How Useful Are Estimated DSGE Model Forecasts for Central Bankers?

Abstract

Dynamic stochastic general equilibrium (DSGE) models are a prominent tool for forecasting at central banks, and the competitive forecasting performance of these models relative to alternatives, including official forecasts, has been documented. When evaluating DSGE models on an absolute basis, however, we find that the benchmark estimated medium-scale DSGE model forecasts inflation and GDP growth very poorly, although statistical and judgmental forecasts do equally poorly. Our finding is the DSGE model analogue of the literature documenting the recent poor performance of macroeconomic forecasts relative to simple naive forecasts since the onset of the Great Moderation. Although this finding is broadly consistent with the DSGE model we employ—the model itself implies that especially under strong monetary policy, inflation deviations should be unpredictable—a "wrong" model may also have the same implication. We therefore argue that forecasting ability during the Great Moderation is not a good metric by which to judge models.