In her press conference on Wednesday Federal Reserve chair Janet Yellen used the term “data dependent” three times as she has been stressing the idea that the Fed will act based on the economic data they receive.
But is the fed as data dependent as she claims?
Goldman Sachs’ Zach Pandl and David Mericle measured the data dependency of the Fed since it first began publishing the “dot plot” in January 2012. Pandl and Mericle found that federal funds rate projections have, on average, been responsive to changes in the outlook for unemployment and inflation. They shared their findings in a note to clients on Thursday.
The pair made their calculations by comparing the changes in the federal funds rate projections to changes in inflation, unemployment, and the neutral funds rate. They found a relatively low sensitivity to both unemployment and inflation compared to Taylor’s Rule. (Simply put, Taylor’s rule is a formula that recommends how central banks should respond to unemployment and inflation levels when setting interest rates.) This implies that the Fed could be relying on other data instead.
However, Pandl and Mericle found that the Fed has shown a trend of becoming increasingly data dependent, especially in the last six months. Still, they said they can’t definitively say whether the “dot plot” from the June FOMC meeting is data dependent or not.They describe it as a “mixed verdict” which might imply that the Fed is allowing fears to kick in rather than working straight from the economic indicators.
On the one hand, the downgrade of the 2015 dots was broadly consistent with the revisions to the SEP forecasts for inflation and unemployment. On the other hand, for the three-year projections as a whole, the downward revisions were larger — by about one 25bp hike — than can be explained with changes in the economic forecast and a standard policy rule. This suggests that other considerations could have played a role in yesterday’s decision, such as an extra degree of caution nearing liftoff, or a renewed focus on “headwinds” given the weakness in Q1 GDP growth.