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short essays and reports on the economic issues of the day
2005 ■ Number 14

Battle at Bond Bluff: Forecasters vs. Financial Markets
Kevin L. Kliesen
n June 30, 2004, when the FOMC upped its intended
federal funds rate by 25 basis points to 1.25 percent, the
data indicated that core CPI had risen by about 1.75 percent for that year (May 2003 to May 2004) and yields on 10-year
Treasury securities had averaged about 4.75 percent that month.
It worried policymakers somewhat that core inflation and longterm interest rates had moved noticeably higher over the previous few months and that the spot price of crude oil (West Texas
Intermediate) was up a little less than 25 percent from a year earlier.
Still, the latest Blue Chip Consensus forecast projected solid real
GDP growth in 2005 (3.5 percent), with moderate CPI inflation
(2.2 percent); the Blue Chip does not forecast the core CPI.
As it stands now, the federal funds rate has been raised to 3
percent and oil prices are up even more; however, as seen in the
chart, the Blue Chip Consensus forecast for real GDP growth has
been remarkably stable. Indeed, the forecast for real GDP growth
in 2005 has remained within a fairly narrow range for most of
the past year despite a rise in the spot price of oil to an average
of $54.31 per barrel by March 2005, an increase of more than 58
percent since January 2004. (The chart indexes oil prices to be 1
in January 2004.)
In a recent speech, Federal Reserve Bank of St. Louis President
William Poole remarked that “the stability of the economy is
reflected in the stability of the forecasts.” But while forecasts for
real GDP growth in 2005 have been remarkably stable, forecasts for core CPI inflation in 2005 have been moving steadily
higher. According to the private-sector forecasting firm
Macroeconomic Advisers, the expected increase in the core
CPI in 2005 has risen from 1.7 percent in January 2004 to 2.5
percent in May 2005. If realized, the 2005 increase would be
the highest core inflation rate in four years.
The steady rise in core inflation forecasts is potentially
worrisome in view of the role that expectations have come to
play in the policymaking process. Over time, monetary policymakers have realized that they can potentially exert influence
over economic activity by affecting expectations of future inflation. Hence, a key part of economic stability is the expectation
of low inflation.
Yet, as the chart also shows, financial markets appear to
have shrugged off the upcreep in expected core inflation. After
peaking at an average of about 4.75 percent in June 2004, the


yield on the 10-year Treasury security has dropped to about 4
percent. The fall in long-term interest rates in the face of rising
inflation, higher oil prices, and continued solid growth prospects
is something of a puzzle. If anything, a decline in long-term yields
in the face of stable economic growth prospects usually means
the market is betting on lower future inflation—implying that
the market views the recent rise in inflation as temporary.
But another view emerged in May, as forecasters trimmed
their 2005 real GDP growth forecast to 3.2 percent. This revision,
more or less, was consistent with the story that long-term interest
rates were declining because of an expectation of weaker growth
going forward (lower real yields). It is possible, though, that this
downward revision in the 2005 forecast was a response to the
weaker-than-expected advance estimate of first-quarter real GDP
growth (3.1 percent). Since then, first-quarter growth has been
revised upward to 3.5 percent and several indicators of economic
conditions in April have come in much better than expected. If
nominal interest rates continue to remain stable in the face of
solid growth, then the interest rate puzzle may simply reflect a
more sanguine inflation outlook from the bond market than from
forecasters. ■

Forecasts for 2005 (Q4/Q4) and Oil Prices and
Long-Term Interest Rates

Index, January 2004 = 1.0
10-Year Yield


Real GDP Growth


Oil Prices (Index)


Core CPI
June 2004










SOURCE: Federal Reserve Bank of St. Louis, Blue Chip Indicators (real GDP), and
Macroeconomic Advisers (Core CPI).

Views expressed do not necessarily reflect official positions of the Federal Reserve System.