BERNANKE: Mr. Chairman, as you noted, our forecast is for moderate, but positive growth going forward for the next few quarters. Economists are extremely bad at predicting turning points, and we don't pretend to be any better. We have not calculated the probability of recession, and I wouldn't want to offer that today.

During the Q&A session

One of the most significant changes in the U.S. economy over the past quarter century has been the marked reduction in economic volatility. Following the terminology of the Great Depression and the Great Inflation, this period of increased stability has been termed “The Great Moderation.”

The Great Moderation—this period of relatively stable GDP growth—has been accompanied by a lower average level and reduced volatility of long-term interest rates. The more stable financial environment makes it easier for firms and households to plan for the future. The Great Moderation has also made the job of forecasters somewhat easier.

The financial market turmoil that began in August hit hard an already struggling housing market. Financial markets appear to be stabilizing, but they have not returned to normal and are still fragile. Most forecasters have reduced their expectations for GDP growth and believe that downside risks have risen. However, the employment report for September, the latest available at this time, does not suggest that the downside risk is occurring. As an aside, the substantial upward revisions to data released in the August report remind us that it is a mistake to place too much weight on any one report.

Econometric models can estimate approximate effects on the overall economy from changes in real estate activity. Still, economists know that our knowledge is incomplete. It is no secret that the downturn in residential real estate activity is more severe than most forecasters expected only a few months ago.

     Well, we approach {energy price forecasting} at the Federal Reserve on essentially two levels.

     First, we try to do a fundamental supply-and-demand analysis, try to look at how we expect demand to grow both not only in the United States, of course, but in emerging markets and around the world and where we see supply emerging in OPEC and outside of OPEC, and try to make some sense of where that market is going.

     But another very important piece of information is futures markets. Investors in -- dealing in NYMEX and other futures markets put their money, essentially making bets where they think the price of oil is going to be at various horizons going out to six or more years.

     Those futures markets have been wrong in the past. They have underestimated the increase in oil prices that we've seen, which is one reason why we're very cautious about it. But over long periods of time they're probably about the best source of information we have about where the markets see energy prices going.

     And so the markets -- those energy markets currently see oil prices remaining high, but leveling off over the next couple of years, to the point where, if that actually happens, overall headline inflation would be about the same as core inflation.

From the Q&A session

Indeed, considerable progress has been made in recent years, at the Board and elsewhere, in developing dynamic stochastic general equilibrium (DSGE) models detailed enough for policy application. These models have become increasingly useful for policy analysis and for the simulation of alternative scenarios. They are likely to play a more significant role in the forecasting process over time as well, though, like other formal methods, they are unlikely to displace expert judgment.

 Interestingly, however, the system approach does not seem to forecast price inflation as well as single-equation Phillips curve models do. This weaker performance appears to reflect, at least in part, the shortcomings of the available data on labor compensation. The two principal quarterly indicators of aggregate hourly compensation are the employment cost index (ECI) and nonfarm compensation per hour (CPH). Both are imperfect measures of the labor costs relevant to pricing decisions. For example, the ECI's fixed employment and occupation weights may not reflect changes in the labor market, and the ECI excludes stock options and similar forms of payment. CPH is volatile, perhaps in part because it measures stock options at exercise rather than when granted, and it is subject to substantial revisions. Moreover, these two hourly compensation measures often give contradictory signals.

[T]he judgments associated with monetary policy are not always as obvious as they might appear. Economic conditions can be unpredictable, and we are under no illusion that we are perfect forecasters. To paraphrase former Federal Reserve Chairman Alan Greenspan, we are essentially risk managers. We need to make policy choices that stand the best chance of moving us toward our objectives, given our imperfect understanding of the changing environment around us.

I hope that forecasters assign very low probability to inflation outcomes over the medium term of three to five years outside the comfort zone no matter what the incoming data look like...

Still, I believe forecasters should assign a relatively low probability to deep recession precisely because of the FOMC’s demonstrated willingness to act aggressively as necessary. 
 

In the monetary policy context, research suggests that inflation-forecasting models have not worked very well in recent years. The reason, I believe, is that the Federal Reserve has been pretty successful in exploiting all available public information in its monetary policy decisions aimed at maintaining low and stable inflation.

The analysis in our study suggests that although Iceland's economy does have some imbalances that will eventually be reversed, financial fragility is currently not a problem, and the likelihood of a financial meltdown is low.

Accordingly, for me, the critical indicators in the time ahead will be the ones that signal whether growth is indeed likely to proceed at a sustainable pace and whether inflation remains on a favorable track. This is a judgment my colleagues and I will need to make meeting by meeting as the incoming information--both the data and, critically, the timely feel for developments that we get from the Reserve Banks' contacts in the community--help us assess the paths for the economy and price pressures.

I think that the market is reading the current numbers in a very sensible way. And what I think we are - need to pay attention to are not little nuances around the current numbers but rather the bigger things that may come along and surprise us. When everything is coming in on-track, no surprises, there really shouldn't be very much to talk about. We need to be thinking ahead to surprises.

Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.

Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.

Finally, the yield curve is only one of the financial indicators that researchers have found useful in predicting swings in economic activity. Other indicators that have had empirical success in the past, including corporate risk spreads, would seem to be consistent with continuing solid economic growth. In that regard, the fact that actual and implied volatilities of most financial prices remain subdued suggests that market participants do not harbor significant reservations about the economic outlook.

Given this reality, policymakers are well advised to follow two principles familiar to navigators throughout the ages:  First, determine your position frequently. Second, use as many guides or landmarks as are available In the context of monetary policy, these principles suggest that policymakers should monitor bond yields carefully in judging the current state of the economy--but only in tandem with the signals from other important financial variables; direct readings on spending, production, and prices; and a goodly helping of qualitative information. Ultimately, a robust approach to policymaking requires the use of multiple sources of information and multiple methods of analysis, combined with frequent reality checks. By not tying policy to a small set of forecast indicators, we may sacrifice some degree of simplicity, but we are less likely to be misled when a favored variable behaves in an unusual manner.