Working Paper

Predictable Forecast Errors in Full-Information Rational Expectations Models with Regime Shifts

Abstract: This paper shows that regime shifts in Full-Information Rational Expectations (FIRE) models generate predictable regime-dependent forecast errors in macro aggregates. Hence, forecast error predictability alone is neither sufficient to reject FIRE nor informative about alternative expectations theories. We instead propose a regime-robust test of FIRE and apply it to a medium-scale New Keynesian model with monetary policy regime shifts that is estimated on US data. While the test fails to decisively reject FIRE, the model conditional on macro data implies expectations that are generally different from observed survey forecasts, thus providing a new empirical motivation for alternative expectations theories.

Keywords: Full-information Rational Expectations; Markov Regime Shifts; Forecasting Errors; Waves of Over- and Under-Reaction; Survey of Professional Forecasters;

JEL Classification: C53; E37;

https://doi.org/10.26509/frbc-wp-202408

Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers

Publication Date: 2024-04-11

Number: 24-08