Forecasting and Policy Making (Paper) - Center for Financial Studies

cent in 2010. As usual, the CBO’s near-term outlook was based on the assumption that ”current laws
and policies governing federal spending and taxes do not change ,” and therefore did ”not include the
effects of a possible fiscal stimulus package”. 1 On January 9, President Obama’s advisers Christina
Romer and Jared Bernstein circulated a report on the impact of the American Recovery and Rein-
vestment Plan predicting that such a plan could raise GDP by 3.6 percent above the baseline forecast
within 2 years (Romer and Bernstein, ????). Their calculations were based on measures of govern-
ment spending and tax multipliers obtained from private sector forecasters and the Federal Reserve.
Over the course of January and early February 2009, CBO prepared several budgetary and economic
impact forecasts of the stimulus legislation debated and eventually passed in the House of Represen-
tatives and the Senate in response to requests by members of U.S. Congress. On March 20, 2009 CBO
released an update of its budget and economic outlook taking into account the policy changes implied
by the ARRA as well as new incoming economic data suggesting a more negative economic outlook
than the data available for the January forecast. 2 On this basis, they predicted a steeper decline of real
GDP in 2009 of -3.0 percent followed by an increase of 2.9 percent in 2010.
This example shows that economic policy is not only based on macroeconomic forecasts, but that
the path of policy itself has a direct effect on projections of macroeconomic aggregates. Thus, fore-
casters need to base their predictions on specific assumptions regarding future policy. For example,
professional forecasters and macroeconomists often use a particular future path for fiscal policy that
they consider most likely to occur or an estimated feedback rule that accounts for the response of
future policy to projected future economic conditions. Forecasters employed by policy institutions
typically also consider forecasts that are conditioned on unchanged policy as in the case of the CBO
outlook. While such forecasts do not represent their best possible prediction of the future course of
events, they are often used as a benchmark for the policy debate that helps set up desirable policy
changes. Another important issue concerns the choice of economic model on which the forecast is to
be conditioned. With regard to the ARRA, for example, a study by Cogan et al. (2010) using state-
of-the-art New Keynesian models estimated much smaller multipliers than the models in Romer and
Bernstein and predicted only about 1/6 of the GDP impact. 3
In the following, we will explore the use of different forecasting techniques, macroeconomic mod-
els and conditioning assumptions in economic policy making. In terms of applications, our focus will
be more on monetary than on fiscal policy. Forecasts play an important role in regular monetary policy
decisions such as interest rate changes, but also in the timing of unconventional policy such as quanti-
tative easing, and major structural changes such as the formation of a currency union. Many monetary
economists even argue that monetary policy should use an inflation forecast as an intermediate policy
target,(Svensson, 1997). In the last twenty years a number of countries have adopted explicit inflation
targeting regimes, in which the stance of policy is adjusted to ensure that the inflation rate is projected
1 See Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2009 to 2019, January 2009.
2 See Congressional Budget Office, A Preliminary Analysis of the President’s Budget and an Update of CBO’s Budget
and Economic Outlook, March 20, 2009.
3 A first working paper version was circulated shortly after the bill was passed in February.
4