Examining Macroeconomic Shocks Based on FOMC Projections

Abstract

Each quarter the Federal Open Market Committee (FOMC) release the projections of its members for the current year values and several future year values of inflation, unemployment, real GDP growth, and the Federal Funds Rate and the overall report that is released is called Summary of Economic Projections (SEP). This thesis examines these projections through the lens of a standard textbook New Keynesian (NK) macro model. Typically, this model is used to generate impulse response functions to trace out the effect of a shock on the path of output, inflation, and interest rates over time. This study reverses this approach to derive the values of the shocks consisted in FOMC projections. We developed the empirical model by using the method of undetermined coefficients to determine the values of the model parameters. Based on this model, we solved for the values of the macroeconomic shocks. We assumed there are three shocks in the economy -the supply shock, the preference shock and the policy shock. The results should be taken as a beginning and not the final word on any issue surrounding the FOMC projections. But this study is informative in demonstrating the evolving nature of the FOMC projections and the implied values of the shocks within a standard model. The results have three perspectives. First, there are the implied value of the three shocks for the current and future years, all based on FOMC projections in December, September, June and March for 2019 to 2022. We compare the path of the FOMC-projected shocks to the path each shock would take from the current year value into the future based on the AR(1) model of the shocks. A second perspective is to examine these episodes for supply shock using alternative values for the AR(1) coefficients. A third perspective is provided by using realized historic values of the variables that the FOMC projects to calculate the implied values of the shocks, and compare these to the value of the shocks from FOMC projections. We aimed to understand Fed’s policy-making better and to understand Fed’s lengthy period of labelling inflation as “transitory” as well as their delay in starting to respond to the rising inflation rates with increase in the policy rate as one would expect from a Taylor rule.