Gauging the Guidance that Models Give the Fed

January 10, 2013

The Federal Reserve plans to keep short-term interest rates close to zero until the unemployment rate falls to 6.5 percent. How the Fed decided to make that policy is a little known fact about the central bank. The Fed uses computer-modeling programs called Ferbus, Edo and Sigma to make predictions about how different policies and events will impact the economy, says the Wall Street Journal.

The main economic model, FRB/US (Ferbus), was launched in 1995 and uses hundreds of mathematical equations to analyze the economy. Different factors can be punched in such as lower interest rates or an increase in government spending and Ferbus will generate a model that predicts the impact on growth and inflation.

The Fed used this model to analyze how long it can keep interest rates low without generating too much inflation. However, the models are deeply flawed.

  • They failed to predict the financial crisis in 2008.
  • Furthermore, they have overestimated the strength of the economy for several years.
  • In addition, they have gaps in how they read and project the economy.
  • For instance, they ignore the nuances of the financial system such as how vulnerable banks are to a financial panic and the effect on the broader economy.  In 1994, small increases in short-term interest rates led to a sharp rise in long-term interest rates. However, the models didn't predict the financial chaos that such a policy would have.

Fed chairman Ben Bernanke has acknowledged the problem and is working on improving the models to better account for financial crises. Fed officials continue to claim that the economic models are not the only things they look at when constructing forecasts and analyses. Rather, the models help them think about the problem.

Some advocates of the model think that critics are too harsh, arguing that the models have made important strides in recent years to include much more detail on the financial sector.

Source: "Gauging the Guidance That Models Give the Fed," Wall Street Journal, December 30, 2012.

 

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