wait-and-see” approach given uncertainty over tariff policy, such a “wait and see” approach is nothing new.