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Complete Issue F EDERAL R ESER VE B FEDERAL RESERVE BANK OF ST. LOUIS ANK OF S T L OUIS R EVIEW MAY/JUNE 2004 VOLUME 86, NUMBER 3 Best Guesses and Surprises William Poole R EVIEW Monetary Policy Actions, Macroeconomic Data Releases, and Inflation Expectations Kevin L. Kliesen and Frank A. Schmid A Rational Pricing Explanation for the Failure of the CAPM Hui Guo How Costly Is Sustained Low Inflation for the U.S. Economy? James B. Bullard and Steven Russell M A Y / J UNE 2004 • V OL UME 86, N UMBER 3 Contents Volume 86, Number 3 R EVIEW 1 Best Guesses and Surprises Director of Research William Poole Robert H. Rasche Deputy Director of Research This article was originally presented as a Cletus C. Coughlin speech at the Charlotte Economics Club, Review Editor Charlotte, North Carolina, February 25, 2004. William T. Gavin 9 Monetary Policy Actions, Macroeconomic Research Economists Data Releases, and Inflation Expectations Richard G. Anderson James B. Bullard Kevin L. Kliesen and Frank A. Schmid Michael J. Dueker Thomas A. Garrett This article analyzes how announced surprises R. Alton Gilbert in monetary policy actions and macroeconomic Hui Guo data releases affect the average rate of inflation Rubén Hernández-Murillo that economic agents expect to prevail over Kevin L. Kliesen the 10-year period following the surprise. The Christopher J. Neely analysis also addresses the effect of Federal Edward Nelson Reserve communication and surprises in Michael T. Owyang Michael R. Pakko monetary policy actions on perceived inflation Jeremy M. Piger risk over this 10-year period. The study shows Patricia S. Pollard that surprises in macroeconomic data releases Frank A. Schmid and monetary policy actions indeed affect the Daniel L. Thornton expected rate of inflation. Further, there is Howard J. Wall evidence that surprises in monetary policy David C. Wheelock actions increase perceived inflation risk, whereas Federal Reserve communication Managing Editor reduces it. George E. Fortier Assistant Editor 23 A Rational Pricing Explanation for the Lydia H. Johnson Failure of the CAPM Graphic Designer Donna M. Stiller Hui Guo Review is published six times per year by the Research Division of the Federal Reserve Bank of St. Louis and may be accessed at our new Many authors have found that the capital web address: research.stlouisfed.org/publications/review. asset pricing model (CAPM) does not explain Single-copy subscriptions are also available free of charge. Send requests to: Federal Reserve Bank of St. Louis, Public Affairs Department, P.O. stock returns—possibly because it is only a Box 442, St. Louis, MO 63166-0442, or call (314) 444-8808 or 8809. special case of Merton’s (1973) intertemporal The views expressed are those of the individual authors and do not CAPM under the assumption of constant invest- necessarily reflect official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors. ment opportunities (e.g., a constant expected © 2004, The Federal Reserve Bank of St. Louis. equity premium). This paper explains the Articles may be reprinted, reproduced, published, distributed, displayed, progress that has been made by dropping the and transmitted in their entirety if this copyright notice is included. assumption that expected returns are constant. Please send a copy of any reprinted, published, or displayed materials to George Fortier, Research Division, Federal Reserve Bank of St. Louis, First, the evidence on the predictability of P.O. Box 442, St. Louis, MO 63166-0442; [email protected]. returns is summarized; then, an example from Please note: Abstracts, synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank Campbell (1993) is used to show how time- of St. Louis. Please contact the Research Division at the above address varying expected returns can lead to the rejec- to request permission. tion of the CAPM. ISSN 0014-9187 MAY/JUNE 2004 i R EVIEW 35 How Costly Is Sustained Low Inflation for the U.S. Economy? James B. Bullard and Steven Russell The authors study the welfare cost of inflation in a general equilibrium life-cycle model that includes households that live for many periods, production and capital, simple monetary and financial sectors, and a fairly elaborate govern- ment sector. The government’s taxation of capital income is not indexed for inflation. They find that a plausibly calibrated version of this model has a steady state that matches a variety of facts about the postwar U.S. economy. They use the model to estimate the welfare cost of permanent, policy-induced changes in the infla- tion rate and find that most of the costs of inflation are direct and indirect consequences of the fact that inflation increases the effective tax rate on capital income. The cost estimates are an order of magnitude larger than other estimates in the literature. ii MAY/JUNE 2004 Best Guesses and Surprises William Poole have a simple message today—that anyone Direct comparison of these forecasts is not straight- interested in monetary policy should spend forward, as there are differences among the variables less time on economic forecasts and more time for which the forecasts are presented, differences I in the forecasting time horizons, and differences in on implications of forecast surprises. If you are in the forecasting business, it makes good sense to averaging, with some forecasts presented on a fourth- write at length about the forecast and the analysis quarter to fourth-quarter basis and others presented behind it. For the rest of us, the forecast provides on an annual-average over annual-average basis. the baseline for examining the most important Nevertheless, at present a remarkably uniform policy issues. The true art of good monetary policy picture from a perusal of these various sources is in managing forecast surprises and not in doing emerges for the major economic indicators. Real the obvious things implied by the baseline forecast. gross domestic product (GDP) is forecast to grow in I’ll proceed by outlining the consensus outlook the 4 to 41/2 percent range from the fourth quarter and then will discuss how I view the job of dealing of 2003 to the fourth quarter of 2004. Inflation as with surprises. I’ll emphasize that the key issue is measured by the consumer price index (CPI) is fore- that monetary policy responses to surprises ought cast in the 11/2 to 2 percent range and as measured not to be random, but as predictable as possible. by the GDP chain price index is forecast in the 1 to There are some principles of good responses that 11/2 percent range over that horizon. The unemploy- make it easier for students of monetary policy to ment rate is forecast to be around 51/2 percent by predict what the Federal Reserve will do. the fourth quarter of 2004. Before digging into the substance of my subject, My colleagues around the Federal Open Market I want to emphasize that the views I express do not Committee (FOMC) table are on average slightly more necessarily reflect official positions of the Federal bullish than the above picture: The midpoint of the Reserve System. I thank my colleagues at the Federal range of forecasts of real GDP growth included in Reserve Bank of St. Louis for their comments— the Monetary Policy Report to the Congress submitted especially Bob Rasche, senior vice president and two weeks ago is 41/2 percent for the fourth quarter Director of Research, who provided special assis- of 2004 over the fourth quarter of 2003. The mid- tance. However, I retain full responsibility for errors. point of the range of inflation forecasts (measured by the chained price index for personal consumption CONSENSUS OUTLOOK TODAY expenditures) in that report is 1.13 percent, and the What is the consensus outlook for the U.S. econ- midpoint of the forecast for the unemployment rate omy today? Numerous forecasts are in the public in the fourth quarter of 2004 is 5.38 percent. I’ll refer domain, from government and private sources.1 to this forecast as the “FOMC members’ forecast.” The forecast reflects a survey of FOMC members, 1 A partial list includes Blue Chip Economic Indicators (published each month); Survey of Professional Forecasters (compiled quarterly by the (published each February in the Economic Report of the President and Federal Reserve Bank of Philadelphia); Wall Street Journal Forecasting updated each July); and Federal Reserve System, Monetary Policy Report Survey (published early January and July of each year); Congressional to the Congress (published each February and July), containing the Budget Office, Budget and Economic Outlook (published each February economic projections of the Federal Reserve governors and Reserve and August); Council of Economic Advisers economic outlook Bank presidents. William Poole is the president of the Federal Reserve Bank of St. Louis. This article was adapted from a speech of the same title presented at the Charlotte Economics Club, Charlotte, North Carolina, February 25, 2004. The author thanks colleagues at the Federal Reserve Bank of St. Louis. Robert H. Rasche, senior vice president and Director of Research, provided special assistance. The views expressed do not necessarily reflect official positions of the Federal Reserve System. Federal Reserve Bank of St. Louis Review, January/February 2004, 86(3), pp. 1-7. © 2003, The Federal Reserve Bank of St. Louis. MAY/JUNE 2004 1 Poole R EVIEW but is not an FOMC forecast per se because the all the three sets of forecasts considered. The root- Committee does not debate and vote on the forecast mean-squared forecast error for the naive forecast to make it a Committee forecast as such.
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