This Is How The Fed Predicts GDP

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by: Matthew Allbee

Summary

According to recent academic research, the Federal Reserve is better at forecasting future economic conditions that the private sector.

The Fed releases a predictor, widely followed by those on Wall Street, of next-quarter GDP to the public well before advanced GDP, the GDP NOW model.

You can use this models superior predictive power to better choose investments and profit from discrepancies with private forecasts and markets.

Understanding how the Federal Reserve forecasts future economic conditions is important for a number of reason. Of course, this will help you understand how the Fed will change monetary policy in the future. Also, according to a 2014 working paper, Federal Reserve forecasters are more accurate than their private counterparts. In this article, I will briefly go over some of the ways that the Federal Reserve does this. I will also introduce you to the Fed's GDP NOW model, a widely followed, publicly-available forecasting tool of the Fed.

The Federal Reserve has benefits over private forecasters which allow them better forecast future condition; information. Certainly, Fed employees have more information on where future monetary policy is going. With this, they can use their extra knowledge of how monetary policy would be set in different conditions to estimate how these changes would affect the economy with more precision.

For instance, this paper explains, the Fed's outperforms private inflation predictions. It finds, unsurprisingly, the Fed benefits from non-public information. Also, Fed forecasters use "professional judgment" and "qualitative information." Another factor in their outperformance.

With this knowledge being unavailable to the public, and may Fed forecasts being significantly time-delayed, how can we use this knowledge, though? This is where the GDP Now model becomes useful.

The GDP NOW model is released by the Atlanta Fed. It begins forecasting 90-days before the advance GDP estimate is released by the Fed, and is updated after most major economic releases (such as the non-farm payroll numbers). According to Forbes, this model performs better than most competing, private forecasts of this type. The GDP NOW forecast is also one of the forecasts that FOMC members receive before meetings.

Because of its use in FOMC meetings, anyone investing in interest-rate sensitive products needs to keep an eye on this number. Since it is so widely followed by Wall Street, changes are likely to affect markets in such products as bonds, financial stocks, cyclical and countercyclical stocks, currencies, and interest-rate sensitive commodities.

As this number is updated after most major releases, it is a good way to stay up-to-date on what economic growth forecasts are at the Fed, in almost real-time. Specifically, the FOMC has announced that it is likely to only raise interest rates if economic growth is significantly better than expected. The GDP Now model will give you insight into whether they believe this is happening.

Another possible opportunity would be if markets are becoming unhinged from the estimated growth that GDP Now is forecasting. While markets are usually efficient, they can sometimes stray from what is probably the best value. One instance of this is with expected GDP or future monetary policy. For instance, if markets are trading as if they didn't expect an interest rate hike for 6 months, but the GDP Now model is showing that the economy is heating up much more quickly than this would imply, you may be able to profit from this discrepancy.

This forecast should be vital information for any investor. Not only is it very accurate, but it is also used as a data point for FOMC decisions. This model can be used to help you prepare for an interest rate hike, or to prepare for a likely divergence between actual GDP and what private forecasters believe it will be. Either of these will help you make money.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.