The Bank of England said on Friday it would overhaul how it forecasts Britain’s economic outlook as part of a “once-in-a-generation” review of its processes after facing criticism for underestimating inflation.
After several years of turmoil – including a pandemic, war in Ukraine and soaring inflation – the central bank has been accused of getting its economic forecasts wrong. It has since started looking for ways to more clearly communicate its views on economic growth and inflation, especially during a period of high economic uncertainty.
“I’m afraid we have a once-in-a-lifetime opportunity to update our approach in a world that remains highly uncertain,” Bank of England Governor Andrew Bailey said.
Last summer, the central bank’s governing body commissioned a rare review focused on inflation forecasts, a key part of making interest rate and other monetary policy decisions. The bank asked former Federal Reserve Chairman Ben S. Bernanke to lead the review.
After an eight-month review of the bank’s staff, processes and technology, Mr. Bernanke made 12 recommendations, including abandoning some of the ways in which inflation forecasts are presented publicly, reconsidering the assumptions underpinning forecasts and more carefully assessing forecast errors. and investing in upgraded software and economic models.
The bank said it was committed to implementing all recommendations. It added that “significant investment” would be needed to develop data, models and people to support forecasts. Bailey said the changes would take some time to implement and the bank would provide an update on progress by the end of the year.
Importance of Forecasting
The central bank is responsible for maintaining price stability, specifically by setting an inflation target of 2% annually. Forecasting is crucial to this process. Because there is a lag in the implementation of monetary policy, officials set interest rates based on forecasts of expected inflation in the coming years.
In the UK, inflation forecasts play an important role in the bank’s communications compared with other central banks, the review said. Traders also react to these interest rate forecasts and expectations by buying and selling government bonds, which affects borrowing rates for companies and households.
One of the questions lawmakers and analysts often ask the Bank of England is why its forecasts were so wrong. Is the economy changing too quickly and unexpectedly, rendering forecasts ineffective, or are there flaws in the forecasting process that make forecasts less useful as uncertainty increases?
The review found it was a combination of the two. “Given the unique circumstances of recent years, the bank’s unusually large forecast errors during this period may have been inevitable,” it said.
How the Bank of England got here
In the past few years, bank of england It was heavily criticized by politicians and public satisfaction with the agency plummeted. Its forecasts have repeatedly underestimated price increases as inflation surges to its highest level in 40 years in 2022. It then underestimated how quickly inflation would slow. Policymakers were first accused of moving too slowly to quell rising prices, and then of cutting interest rates not fast enough to support the economy.
The Bank of England is not the only central bank facing pressure. Others, including the Federal Reserve and the European Central Bank, It has been criticized for predicting that inflation in 2021 will be “transitory”. Instead, it has been going on for several years. Many central banks have large forecast errors. The review found that the Bank of England’s recent errors were actually smaller than those of the European Central Bank.
But in Britain, inflation has been higher than in its Western European neighbours. Bailey said the bank’s model and infrastructure were “challenged by the scale and unpredictability of the shock”.
The central bank said the UK has faced economic shocks in the past but they were manageable within the existing monetary policy framework. But then a series of bad economic events occurred in the country. First came Brexit, which restricted trade, then pandemic lockdowns that shut down parts of the economy, and finally soaring energy prices that rocked households and businesses. All of this caused inflation to soar, peaking at more than 11%, surprising policymakers.
what will change
The review said the most serious problem lay in the software, which was outdated and had “significant flaws” in the main economic model. The problems created “a complex and unwieldy system” that limited the bank’s staff from conducting useful analysis, including alternative forecasting scenarios.
“It’s a bit like fixing a car while it’s running,” Bernanke said, as staff still have to support policymakers while updating the forecast process.
Bernanke suggested the central bank place less emphasis on so-called central inflation forecasts, which are based in part on traders’ expectations for interest rates, and more frequently use alternative scenarios to signal risk and uncertainty.
Currently, the bank’s forecasts do not always reflect policymakers’ views on what the future of interest rates may be because they are based on financial markets. This can cause confusion in forecasts.
For example, the committee raised interest rates in 2022, but in order to signal to traders that it would not continue to raise rates as expected, banks predicted a prolonged recession. Traders changed their bets and a recession never materialized.But predict damage the reputation of the bank.
Bernanke stopped short of proposing a more revolutionary change to the forecast, basing it on policymakers’ expectations for future interest rates. He said it would be a “very important” change and should be considered later.During his tenure at the Fed, Mr. Bernanke launched similar policies so called dot plot.
Former UK Treasury official Clare Lombardelli, who will join the central bank as deputy governor in July, will be responsible for implementing the changes.
