By JON HILSENRATH
When the Federal Reserve said in December that it would keep short-term interest rates near zero until the unemployment rate falls to 6.5%, it was backed by a team of geeks who get little attention outside the central bank but a lot of attention inside.The geeks have names such as Ferbus, Edo and Sigma. They are computer-modeling programs the central bank uses to make predictions about how various policies and events will play out across the economy.
In December, the Fed wanted to telegraph how long it would keep interest rates low. To do that it used forecasting models to map out different scenarios. Looking to the models for guidance, Fed officials decided to announce they would keep interest rates near zero until the unemployment rate drops to 6.5%. The models told them such a commitment would help nudge unemployment lower—it was 7.7% in November—and wouldn't risk a big burst of inflation.
But here is the problem: The models are deeply flawed. They failed to foresee the financial crisis in 2008 and have tended to overestimate the strength of the economy for several years.
Could they fail the Fed again?
Of course, no model or human can perfectly predict the future. But the Fed models have a more specific problem. Despite all their complexity and sophistication, they have long been plagued by gaps in how they read and project the economy. One of the biggest is that they have ignored the nuances of the financial system—one of the primary channels through which Fed policy works.
The models have formulas that predict how many pennies an investor will spend for every $1 increase in his stock-market portfolio or how much less banks might lend if interest rates go up half a percentage point. But they haven't predicted the vulnerability of banks to a financial panic or how that vulnerability affects the broader economy.
Fed officials are well aware of this flaw. Chairman Ben Bernanke himself documented the importance of financial-system fragility in his days as an academic. Central-bank staffers are now undertaking a wide-ranging effort to update and improve the models to better account for financial crises. But it is a decadelong project that is far from complete.
Ben Bernanke has said computer modeling helps inform Fed policy.
The financial gaps in the models worry Nathan Sheets, a Citigroup C -0.61% economist who was Mr. Bernanke's top international adviser at the Fed from 2007 to 2011. Mr. Sheets points to 1994 as an example of why. Back then, small increases in short-term interest rates by the Fed led to a surge in long-term interest rates. The models didn't foresee the financial chaos that would ensue, including the collapse of investment bank Kidder Peabody & Co., the bankruptcy of Orange County, Calif., and the Mexican peso financial crisis.
What will happen when Fed officials raise interest rates in the future? The models make predictions about unemployment and inflation, but Mr. Sheets worries they might not foresee new financial shoes poised to drop.
"They've really internalized these models and that's very risky," Mr. Sheets said.
The Fed's main economic model, launched in 1995, is called FRB/US, pronounced "Ferbus." It uses hundreds of different mathematical equations to describe how the economy works. Punch in a lower interest rate, and Ferbus spits out predictions of how much growth and inflation should follow. Punch in some other event—like a sudden contraction in government spending or a jump in tax rates—and it spits out predictions of how the economy should respond. Smaller-scale models since have been developed, with more advanced techniques, including Edo and Sigma.
The fingerprints of Ferbus and its friends are all over the Fed's latest interest-rate decisions. In two important speeches this year, Fed Vice Chairwoman Janet Yellen described in detail how she and Fed staff used the models to gauge how long interest rates could remain low without generating too much inflation, though she acknowledged in the speeches it would be "imprudent to place too much weight" on the models. Mr. Bernanke, in his December news conference, said the Fed ran a range of scenarios through different models to come up with its interest-rate plan.
Fed officials say they aren't slaves to economic models and that while the models help them think about problems, they don't dictate their responses. "Model results are just one input into forecasting and policy analysis," Michael Kiley, a Fed economist and senior modeler, said in a presentation in New York this year.
Mark Gertler, a New York University professor and co-author with Mr. Bernanke during his days in academia, plays down Mr. Sheets's critique. The models have made important advances in recent years and now include much more detail on the financial sector, Mr. Gertler says. Four years after the financial crisis, he says, Fed officials are "intimately aware of the issue of financial vulnerability."
Yet given the unknowns about unconventional Fed policies, Mr. Sheets's warning warrants attention.
Write to Jon Hilsenrath at jon.hilsenrath@wsj.com
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