Forecasts , Indicators , And Monetary Policy

Conducti ng monetary policy is a difficult business. It's easy enough to set a policy goal such as price stability or low and stable inflation , but because monetary policy affects the economy with a lag, achieving those goals requires an ability to peer into the future. A change in the money supply or interest rates today won't affect inflation for months, or even years, down the road. Consequently, policymakers use economic models and forecasts to help them make decisions. Historically, economists and policymakers have used two major approaches to help predict future outcomes. The first approach relies on large-scale statistical models of the economy that capture historical relationships among hundreds of economic variables. The second approach is simpler: focus on small models containing just a few variables, such as money growth and interest rates, that seem to provide information about future output growth, employment , and inflation. Unfortunately, such models can fail to give reliable predictions, especially when factors affecting the economy change in a major way. Thus, after the oil-price shocks of the 1970s, fore-*Keith Sill is a senior economist in the Research Department of the Philadelphia Fed.