Does the Fed understand the headwinds caused by its zero interest rate and quantitative easing policies?

Reuters ran an interesting article that suggests that the Fed's econometric model for predicting economic performance doesn't work in the presence of zero interest rates and quantitative easing.

Regular readers are not surprised by this finding as they know that in the 1870s Walter Bagehot, the man who wrote the book on central banking, Lombard Street, observed that interest rates must not go below 2%.

Mr. Bagehot understood that there would be significant economic headwinds to rates under 2%.  Today those headwinds include the "Pension Fund death spiral" and savers cutting back on consumption.

Based on my experience at the Fed and papers by economists like William White, none of these headwinds is in the Fed's econometric model.

The model simply assumes that market participants react the same way to lowering interest rates from 2% to 0% as they do when rates are lowered from 8.5% to 6.5%.  As a result, it predicts a far better economic performance than actually occurs.

How can the Fed's model be fixed?

It could take into account the headwinds created by its own policies.

But doesn't that mean that the Fed would have to admit that zero interest rates and quantitative easing are flawed policies?

Yes, but the evidence is in the performance of the Fed's own models.

Has the Federal Reserve watched the U.S. recession and painfully slow recovery through rose-colored glasses? 

A look at the U.S. central bank's economic forecasts over the past five years suggest it has. 

Since October 2007, when the Fed's policy committee began giving quarterly predictions for GDP growth and the jobless rate, the central bank has downgraded its nearer-term forecasts almost two-and-a-half times as often as it upgraded them. 

The gap between Wall Street's expectations for 2012 growth and the Fed's own current view points to yet another downgrade on Thursday, when policymakers wrap up a two-day meeting that has world financial markets rapt. 

The trend of back-pedaling shows how poorly the central bank has fared at reading the economic tea leaves, with the Fed's optimism a likely factor in policy decisions through the Great Recession and its fallout, economists say.

"The Fed has been kind of consistently overestimating where growth should be ... it has expected too much," said Eric Stein, a portfolio manager at Eaton Vance....

This reflects the simple fact that the Fed's model does not take into account the headwinds created by the Fed's policies.

All told, disappointed policymakers had to ratchet down GDP growth estimates for the current year and the following year, or lower their unemployment estimates, a total of 53 times over the past five years. That compares to 22 forecast upgrades. 

Officials left their estimates unchanged only five times. 

Many of the upgrades were clustered from late 2009 to the spring of 2010, as the nation first began emerging from its worst recession in decades....

Of course, officials at the U.S. central bank have been far from alone. 

"The shocks and surprises have definitely been coming from one direction the last few years," said Peter Hooper, chief U.S. economist at Deutsche Bank Securities in New York. "Everyone was expecting the usual bounce after the recession, but that didn't happen."

Which simply suggests that the economics profession as a whole does not understand or chooses to ignore the headwinds associated with zero interest rate policies or quantitative easing.