Editors' Summary

The brookings panel on Economic Activity held its seventy-fourth conference in Washington, D.C., on September 5 and 6, 2002. This issue of Brookings Papers on Economic Activity includes the papers and discussions presented at the conference. The first paper reviews the process and methods of inflation and output forecasting at four central banks and proposes strategies for improving the usefulness of their formal economic models for policymaking. The second paper analyzes the implications for monetary policymaking of uncertainty about the levels of the natural rates of unemployment and interest. The third paper examines reasons for the recent rise in current account deficits in the lower-income countries of Europe and the role of economic integration in breaking the link between domestic saving and domestic investment. The fourth paper applies a new decomposition of productivity growth to a new database of income-side output to examine the recent speedup in U.S. productivity growth and the contribution made by new economy industries.

Despite a growing transparency in the conduct of monetary policy at many central banks, little is still known publicly about the actual process of central bank decisionmaking. In the first paper of this issue, Christopher Sims examines this process, drawing on interviews with staff and policy committee members from the Swedish Riksbank, the European Central Bank, the Bank of England, and the U.S. Federal Reserve. Central bank policy actions are inevitably based on forecasts of inflation and output. Sims' interviews focused on how those forecasts are made, how uncertainty is dealt with, and what role formal economic models play in the process. In the case of the Federal Reserve, a history of subjective and model-based forecasts is publicly available, allowing Sims to evaluate and compare their performance both with each other and with private forecasts. He offers observations about how the performance of large econometric models could be improved, and how statistical inferences from them could be made more useful to policymakers.

Sims begins with an informative overview of the process that takes place at each of the central banks before policy decisions are made. Within each institution, a policy round proceeds through a number of meetings among staff through which a forecast is arrived at iteratively, but the number of meetings, the way discussions are ordered, and the involvement of policy board members all vary. At the Federal Reserve, staff prepare the forecasts without policy board participation. At the other central banks there is typically some involvement of the policy board, and at the Bank of England some board members attend the meetings from the earliest stages. Each central bank has a primary macroeconomic model (the Riksbank has two) that is used to construct projections of the economy conditional upon various assumptions about future disturbances or policies; each also informally uses one or more secondary models. Sectoral experts play a major role at all four central banks. At the Federal Reserve their forecasts are compared with those from the primary model, and discrepancies serve as a basis for further discussion and possible adjustment of the primary model's forecast. The Federal Reserve's Green Book and the Bank of England's inflation reports summarize the results of the forecasting process and present a variety of potential time paths for the economy, which serve to communicate forecasting uncertainty. Other central banks also typically consider a range of outcomes.

Sims examines the situation at the Federal Reserve in greater detail than the others, analyzing the accuracy of the staff forecasts for inflation and output. These are publicly available, with access restricted only by a five-year nondisclosure rule. He expands in several ways on a recent study of the judgmental Green Book forecasts by Christine Romer and David Romer, adding four or five years of data, including the Federal Reserve's model-based forecasts in the assessment, and comparing both sets of forecasts with private forecasts. Through 1995 the model-based forecasts were based on the MIT-Penn-SSRC (MPS) model, developed in a collaborative academic effort and maintained by the Federal Reserve staff. Since then, model forecasts have been based on the new FRB/US model developed within the Federal...