Monetary policy is arguably the most important factor for forecasting the price level over the next few years. By understanding how the Federal Reserve intends to conduct monetary policy, one can form a reasonable expectation of how the price level is likely to evolve.
The Federal Open Market Committee (FOMC) is the Federal Reserve’s monetary policy committee. It consists of the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, each of whom serve a one-year term on rotation.
The FOMC meets eight times per year to assess the condition of the economy and determine the appropriate course of monetary policy given the Federal Reserve’s Congressional mandate to promote maximum employment, stable prices, and moderate long term interest rates.
Four times per year, each FOMC participant submits a projection of the most likely outcome for inflation in the personal consumption expenditure price index (PCEPI). These projections are based on information available at the time of the meeting and are made under the assumption that monetary policy will be conducted appropriately, as each individual FOMC member sees it, and that the economy is not affected by any unforeseen disturbances.
Given FOMC member projections, it is relatively straightforward to forecast the price level under the assumptions that (1) the FOMC conducts monetary policy as the median committee member intends, (2) there are no unforeseen disturbances to the economy over the forecast period, and (3) projected inflation is constant from month to month across each year.
In assessing the extent to which the median FOMC member projection is accurate, one must keep assumptions (2) and (3) in mind. Unforeseen disturbances to the economy might result in a higher or lower price level than was anticipated, but this does not necessarily imply that the initial projection was biased.
Likewise, a variable monthly inflation rate does not imply the median FOMC member’s projection is inaccurate, since above-projection inflation might be offset by below-projection inflation over the course of the year. With this in mind, it is perhaps most appropriate to evaluate projections at the end of each year.
We present the price level alongside the forecasted price level based on median FOMC member projections, noting parenthetically when the forecast was made. Each series uses January 2020 as the base year, meaning each observation is expressed as a percent of the observation in January 2020.