The Bank of England announced on Friday that it would overhaul the way it forecasts the outlook for the UK economy as part of a “once in a generation” review of the Bank of England’s processes, following criticism that it was underestimating inflation.
After a tumultuous few years that included a pandemic, war in Ukraine and soaring inflation, the central bank was accused of missing economic forecasts. Since then, we have begun exploring ways to more clearly communicate what we think will happen 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 unfortunately remains highly uncertain,” Bank of England Governor Andrew Bailey said.
Last summer, the central bank’s governing body commissioned an unusual review focused on inflation forecasts, a key part of setting interest rates 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 announced plans to eliminate some of the ways the bank publishes its inflation forecasts, reconsider the assumptions on which forecasts are based, and reduce forecast errors. It made 12 recommendations, including rigorous evaluation and investment. Software and economic model upgrades.
The bank said it is committed to implementing all recommendations. It added that “significant investment” would be required to develop the data, modeling and staff to support the predictions. Bailey said it will take some time for the changes to take effect, but the bank plans to provide an update on its progress by the end of the year.
Importance of prediction
The central bank is responsible for maintaining price stability, particularly with an annual inflation target of 2%. Forecasting is essential to this process. Monetary policy works on a staggered basis, so officials decide interest rates based on their predictions of what inflation is expected to be several years from now.
Inflation forecasts play a larger role in the bank’s communications in the UK compared to other central banks, the study said. Traders also buy and sell government bonds in response to these forecasts and expectations about interest rates, which in turn affects the borrowing rates for businesses and households.
One of the questions MPs and analysts often ask the Bank of England is why its forecasts were so wrong. Were forecasts ineffective because the economy changed so quickly and unexpectedly, or were the forecasting processes flawed and less useful in times of heightened uncertainty?
In our reviews, we found it to be a combination of both. “Given the unique circumstances of recent years, unusually large forecast errors by banks for the same period were probably inevitable,” the report said.
How did the Bank of England get here?
The Bank of England has been heavily criticized by politicians in recent years, and public satisfaction with the bank has plummeted. The company’s forecasts repeatedly underestimated price increases as inflation rose to a 40-year high in 2022. And they underestimated the speed at which inflation would slow. Policymakers were first accused of acting too slowly to curb rising prices, then of not cutting interest rates fast enough to support the economy.
The Bank of England is not the only central bank under pressure. The Federal Reserve, the European Central Bank and others were criticized for predicting that inflation in 2021 would be “transitory.” Rather, it lasted for several years. And many central banks had large forecast errors. The Bank of England’s recent errors were actually smaller than those of the ECB, an investigation has found.
However, inflation remains higher in the UK than in neighboring Western European countries. Mr Bailey said banks’ models and infrastructure were “challenged by the scale and unpredictability of the shock that hit us”.
The central bank said the UK had previously faced economic shocks, which were manageable within the existing monetary policy framework. But then, bad economic events continued in the country. First Brexit curbed trade, then pandemic lockdowns shut down parts of the economy, and finally soaring energy prices shook households and businesses. All of this led to a spike in inflation, which peaked at more than 11% and surprised policymakers.
what will change
The review said the most serious problems were with outdated software and that key economic models had “serious flaws”. The problem, which created a “complex and unwieldy system,” prevented bank staff from conducting useful analysis, including alternative forecast scenarios.
“It’s a bit like fixing a car while it’s running,” Bernanke said, because staff still has to support policymakers while updating the forecasting process.
Bernanke recommended less emphasis on so-called central inflation forecasts, which are based in part on traders’ expected interest rates, and more frequent use of alternative scenarios to illustrate risk and uncertainty.
Currently, the Bank’s forecasts are based on financial markets and do not necessarily reflect what policy makers think about the likely future of interest rates. That can lead to confusing predictions.
For example, the committee did raise interest rates in 2022, but the central bank predicted a prolonged recession to signal to traders that it would not continue to raise rates as much as expected. Traders changed their bets, but a recession never materialized.But the forecast damaged the bank’s reputation.
Bernanke avoided recommending more radical changes to expectations based on policymakers’ expectations for future interest rates. He said this was a “very significant” change that would need to be considered at a later date. During his time at the Fed, Mr. Bernanke introduced something similar to the so-called dot plot.
Claire Lombardelli, a former UK Treasury official who will join the central bank as deputy governor in July, will be responsible for implementing the changes.