Given our inevitably incomplete knowledge about key structural aspects of an ever-changing economy and the sometimes asymmetric costs or benefits of particular outcomes, the paradigm on which we have settled has come to involve, at its core, crucial elements of risk management. In this approach, a central bank needs to consider not only the most likely future path for the economy but also the distribution of possible outcomes about that path. The decisionmakers then need to reach a judgment about the probabilities, costs, and benefits of various possible outcomes under alternative choices for policy.

The risk-management approach has gained greater traction as a consequence of the step-up in globalization and the technological changes of the 1990s, which found us adjusting to events without the comfort of relevant history to guide us. Forecasts of change in the global economic structure--for that is what we are now required to construct--can usefully be described only in probabalistic terms. In other words, point forecasts need to be supplemented by a clear understanding of the nature and magnitude of the risks that surround them.

With respect to forecast errors, the future is more likely to be like the past several decades than like the past year.

When we put all the recent data together, we get a mixed picture that does not require a fundamental change to the outlook. Nevertheless, we should not forget the usual forecast errors.

The fact is that the standard error for the one-month change in payroll numbers is nearly 70,000, and making too much of any one monthly number is ill-advised...it is important to not overemphasize short-term deviations while ignoring long term trends.

[U]nder a forecast-based policy regime, policymakers must predict how the economy is likely to respond in the medium term--say, over the next six to eight quarters--to alternative plans for monetary policy.

Under the forecast-based approach, in contrast, the public will generally find inferring the likely course of policy to be a great deal more difficult. In that regime, policy plans depend in a complex way on policymakers' outlooks, risk assessments, and objectives, which the public is unlikely to deduce accurately without guidance. Clear communication thus appears to be especially important for central banks that employ a forecast-based approach to policy--a category that includes most contemporary central banks, including the Federal Reserve.

The use of "fan charts" to indicate the range of uncertainty would be helpful in this regard[forecasting future Fed policy]; and indeed, providing more information about uncertainty for all FOMC forecasts would be a useful innovation.

When thinking about the outlook, I am always well aware that the only sensible stance for me is to be an informed consumer of forecasts. I am not myself an expert forecaster, and do not—cannot—spend enough time forecasting to expect to outperform those who make a living from that occupation.

Every forecaster must cope with how best to convey not only what he believes to be the most likely outcome in the forecast, but the uncertainty around that forecast. No method is perfect, but the fan chart has a number of favorable characteristics. It encompasses in one picture not only the most likely outcome, but the growing uncertainty about that outcome as one moves into the future, and any sense that the risks around the outcome are skewed more in one direction or the other. And comparing fan charts between Reports can convey shifts in uncertainty and risks over time, as well as changes in the central tendency.

The inflation forecast and the inflation report are key elements in making policy under the inflation target set by the government and in explaining the policy to the public. MPC members agreed that the process of arriving at the forecast has many useful aspects. It has helped the Committee come to some common understandings on a basic framework for analysis of economic developments, the causes of inflation, and the transmission of monetary policy.

In light of these difficulties, the first priority of the MPC might be to improve the clarity and usefulness of its current forecast made under constant interest rates. To further aid the public in forming expectations about future interest rate changes, the Committee might consider extending the forecast beyond two years either formally in the fan chart, or informally in a discussion of tendencies. Such an extension, together with information about the risks to the forecast, should help the public make informed judgments about the likely course of interest rates. In addition, the Committee might encourage research on how it could determine and publish any views it had about the possible future evolution of the policy rate.

At the Board, the staff forecast, presented in the Greenbook prior to each of the eight FOMC meetings each year, is fundamentally judgmental. It is developed by a team of sector specialists who consult, but are not bound by, a number of structural econometric equations describing their sectors, and further armed, in some cases, with reduced-form equations and atheoretical time series models. The team develops the forecast within the context of agreed-upon conditioning assumptions, including, for example, a path for short-term interest rates, fiscal policy, oil prices, and foreign economic policies. They begin with an income constraint and then participate in an interactive process of revisions to ensure that the aggregation of sector forecasts is consistent with the evolving forecast for the overall level of output.

The best story I know is the one about an economic forecaster who was sitting in front of his computer one night, and all of a sudden, a genie came out of the tube and told him that he was his personal genie. He could have anything he wanted, but he had one wish, only one wish. But that wish could be anything he wanted.

So the economist, who had been in the business for about 25 years, the forecaster had, and he wasn't doing as well as he would like financially. He thought for a while and he said. Tell you what I'd like to have as my one wish. I'd like to have $10 billion. That'll make me the richest, certainly the richest economic forecaster in the world.

 Well, when he said, the genie got a very frightened look on his face, and said, you know, I'm a genie and I've got a lot of magic.

But that's a lot of money; that's a tall order. Just in case I can't pull it off how about giving me a backup wish? So the forecaster thought long and hard finally he said, you know, I'll tell you what, my backup wish is I've forecasting now for 25 years and my backup wish is that this year, in '96, I get my economic forecast right. The genie just looked at him and said I'll have the money for you in the morning!