Bank of England will revise its forecasts after inflation surprises

The Bank of England said on Friday it would overhaul the way it forecasts the British economy as part of a “once in a generation” review of its operation after coming under criticism for underestimating inflation.

After a turbulent few years — which included the pandemic, war in Ukraine, and soaring inflation — the central bank was accused of bungling its economic forecasts. Since then she has set out to find ways to more clearly articulate what she believes will happen to economic growth and inflation, especially in times of extreme economic uncertainty.

“We have a once-in-a-generation opportunity to modernize our approach, in a world that remains, I fear, highly uncertain,” said Andrew Bailey, Governor of the Bank of England.

Last summer, the central bank's governing body commissioned a rare review, which focused on inflation expectations, an important part of setting interest rates and other monetary policy decisions. The bank has asked former Federal Reserve Chairman Ben Bernanke to lead the review.

After eight months of scrutiny of the bank's staff, operations and technology, Bernanke made 12 recommendations, which included eliminating some of the ways he publicly presents his inflation forecasts, reconsidering the assumptions underpinning the forecasts, assessing forecast errors more closely, and investing in forecasts. – Updating software and economic models.

The bank said that it is committed to implementing all recommendations. It added that it would need to make “significant investments” to develop data, modeling and staffing to support the forecast. Mr Bailey said it would take some time to implement the changes, and the bank would provide an update on its progress before the end of the year.

The importance of expectations

The central bank is responsible for maintaining price stability, specifically by targeting inflation at an annual rate of 2 percent. Forecasting is crucial to this process. Because monetary policy operates on a time-lag system, officials base interest rates on expectations of where inflation is expected to be in a few years.

In Britain, inflation expectations play a larger role in the bank's communications than with other central banks, the review said. Traders also react to these expectations and expectations about interest rates by buying and selling government bonds, which affects the borrowing rates of businesses and households.

One question lawmakers and analysts often ask the Bank of England is why its forecasts were so wrong. Was the economy changing too quickly and unpredictably, making forecasts ineffective, or was the forecasting process flawed, making it less useful in times of heightened uncertainty?

The review found it was a combination of both. “Given the unique circumstances of recent years, unusually large forecast errors by the bank during that period were probably unavoidable,” he said.

How did the Bank of England get here?

Over the past few years, the Bank of England has been heavily criticized by politicians, and public satisfaction with the institution has declined. Its forecasts have repeatedly underestimated price increases as inflation in 2022 rises to its highest levels in four decades. Then he underestimated the speed at which inflation slowed. Policymakers were initially accused of acting too slowly to rein in rising prices, and then of 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, have been criticized for predicting that inflation in 2021 will be “temporary.” Instead it continued for several years. Forecast errors were large at many central banks. The review found that recent errors made by the Bank of England were actually smaller than those of the European Central Bank.

But in Britain, inflation remained higher than in its Western European neighbours. The bank's models and infrastructure “have been challenged by the sheer scale and unpredictability of the shocks that have hit us,” Bailey said.

The central bank said that Britain was accustomed to facing economic shocks that could have been controlled within the current monetary policy framework. But then the country experienced a series of bad economic events. First, it was Brexit, which restricted trade, then pandemic lockdowns shut down parts of the economy, and finally, rising energy prices shook households and businesses. All of this led to a jump in inflation, which at its peak exceeded 11%, and caught policymakers by surprise.

What will change?

The review said the most serious problems were with the software, which was outdated, and that the main economic model had “major shortcomings”. The problems created a “complex and unwieldy system” that limited the ability of bank staff to conduct useful analyses, including alternative forecasting scenarios.

“It's a bit like fixing a car while it's running,” Bernanke said, because staff still have to support policymakers as they update forecasts.

Bernanke recommended that the bank reduce emphasis on so-called central forecasts for inflation, which rely in part on traders' expectations of interest rates, and frequently use alternative scenarios to reflect risks and uncertainty.

Currently, the bank's forecasts do not always reflect what policymakers think about the likely future of interest rates, because they are based on financial markets. This can lead to confusing expectations.

For example, in 2022, the committee raised interest rates, but in an attempt to signal to traders that it would not continue to raise interest rates as much as it expected, the bank predicted a prolonged recession. Traders changed their bets, and the recession never happened. But expectations The bank's reputation was tarnished.

Bernanke stopped short of recommending a more revolutionary change in the outlook that would base policymakers' expectations on future interest rates. He said that would be a change of “huge importance” and should be considered later. While at the Fed, Mr. Bernanke introduced something similar with so-called dot charts.

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.