ECB economists Erhmann and Fratzcher, together with other colleaugues continue to publish excellent papers which help us, central bankers, understand better what we do. Their recent paper, titled “Geography of skills , …”, looks at forecasters ability to predict inflation and call next Fed rate move. Results are very interesting, for example authors find that economists who worked for Federal Reserve Board of Governors are able to forecast better (with smaller forecast error) than those who did not. Non technical summary of their paper follows:
” Information and geography play an important role in financial markets by affecting asset prices, trading behavior, and the location choice of financial firms. There is ample evidence in the literature that geography and information also matter when it comes to the performance of financial market analysts and the profitability of mutual fund investments. For instance, it has been shown that profits tend to be higher when funds invest in firms located near to the fund’s offices, and market analysts perform better when they focus on firms close by The present paper analyzes whether this role of information and geography extends to the way financial market participants anticipate US monetary policy. In particular, we ask to what extent geography, regional economic developments, and personal skills determine the ability of professional forecasters to predict monetary policy decisions by the US Federal Reserve. The paper uses a novel dataset of 268 professional forecasters who are located across 98 cities in 15 countries, for FOMC decisions between February 1999 and September 2005. The dataset contains each forecaster’s survey expectations for FOMC decisions, as well as information about the individual’s forecasts of inflation and economic activity. Moreover, the data includes information related to analysts’ skills, e.g. the type of institution, his or her position within that institution, employment record and educational background. We combine this dataset with information about the economic conditions specific to the region in which each individual is located. As a key stylized fact, the degree of heterogeneity in the forecast performance across individuals is large: after grouping forecasters by performance over the full sample period, the absolute forecast error differs by 5 basis points (b.p.) between the best and the worst 10%. This difference rises to 10 b.p. when analyzing only those FOMC meetings that had some degree of heterogeneity across forecasters. We find such forecaster heterogeneity to be important, in the sense that heterogeneity of monetary policy expectations significantly raises financial market volatility in response to the announcement of monetary policy decisions. What explains the heterogeneity in expectations across Fed watchers? As to geography, we find that regional economic developments matter, as forecasters make larger errors the more economic developments in their home region differ from their average. Moreover, the prediction error of those in New York City or in other financial centers, either in the USA or abroad, is about 2 b.p. lower. Forecasters who are located in or close to Washington DC do even better by exhibiting an error that is 4 b.p. lower. A complementary finding is that differences in forecast performance are related to the skills of individual forecasters. We find that analysts who work for investment banks do better than others. Professional experience and education also matter for forecast accuracy: analysts who previously worked for the Federal Reserve’s Board of Governors perform better, as do analysts with a Master’s degree. In addition, the empirical analysis shows that forecasters who do well in predicting monetary policy also do well in anticipating US inflation, providing the most direct piece of evidence that skills and individual background are significantly linked to the forecast accuracy. Finally, we investigate the role of communication by the Federal Reserve for heterogeneity in forecast performance. We find that more communication reduces disparities in forecast performance stemming from differences in regional economic conditions, whereas we find that the superior forecast accuracy of some analysts is related to their ability to extract relatively more or better information from Fed communication.”
What lessons should be derived from this paper? I think that one should achieve such level of transparency, that investment or commercial banks analysts reach the same level of understanding about central bank decision making process, as if they were central bank economists. Secondly, central bank communication should be such, that economists can reach similar level of monetary policy understanding irrespectively of their location.