Error correction (or blame deflection?)

For anyone interested in the practice and methodological issues associated with economic forecasting, you could do a lot worse than read the Bernanke Review of forecasting at the Bank of England. According to the FT, the former Fed chair who was commissioned to produce a report on the BoE’s forecasting practices after its failure to predict the rise in inflation in 2022, was “brutally honest about [its] failings.“ Brutal might be overstating it, but it was an honest assessment that one feels is shared by many BoE insiders. As one might expect, not all economists agreed with all of its conclusions but there was a lot to like about it.

The fact that Bernanke outlined many shortcomings in the BoE’s practices should come as no surprise. No system is ever perfect, and the fact that the current monetary framework has been in place for almost 30 years does suggest that it is time to have a close look. There are a number of questions around the whole process, however. Why was it necessary to have such a review in the first place? If the processes really are as poor as Bernanke highlighted, why did it require an external review to point it out? And if the purpose of the exercise was to address policy errors, should we not be spending time looking at the policy making process rather than putting a lot of effort into the forecast generation process? I will deal with these points below.

What were the conclusions?

It is perhaps instructive first to reflect on Bernanke’s main process recommendations. One of the most widely trailed in advance was the suggestion that the BoE publish scenarios alongside the main forecast. This would “help assess the costs of potential risks to the outlook” and “stress test the judgements made by the MPC.” There is a lot of merit in doing this: The experience of recent years which has produced the Covid-19 pandemic and the oil price shock, suggests that a single forecast with a univariate central case cannot adequately capture all future states of the world. Even allowing for risks in the form of a fan chart, no forecast could capture shocks of the magnitude of 2020 (see chart below). The Bernanke Review went as far as suggesting that “the fan charts as published in the MPR have weak conceptual foundations, convey little useful information over and above what could be communicated in other, more direct ways, and receive little attention from the public. They should be eliminated.” While there is some truth in this, it may be going too far to eliminate them, as fan charts are a very useful way of conveying risks around a central case in a stable environment, and there is a case for retaining them.

Another very important consideration was the nature of conditioning assumptions, particularly for the future path of interest rates. There are a number of reasons why using market rate expectations as the appropriate starting point is less than optimal. For one thing, “forward rates implied by the market curve are not pure forecasts of future rates, because forward rates may incorporate risk and liquidity premiums.” In addition they may not reflect the MPC’s best judgement of the path of rates, meaning that “a forecast conditioned on the market curve may be misleading.” One alternative is for the central bank to give a preferred path for rates, much as the Riksbank does, although as I argued in this post in 2019, this could simply create a hostage to fortune. Instead, the practice of offering alternative scenarios based on different rate paths will probably suffice.

A final big point, and one that is close to my heart, is that the software required to manage and manipulate data “is seriously out of date and difficult to use” and should be upgraded and constantly monitored. I don’t know which systems Bernanke is referring to but my own experience with languages such as R and Python, now en vogue in economic circles, is that they are far less user-friendly and flexible than some of the systems designed in the 1970s. The review was also critical of the BoE’s macro model, COMPASS, unveiled to great fanfare in 2013. Bernanke did not explicitly say that DSGE models may not be up to the job of forecasting but he offered the view that structural models (of the kind I have long advocated) still have a role to play in forecasting – after all, the Fed still uses them.

Policy considerations

The elephant in the room, however, is why it was felt that such a review was required in the first place. The answer, to put it bluntly, is that it was designed to keep politicians off the BoE’s back after it was accused of failing to predict the huge rise in inflation in 2022 (true) and the fact that its policy response was too slow (less true). In fact, the BoE's inflation forecast in February 2022 was above that of the consensus, predicting end-2022 inflation at 5.8% versus a consensus expectation of 4.6% (outturn: 10.8%) and end-2023 inflation at 2.5% versus the consensus prediction of 2.1% (outturn: 4.2%). Thus, while the BoE forecast was a significant under-estimate, it was less so than most forecasters.

As for the policy response, as I (and many others) have noted previously there was little anyone could have done to prevent an inflation spike in the face of an external oil price shock. Recall that the UK had just come off the back of a pandemic which had resulted in the steepest decline in output in 300 years and whose long-term effects were at that time still unknown. It did not feel like the right time for a sharp tightening of monetary policy. However a review of process is a standard response to issues that are more a matter of policy. Simply put, it is a way to deflect attention.

Another issue worth addressing is the question raised by the Sunday Times economics editor David Smith as to why it took an external review to highlight these shortcomings, which were well known internally. We are very much in speculative territory here, but since Bernanke took a lot of evidence from BoE insiders – past and present – it is hard to avoid the conclusion that this review offered an opportunity to tackle internal inertia. This may be the result of senior managers lack of knowledge of the issues involved; the fact that their attention has been diverted by other policy matters in recent years (Brexit, the pandemic) or simply a lack of budget resources. Either way the Review is a good way to get their attention.

Last word

It is always a good thing to review forecast models and processes, especially when they have been in place for so long and the Bernanke Review put the BoE’s process under a lot of scrutiny. In many ways it simply came across as a call to modernise a system, which in the grand scheme of things was already pretty decent but perhaps had been neglected a little over the past decade. However, the one thing it will not fix is that the future is inherently unknowable. No matter how state of the art, no forecasting system can cope with the kind of shocks to which we have been subject of late. Give it another decade and we will be having this debate all over again.

More thought, less groupthink

Assessing today’s rate hike

In light of the Fed’s 75 bps hike yesterday, the BoE had little choice but to raise rates by 25 bps today with the case for action strengthened by the fact that it now predicts inflation will reach 11% before the year is out. The markets were split 50-50 between a 25 bps and a 50 bps rise - either way they will still be at record lows in real terms - but the less aggressive option has left many dissatisfied. The hawkish camp believes that rates must rise more quickly to bear down on inflation – incremental hikes of 25 bps just do not cut the mustard. Conversely, the dovish element – admittedly a minority at present – believes that aggressive rate increases are misguided at a time when the economy is clearly slowing (the BoE predicts that Q2 GDP will contract by 0.3%).

This is a genuine conundrum and there are many question marks as to whether rate hikes are the right way to deal with inflation caused by a supply shock. Higher interest rates act on inflation by curbing demand: The magnitude of the contraction required to rebalance supply and demand in such circumstances is probably much bigger than politicians, and indeed central bankers, are prepared to accept. After all, higher rates are not going to result in more oil being pumped or an increase in Asian semiconductor supply. I was thus taken by the Tweet from the journalist Ryan Avent, who noted “I feel like there's a good chance we're reading macro papers in 20 years which are like ‘the recession of 22-3 was yet another case of Fed overreaction to energy-price shocks.’”

Moreover the linkages from the real economy to prices are highly imprecise. Given that it takes up to two years for tighter monetary policy to impact on the economy, it is likely that a host of other factors will swamp price trends in the interim. Clearly, central banks are using monetary policy to try and influence inflation expectations, particularly wages. However, this is a risky strategy. Faced with rising food and energy prices, the like of which we have not seen for 40 years, workers are not going to sit idly by whilst the prices of goods and services which they consume are going up. And when central bank actions impact on their interest costs, it is no surprise that trade unions respond with industrial action.

This is not to say that central banks should necessarily refrain from hiking rates. But it is an illustration of how the textbook models used by economists to describe the workings of the economy often fall apart when circumstances change. Just as the 1970s sounded the death knell for structural macro models which did not incorporate forward-looking expectations, it will be interesting to see whether the current vogue for forward-looking DSGE models emerges unscathed from today’s events. After all, one of the criticisms levelled at central banks is that they failed to foresee the inflationary shock.

As it happens, I have sympathy with central banks’ position. Random shocks are by their nature unexpected and although central banks did highlight that inflation would rise in the course of 2022, they could not reasonably have predicted the impact of the war in Ukraine. That said, the likes of the BoE probably should have curtailed their QE programmes once it became clear that the economy was recovering. However, even by summer 2021 they had already pumped significant amounts of liquidity into the system and the effect of calling a halt earlier than planned would have had a marginal effect on inflation at best.

The groupthink criticism

At least we cannot criticise the BoE for sitting on its hands. Rates have risen at five consecutive meetings for the first time since the MPC was established in 1997. It was not always this way: After unprecedented policy easing in the wake of the Lehman’s bankruptcy, the BoE (in common with most other central banks) kept interest rates at their 2009 emergency settings for the next nine years. This contributed to excessive asset price inflation, notably for housing, and gave rise to criticisms of groupthink as the MPC ignored all the concerns surrounding a prolonged ultra-loose monetary stance and focused purely on the near-term inflation outlook.

Former MPC member Danny Blanchflower has been one of the strongest critics of groupthink, pointing to the lack of intellectual diversity on the Committee and arguing that there are fewer independent thinkers who are drawn from an increasingly narrow talent pool. As he noted in a Tweet in May, “still nobody on the MPC lives or comes from north of the Watford gap so diversity means only London  (8) & USA (1) are represented? No Birmingham Leeds Belfast Glasgow Newcastle Cardiff Liverpool Manchester representation? No representation of business?” Blanchflower may sometimes be overly critical of the BoE but he does have a point. For example, there has never, to my knowledge, been a Scottish representative on the Committee during its 25 year existence.  Given that Scotland accounts for 8% of the UK population, one would have thought they deserve some representation. Indeed, there have been more representatives born in Argentina, Belgium, India and the United States than those born north of the border.

Assessing the evidence

To assess Blanchflower’s claim that the Committee is drawn from an overly narrow pool, it is instructive to examine the universities from which MPC members graduated. Taking their highest university degree as the relevant benchmark, 12 of the 46 past and present members obtained their highest qualification from Oxford whilst another 9 were graduates of the LSE and 7 were from Cambridge. Only thirteen universities are represented in the list, which will rise to 14 when Swati Dingra replaces Michael Saunders in August. Widening the list to include those who attended British universities as an undergraduate reveals that 16 MPC members attended Oxford (almost 35% of the total) whilst 12 have Cambridge connections (26%) and 5 have an LSE-only affiliation. The response to this is that these universities attract some of the brightest and the best. The fact that they have strict entry criteria means that those with the best academic performance are more likely to study there. But by any standards this is a small sample from which to draw and does nothing to refute Blanchflower’s suspicions of selection bias.

The old joke has it that if you ask a question of nine economists, you will get nine different opinions  and another of Blanchflower’s criticisms is that there is simply not enough dissent from the majority view on the MPC. We are on more solid ground here. I have applied two ways to measure the independence of individual voting patterns: One is the proportion of times an individual votes for an option other than the committee consensus – for example, a person who votes for a 50 bps hike rather than the majority view of 25 bps is a dissenter on this measure. Another metric is the number of times an individual votes in the opposite direction to the majority, which is a stricter measure of dissent.

Based on 25 years of MPC voting, the dissent measure, which calculates the proportion of members voting for something other than the committee average, is recorded at 14.4% over the period 1997 to 2008 versus a post-2009 figure of 6.5%. Obviously times were different in the wake of the 2008 crash when there was a universal belief that an expansive monetary policy was required. But it is notable that this dissent measure recorded a figure of 16.5% during Eddie George’s term as Governor, falling to 9.3% under Mervyn King and just 6.9% under Mark Carney. Whisper it quietly, but under Andrew Bailey’s tenure the dissent measure has crept up to 7.8%. But the numbers do back up Blanchflower’s claim that there is a lot less dissent in the voting patterns.

On the stricter measure of directional dissent, a similar pattern applies. Pre-2009, on 12.9% of occasions MPC members pushed for directional rate moves which were out of line with the committee consensus versus 5.6% post-2009. The post-2009 figure is low and would appear to confirm the fact that MPC members were reluctant to stick their head above the parapet and call for rate hikes.

Last word

For all the criticism that the BoE kept rates too low for too long in the wake of the 2008 crash – a view with which I concur – and that it has been dominated by groupthink, the events of recent months appear to have shaken the MPC out of its complacency. Although there are those who believe that it should have been more aggressive today and hiked by 50 bps, my own view is that the 25 bps increase was the right move. Doing nothing was not an option but acting too aggressively would exacerbate recession concerns, which is the last thing beleaguered households need now.

Not a pretty picture

This week’s decision by the BoE to raise interest rates another 25 bps to 1% takes Bank Rate to its highest since 2009 and in the process managed to please nobody. Consumers certainly do not welcome it, nor do the markets if pressure on the pound is any guide. Following on from the Fed’s 50 bps rise on Wednesday, central banks are now acting on their rhetoric to take action against the big rise in inflation which is running at 40-year highs in the US and 30-year highs in the UK. This puts the spotlight on the ECB which has yet to follow up its recent more hawkish message with action. But maybe the ECB, like many of us, has significant reservations about countering an adverse economic shock with a tightening of policy which in the short-term will squeeze the economy and make life harder for consumers and businesses which are already reeling under the strain.

The BoE’s economic forecast grabbed a lot of headlines with its prediction that CPI inflation will hit 10.2% by the fourth quarter of 2022, which would be the highest ever CPI inflation reading on data back to 1989 (the RPI series, by contrast, can be extended back to 1914). It also forecast that GDP will contract slightly in 2023, though the quarterly profile suggests that the technical definition of recession, in which there are two consecutive quarterly contractions, is not fulfilled. Looking out over the next three years, the forecast is consistent with annual average growth of just 0.3% which is a grim picture and not one in which a central bank would normally be expected to raise interest rates. So why do it? Aside from the surge in headline CPI inflation, the minutes of the MPC meeting made it clear that the Committee is concerned about the tightness of the labour market and the potential for a spillover to wages. We should thus view this week’s rate increase as a precautionary measure.

When looking ahead it is important to be aware of the interest rate assumptions underpinning the forecast. The baseline (modal) forecast is conditional on market interest rate expectations in which Bank Rate is expected to hit around 2½% by mid-2023 before falling to 2% by mid-2025. Under this assumption, GDP contracts by around 0.25% next year and the output gap widens to 1¼% on a twelve month horizon which under normal circumstances would be considered disinflationary. The central case projection also foresees rising unemployment, with the jobless rate rising by two percentage points to 5.5% on a three year view. These forces combine to produce a sharp slowdown in CPI inflation over the forecast horizon, with inflation close to target on a two year view (2.1%) and well below it by Q2  2025 (1.3%). In the alternative scenario, in which interest rates hold at 1%, the fall in output is less dramatic, with GDP growth next year averaging +0.8%. The rise in unemployment (jobless rate at 4.2% by mid-2025) and fall in inflation (still above target at 2.2% by mid-2025) are correspondingly slower. On the basis of these two forecast paths one conclusion we might draw is that in order to hit the inflation target on a three year view, rates will rise further but perhaps by less than the market is currently pricing in.

Any forecast relies on assumptions about the future, and those regarding energy prices are particularly uncertain but will have major implications for the inflation projection. As it currently stands, the BoE assumes household energy bills will rise by another 40% in October when the domestic price cap is up for its biannual review, following the 54% rise in April (5 percentage points of which were accounted for by the costs resulting from those suppliers that went bust in recent months). Yet the BoE admits that if energy prices “fall back to the levels implied by futures curves …  the level of GDP would be nearly 1% higher by the end of the forecast period and excess supply and unemployment around ¾ percentage points lower. CPI inflation would fall back towards the target more rapidly than in the central projection and would be around ½ and over 1 percentage points below the target in two and three years’ time respectively.” Bottom line: Things may not turn out quite as bad as this forecast suggests.

There are some other elements of the forecast which don’t necessarily stack up. First, if energy prices do rise by 40% in the fourth quarter, the slowdown in inflation in 2023 looks quite ambitious – the BoE estimates that energy will add only 0.25 percentage points to inflation versus 4 points in 2022. Average earnings inflation is expected to slow from 5¾% this year to 4¾% in 2023 despite the fact that if the labour market is as tight as the BoE believes, surely there will be greater upward pressure on wages rather than less as workers try to recoup some of the real wage losses suffered in 2022. This would point to upside risks to the inflation forecast and it is noteworthy that the BoE sees risks to the inflation outlook as tilted marginally to the upside.

If inflation does turn out higher, should the BoE be more aggressive in raising rates compared to current market expectations? In my view, no. Higher inflation will continue to act as a brake on real incomes and activity rates, and in an environment where the UK is struggling to come to terms with a post-Brexit world the headwinds are strong enough without an additional monetary burden (the BoE’s forecast looks for net trade to subtract 1.5 percentage points from growth next year).

Not everyone agrees. Former MPC member Adam Posen is quoted as saying that “The central bank has no choice but to cause a recession when a broad range of prices are rising at such a strong pace … It is duty bound to bring inflation down after more than a year when it has been more than 2 percentage points above its 2% target level during a period of full employment.” This is both irresponsible and wrong from an economist whose work I admire and is the kind of thinking which gets economists a bad name. It also ignores the fact that the BoE’s mandate is to maintain price stability subject to “the Government’s economic policy, including its objectives on growth and employment.” Given the Conservatives’ poor showing in this week’s local elections, I cannot imagine anyone in government believes that exacerbating the cost of living crisis is going to make them any more popular at the ballot box.

Another issue which perhaps did not get as much prominence as it deserved was that in lifting Bank Rate to 1%, the BoE has reached the threshold at which it will consider actively running down its balance sheet. We can expect more guidance as to how this might happen in the August Monetary Policy Report. Suffice to say that if the BoE is raising interest rates whilst simultaneously engaging in quantitative tightening, it is likely to make a bad situation worse.

A little less conversation (a little more action please)

The investor community was distinctly unimpressed with the BoE’s decision to leave interest rates on hold yesterday with accusations that it had raised expectations ahead of the MPC meeting, only to dash them again. I have a lot of sympathy with those who were caught out, having spent years trying to discern the messages from central banks, and it is always immensely galling when policymakers drop hints only to act contrary to these messages. But it is equally important to understand that central bank messaging is always ever conditional and this subtlety is often overlooked during the media frenzy. However, this episode calls into question the usefulness of forward guidance as a policy tool and the BoE will clearly have to work on its communication strategy. There is also a question of whether a rate hike to counter a supply-side boost to inflation was ever the right approach in the first place.

Communication breakdown

Starting first with the communications, Governor Andrew Bailey told an online panel discussion organised by the G30 group on 17 October that "monetary policy cannot solve supply-side problems - but it will have to act and must do so if we see a risk, particularly to medium-term inflation and to medium-term inflation expectations … And that's why we at the Bank of England have signalled, and this is another such signal, that we will have to act." There were mutterings at the time that such a strong statement, made on a Sunday when markets were closed, should not have been made unless it signalled a shift in policy communications. A few days later the BoE’s new chief economist, Huw Pill, said in an FT interview that “I think November is live” and went on to add “the big picture is, I think, there are reasons that we don’t need the emergency settings of policy that we saw after the intensification of the pandemic” (a view I would endorse). But Pill also tried to take some heat out of the debate by noting “maybe there’s a bit too much excitement in the focus on rates right now.”

The latter point is the bit that was overlooked in the media commentary that followed. The BoE really ought to know better by now that markets simply do not do subtlety. Interest rate decisions are viewed as binary and markets are very poor at determining the distribution of risks unless they are spoon fed. There were also a couple of exogenous factors to take into consideration. Central banks are generally wary of moving ahead of the Fed, and with the FOMC having kept rates on hold the previous evening, the BoE may well have been sensitive to the prospect of acting unilaterally. Moreover, the MPC was not helped by the timing of the tax-raising Budget, released at the start of the MPC ‘purdah period’, which allowed the BoE no time to nudge expectations.

Better ways to communicate

A couple of years ago, former MPC member Gertjan Vlieghe gave a speech in which he suggested there were better ways of communicating monetary policy than the BoE does now. The speech was somewhat overlooked but in my view was a very thoughtful contribution to the policy debate that deserved more consideration. Vlieghe argued that there was a case for the MPC to communicate end-year forecasts for the policy rate. In his view this would take some heat out of the debate by reducing the focus on the very near term (though it may occasionally make life difficult at the final MPC meeting of the year). He reported that central banks in Sweden, Norway and New Zealand, which publish explicit forecasts, were satisfied that this method improved transparency. However, I have reservations that such an approach would work in the UK. Although Vlieghe noted that “it would be important to communicate the degree of uncertainty around this path”, my concern is that the commentariat would not necessarily understand the distinction between a conditional and an unconditional forecast. We are thus likely to end up in a situation where failure to deliver on the central case would be seen as a policy error.

If the BoE were to change its communication strategy, my own preference would be for it to adopt something akin to the Fed dot plot in which individual committee members give their own (anonymised) views on how they believe rates will develop. Here, too, there are many arguments against. For one thing, a dot plot does not identify how interest rate forecasts are linked to growth and inflation forecasts. Moreover the markets would likely focus on the diversity of views rather than the median outcome thus missing the point of the communication.

If we do not like this idea there is always the radical option of not trying to appease markets in the first place. Indeed, explicit monetary policy communication is a relatively recent phenomenon with the Fed switching to this strategy only in 1994. It is not as if the forward guidance policy espoused by former Governor Mark Carney has been a great success. If one of the objectives of monetary policy communication is to increase transparency, the outcome in the wake of yesterday’s decision, when sterling fell by 1.5% against the dollar and bond yields declined by 14 bps, is the sort of transparency that investors could probably live without.

Should interest rates be raised at all?

The issue of whether central banks should raise interest rates is one which I will undoubtedly look at in more detail in future. However, a couple of quick thoughts are in order. I have long taken the view espoused by Huw Pill that central banks have been too slow in taking back the emergency monetary easing put in place to cope with exceptional circumstances. In my view, one of the BoE’s errors in recent years has been the asymmetric nature of its reaction function. It has rightly cut interest rates during times of stress to provide support to the economy. But once the emergency is over, it has justified the decision to keep rates on hold by an absence of inflationary pressures rather than referring to a normalisation of economic conditions. This asymmetry has resulted in real interest rates remaining in negative territory for much of the past decade, with all the attendant distortions that have resulted.

Furthermore, with the BoE expecting inflation to get close to 5% next year, it is difficult to understand why a central bank which talks so much about hitting its inflation mandate continues to sit on its hands. Obviously the inflation spike is being driven by energy trends and supply bottlenecks in the wake of the pandemic, neither of which are amenable to monetary policy actions. But if the central bank does not want to raise rates at a time when inflation is heading towards its highest in 14 years, when will it ever?

Matters were undoubtedly complicated by the release of the budget last week, in which the main takeaway was the ongoing squeeze on household incomes. A rate hike would clearly have played badly in those circumstances. But what the episode demonstrates is that the BoE will have to think a lot more clearly about how it communicates its message, and perhaps equally importantly who it is communicating with? The decision to keep rates on hold sends a positive message to households that the BoE does not intend to make their lives harder but rattled markets which got carried away with the central bank’s message (obviously a rate hike would have reversed the two situations).

There are no easy answers to the conundrum of market communication, but clarity and consistency are the watchwords and arguably the BoE has fallen a bit short on both. Perhaps the problem can best be summed up in Alan Greenspan’s famous quote: “I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant.” It is easy to be critical of both the BoE for its mixed messages and investors for reading too much into its pronouncements. But if ever there was a sign that communications need to be rethought, this week's events provided it.