In my last post, I asserted:

The actual amount of tightening will ultimately depend on the evolution of the forecasts for unemployment and inflation. If the expectation for unemployment drifts lower for this year, for instance, the median dots are likely to shift higher to ensure that the Fed continues to meet its mandate.

Can we quantify the impact of a changing economic forecast on the projected amount of tightening this year? Yes, using the methodology of Federal Reserve Bank of San Francisco economists Fernanda Nechio and Glenn Rudebusch. In a recent article, they argue the change in the Federal Reserve’s 2016 projected rate increase from 100bp to 25bp was consistent with a simple extension of a Taylor-type policy rule, specifically:

Funds rate revision = neutral rate revision + (1.5 × inflation revision) – (2 × unemployment gap revision).

Recall that the interest rate projections contained in the Fed’s Summary of Economic Projections (SEP) are not policy commitments. They are forecasts that we should expect to change with evolving forecasts of key variables, notably inflation and unemployment. The Fed’s credibility should not be judged on the accuracy of its rate forecast. It should be judged on its ability to meet its mandate. Actual policy should shift relative to the rate forecast as economic conditions change.

We can look to the December 2016 SEP as an example of the Nechio-Rudebusch approach. The Fed’s median rate forecast for 2017 rose 0.3 percentage points relative to the September SEP (Note: There is a rounding issue here. Effectively, the forecast changed from two to three 25bp hikes). The median neutral rate estimate (the longer run forecast of the funds rate) rose 0.1 percentage points. The inflation forecast (Nechio-Rudebusch use core inflation) was unchanged. The unemployment forecast fell 0.1 percentage points while the estimate of the natural rate of unemployment (the longer run forecast of the unemployment rate) remained unchanged. Thus the Fed revised down the unemployment gap estimate by 0.1 percentage points.

Applying the Nechio-Rudebusch policy rule:

0.3 percentage points = 0.1 percentage points + (1.5 x 0.0 percentage points) – (2 x (-0.1 percentage points)

In other words, the changing economic forecast for 2017 explains the magnitude of the change in the 2017 rate projection. Thus, we should watch incoming data for its impact on the forecasts for key variables to estimate its impact on policy.

In practice, we might expect minimal revisions of the longer run rates of interest and unemployment over the course of 2017. The estimate of the neutral interest rate declined substantially in 2015 and early 2016, but I suspect that pattern will not repeat in 2017. The estimate has already held fairly steady since the June 2016 SEP. Also note that the Laubach-Williams estimates of the natural rate of interest are now edging upward:

The era of declining estimates of the natural rate of interest may be over. Likewise, the estimate of the natural rate of unemployment remains at the March 2016 SEP. Assuming these parameters remain constant in 2017, the variation in the fed funds rate projection will depend on the unemployment and inflation and inflation forecasts.

As a practical example, I view the December employment report as consistent with the December SEP economic forecasts. The pace of underlying job growth continues to slow toward a range that is likely consistent with a steady unemployment rate after the demographic impacts on labor participation reassert themselves. This suggests the Fed’s forecast for a fairly small (0.2 percentage points) fall in the unemployment rate is largely unchanged. Hence, the employment report should not impact the median rate forecast for 2017.

Bottom Line: The Fed’s policy stance shifts in consistent manner. Important to understanding these shifts is estimating the impacts of incoming data on the Fed’s medium term forecast. In my opinion, the policymakers spend too little time discussing the impact of incoming data on their forecasts, leading to the perception that policy is more backward than forward looking. The above example illustrates, however, the importance of the latter for monetary policy.