P*: Not the Inflation Forecaster's Holy Grail

Abstract

Last summer, the Board of Governors of the Federal Reserve System unveiled a new, experimental way to forecast trends in inflation, which it calls P-Star (P*).The announcement received an enormous amount of publicity throughout-and even outside-the United States.One journalist captured the excitement and optimism generated by the new forecasting method particularly well: "Economists have long been searching for the holy grail-an accurate thermometer with which to forecast inflation. . . .Some think they have found it." 1 They haven't.At first glance, P* may look like an especially good way to forecast inflation.But a closer look raises doubts about that.And those doubts are confirmed by some simple tests of its forecasting ability.Had P* been used to forecast inflation in the 1970s and 1980s, its track record would not have been much better than those of other forecasting methods.While P* may not be a bad way to forecast inflation, it is certainly not an exceptionally good way either. What's So Appealing About P*?This new inflation forecasting method is appealing to many people because it is fairly simple, it seems to make sense, and it is consistent with a widely respected theory of what causes inflation in the long run.t Revision of a speech to the Board of Directors of the Federal Reserve Bank of Minneapolis on November 16,1989.The speech updates the author's report of December 12, 1988.The author has benefited from comments by Jeffrey Hallman, Richard Porter, and David Small.J The Board's new forecasting method is described in Hallman, Porter, and Small 1989.The above quotation is from the Economist (Business/Economics focus, 1989).Other P* publicity includes a front-page story in the New York Times (Kilborn 1989), two stories in the business section of a Sunday New York Times (Hunt 1989 and Lee 1989), and stories in Business Week (McNamee 1989) and the American Banker (Heinemann 1989). 2 M2 includes (1) the components of the Fed's Ml definition of money [currency held by the public, travelers' checks of nonbank issuers, demand deposits at banks and thrifts, negotiable order of withdrawal (NOW and Super-

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