The Bank of England said on Friday it would review the way it forecasts the outlook for the UK economy as part of a “one-off” review of its process after being criticized. cited for underestimating inflation.
After a tumultuous few years – including a pandemic, war in Ukraine and rising inflation – the central bank has been accused of making erroneous economic forecasts. Since then, they have begun looking for ways to more clearly communicate what they think will happen with respect to economic growth and inflation, especially in times of economic uncertainty.
“We have a once-in-a-generation opportunity to update our approach, in a world that I fear remains very uncertain,” said Andrew Bailey, Governor of the Bank of England.
Last summer, the central bank's regulator conducted a rare review that focused on inflation forecasts, a key part of setting interest rates and monetary policy decisions. other bad. The bank asked former Federal Reserve chairman Ben S. Bernanke to lead the review.
After eight months of scrutinizing the bank's staff, processes and technology, Mr. Bernanke made 12 recommendations, which included eliminating some of the ways the bank publicly presented its inflation forecasts. generation, reconsider the assumptions underpinning forecasts, evaluate forecast errors more closely, and invest in software and economic model upgrades.
The bank said it is committed to implementing all recommendations. They added that they would need to make “significant” investments to develop the data, modeling and staff to support the forecasts. Mr Bailey said the changes would take some time to implement and the bank would provide an update on its progress before the end of the year.
The importance of forecasting
The central bank is responsible for maintaining price stability, in particular by targeting inflation at 2% annually. Forecasting is crucial to this process. Because monetary policy operates with a lag, officials set interest rates based on predictions of how much inflation is expected to occur over the next few years.
In the UK, inflation forecasts play a larger role in bank communications than at other central banks, the review said. Traders also react to interest rate forecasts and expectations by buying and selling government bonds, which affects borrowing rates for companies and households.
One of the questions often asked by lawmakers and analysts of the Bank of England is why its forecasts are so wrong. Is the economy changing too quickly and unexpectedly, making forecasting ineffective, or is the forecasting process flawed, making it less useful in times of uncertainty? higher?
Reviews suggest it is a combination of both. “Given the exceptional circumstances of recent years, unusually large forecast errors by the bank during that period were probably inevitable,” it said.
How the Bank of England got here
During the past few years, Bank of England has been heavily criticized by politicians and public satisfaction with the institution has plummeted. Their forecasts repeatedly underestimate price gains as inflation rises in 2022 to its highest level in four decades. They then underestimated the slowdown in inflation. Policymakers were accused of initially moving too slowly to stem price increases and then not cutting interest rates quickly enough to support the economy.
The Bank of England is not the only central bank under pressure. Others, including the Federal Reserve and the European Central Bank, was criticized for predicting that 2021 inflation would be “temporary.” Instead it has been around for several years. And forecast errors are huge at many central banks. In fact, the Bank of England's recent errors have been smaller than those of the ECB.
But in Britain, inflation remains higher than in its Western European neighbors. The bank’s models and infrastructure “are challenged by the sheer scale and unpredictability of the shocks that hit us,” Mr. Bailey said.
The central bank said Britain had faced economic shocks that were manageable within the current monetary policy framework. But then the country went through a series of bad economic events. First came Brexit, trade restrictions, then pandemic lockdowns that shut down parts of the economy and finally skyrocketing energy prices that rocked households and businesses . All of this led to soaring inflation, which at its peak exceeded 11% and caught policymakers by surprise.
What will change?
The review said the most serious problems were with outdated software and the main economic model had “significant shortcomings”. The problems created “a complex and difficult-to-use system” that limited the bank's staff from performing useful analysis, including alternative forecasting scenarios.
“It's a bit like fixing a car while it's running,” Mr. Bernanke said, because staff still have to support policymakers while updating forecasting processes.
Mr. Bernanke recommended that the bank place less emphasis on so-called central inflation forecasts, which are partly based on what traders expect about interest rates, and use alternative scenarios more frequently to show present risks and uncertainties.
Currently, bank forecasts do not always reflect what policymakers think about the future of interest rates, because they are based on financial markets. That can lead to misleading forecasts.
For example, in 2022, the committee raised interest rates, but in an effort to signal to traders that it would not continue to raise rates as much as expected, the bank forecast a prolonged recession . Traders changed their bets and the recession never materialized. But forecast destroy the reputation of the bank.
Mr. Bernanke did not propose a more revolutionary change to the forecasts based on policymakers' expectations of future interest rates. He said it would be a “hugely consequential” change that would need to be considered later. While at the Fed, Mr. Bernanke introduced something similar the so-called dotted box.
Clare Lombardelli, a former British Treasury official who will join the central bank as deputy governor in July, will be responsible for implementing the changes.
