Central banking is a complex blend of art and science. It requires not only making economic judgments but also effectively communicating them – a task that major central banks have struggled with in recent years. Recognizing their imperfect record, the Bank of England recently announced a review of its performance.
The OECD predicts that UK inflation will be the highest among G7 countries this year. Concerns about persistent price growth have arisen due to higher-than-expected wage and inflation data, and a BoE survey revealed that public satisfaction with the institution hit an all-time low in May.
Like all central banks, the BoE faces the challenge of improving its forecasting processes. Economic models rely on historical relationships, and their predictive capacity weakens when unexpected events like the COVID-19 pandemic and the conflict in Ukraine occur. Many central banks were slow to raise rates before inflation reached 40-year highs last year.
In times of high uncertainty, any modeling approach would struggle. This underscores the importance of central banks’ ability to effectively convey their forecasts. The Bank of England’s review presents an opportunity for significant progress.
Transparency is crucial. The way a central bank communicates its forecasts and interest rate decisions directly affects future rate and inflation expectations, which have tangible impacts on household, business, and investor decisions. Therefore, enhancing trust and understanding in the central bank’s forecasts improves the effectiveness of monetary policy.
Guiding the markets has been challenging for the Bank of England, particularly during this rate-raising cycle. “Consistently… it has suggested that interest rates wouldn’t need to rise as far as the markets expect,” noted Paul Dales, chief UK economist at Capital Economics. “But it has then raised rates further than the markets expected.”
An improved inflation forecast would undoubtedly be beneficial. The review should examine why the BoE consistently underestimated inflation persistence and labor market tightness, factors that contribute to price pressures. However, the convoluted manner in which the BoE presents its projections exacerbates the problem.
Currently, the BoE’s inflation forecasts are based on the markets’ own expectations for the bank rate. Gertjan Vlieghe, a former external Monetary Policy Committee member, highlighted the flaws of this approach in a 2019 speech: “We communicate about what we think we may do, by showing you a forecast of what will happen if we do something else.” This is rather confusing.
One option for the BoE is to emphasize its inflation forecasts based on interest rates remaining at their current level. This provides markets with a clearer understanding of the BoE’s perception of the inflation challenge it faces. Additionally, the Monetary Policy Committee’s fan charts, which display projected outcomes, often suggest that inflation will eventually return close to its 2 percent target over the forecast horizon, further confusing the market about necessary rate adjustments.
An alternative, as suggested by Vlieghe, is to present forecasts using the MPC’s preferred path for interest rates at annual intervals – a practice followed by the US Federal Reserve, Reserve Bank of New Zealand, and Norges Bank. Explicitly outlining the likely rate trajectory would enhance everyone’s ability to assess the BoE’s potential actions.
This approach also carries procedural benefits. The potential for disagreements among MPC members regarding the preferred rate path could stimulate more robust debates on the economic outlook. This is especially valuable during uncertain times when diverse perspectives take on heightened significance compared to herd thinking.
The BoE could also adopt a model similar to the Fed’s “dot plot.” The Federal Open Market Committee publicly publishes members’ aggregated economic forecasts and their yearly preferred rate paths while preserving anonymity. Requiring individual projections could promote more rigorous committee deliberations, as members take greater ownership of their forecasts. However, additional information can sometimes lead to confusion. Berenberg suggests that a combination of central forecasts based on no rate change and the use of “dot plots” akin to the Fed’s approach could be the best solution for the BoE.
Regardless of the chosen approach, the BoE’s forecasts should, at the very least, provide insights into how the institution expects the economy to evolve and what rate trajectory is necessary to achieve its target. Currently, this information is presented in a roundabout manner. Although making these changes won’t solve all of the BoE’s problems, it will facilitate better public understanding of the institution’s objectives and make its job a bit easier.
Denial of responsibility! VigourTimes is an automatic aggregator of Global media. In each content, the hyperlink to the primary source is specified. All trademarks belong to their rightful owners, and all materials to their authors. For any complaint, please reach us at – [email protected]. We will take necessary action within 24 hours.
