From James Hamilton: Central Bank of Cyprus Governor Athanasios Orphanides and Goethe University Professor Volker Wieland (both former staff economists of the U.S. Federal Reserve Board).... explored what happens when we try to explain the fed funds rate not from the actual values of inflation and GDP, as in Taylor's original formulation, but instead with the forecasts of inflation and GDP that the Fed provides through its semiannual Humphrey-Hawkins report. Brandeis Professor Stephen Cecchetti, former Director of Research at the Federal Reserve Bank of New York and Associate Economist of the Federal Open Market Committee, protested that these forecasts were sometimes produced in a somewhat ad hoc fashion. But Orphanides and Wieland noted that the fit of a Taylor Rule to the data improved substantially when forecasts were used in place of actual outcomes as explanatory values in the regression, with the Rbar squared increasing from 0.74 to 0.91. In particular, the forecasts explain why the Fed chose to cut interest rates a little sooner in the early phases of the recessions of 1990 and 2001, as the Fed (correctly) anticipated the downturn. On the other hand, an error in predicting the resurgence of inflation in 2003-2004 may explain some of the slowness of the Fed to raise interest rates, on which we've commented previously.
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