Why Is the Federal Reserve Always Surprised by Inflation?

The central bank owes the public an explanation—and a serious effort to correct its flawed model.

By Joseph C. Sternberg of The WSJ. Excerpts:

"the central bank’s model of the economy—the set of spreadsheets, as it were, that are supposed to help Fed staff economists and leaders understand developments on Main Street.

The primary model, known as FRBUS, is impressive. Central-bank staff can plug some 500 variables into about 170 equations to try to understand how changes to the unemployment rate, household incomes, mortgage rates or myriad other factors might influence economic growth and inflation.

It’s also deeply flawed. FRBUS doesn’t adequately account for the effects of fiscal policy, such as the $10 trillion in cumulative deficit spending since the start of 2020, constituting subsidies and other expenditures Congress and successive administrations pumped into the economy. The model didn’t predict the inflationary consumption explosion of that era, and probably has way overstated the (largely illusory) benefits of government infrastructure spending for future productivity and economic growth. The model chronically misunderstands the labor market, and overestimates the effect of a tight labor market on inflation. 

Perversely, the model also assumes that inflation will return to the Fed’s 2% target because people will believe officials when they say inflation will be 2%. If that sounds like circular thinking, it’s because it is. Worse, because the central bank’s models overemphasize the role of everyone’s expectations of future inflation as an input into current inflation, the Fed focuses on shaping those expectations via forward guidance. Yet when that forward guidance is based on an erroneous model of inflation . . . At this point the mind really does start to boggle."