(Bloomberg) — Ben Bernanke put the US Federal Reserve on the cutting edge of economics 12 years ago by collecting policymakers’ forecasts, including their outlook for interest rates, into groups of “dot plots.”
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This week, the former Fed chair is expected to suggest the Bank of England adopt a new innovation — a flexible set of “scenarios” — in a bid to update its forecasting process and repair its battered reputation.
Bernanke was asked last July to lead a review of the BOE’s forecasts after the UK’s central bank failed to predict inflation would hit a four-decade high of 11.1% and that it would remain elevated. Governor Andrew Bailey came under fire from members of Parliament and independent economists for allowing a price spiral worse than both the US and euro zone.
Bernanke’s proposals, due for release on April 12, will play into the debate about how the BOE’s monetary policy committee makes and communicates its outlook for the UK economy – words that investors carefully parse to value government bonds and the pound. Huw Pill, the chief economist, said in March the review “will offer a once in a generation opportunity to renew and improve the MPC’s framework.”
The issue is especially charged at the moment, with an election expected in the second half of the year and Prime Minister Rishi Sunak’s government trailing the Labour opposition in the polls. MPs from Sunak’s Conservative party have criticized the BOE’s performance through the pandemic and after, pressing Chancellor of the Exchequer Jeremy Hunt to tighten oversight of the institution. However, Bernanke is expected to show the BOE’s errors were far from unique and were a product of the unusual volatility of the past few years.
Neither Bailey nor Bernanke offered comment ahead of the report, but remarks by policymakers over the past few months sketch a roadmap for what’s likely to emerge.
The former Fed chair has taken a broad look at the BOE’s systems and will make a number of recommendations, including upgrading the forecasting infrastructure used by the rate-setting MPC. But his report will not be prescriptive.
Instead, Bernanke is likely to lay out a buffet of options and leave it to the MPC to choose how to proceed. Clare Lombardelli, who replaces Ben Broadbent as deputy governor later this year, will “lead the actions” in response, the Treasury said at the time of her appointment last month. The BOE will publish an accompanying response but is not expected to make any final decisions. Hunt would need to be consulted before changes are made.
One expected outcome is that the BOE’s “fan charts” will be replaced with “scenarios” that can be adapted to events and better communicate the different positions held by MPC members. The fan charts, introduced almost 30 years ago, will be “retired,” Bailey told the Financial Times on March 22.
Scenarios emerged as a tool during the pandemic to address the uncertainties policymakers had to consider and to show how the central bank would react to alternative developments. Bailey told MPs in February they could provide “better ways of conveying the range of views” on the MPC. But, in his FT interview, said he had yet to be convinced they will improve communication.
“The risk is that presenting alternative paths could distract from the central message of the forecast,” said Dan Hanson, chief UK economist at Bloomberg Economics.
Sweden’s Riksbank started using scenarios regularly last year. It believes they have proved “important for policy communication” and “allow economic agents to be better prepared for changes in monetary policy.”
Bloomberg Economics on Bernanke…
“He could suggest steps to address one of the long-standing challenges to the BOE’s approach – basing its projections for growth and inflation on interest rate forecasts which it may or may not agree with, while staying silent on its own view. The solution? Publish a single forecast that is underpinned by the Monetary Policy Committee’s ‘best collective judgment’ about how its policy rate should evolve.”
—Dan Hanson and David Wilcox. Click for the INSIGHT.
Some form of innovation is needed to address what has repeatedly proved one of the BOE’s toughest challenges: communicating to the public and the markets simultaneously. In November 2022, the problem blew up because markets were pricing in several rate rises that the BOE at the time did not believe would happen.
BOE officials signaled their unease to investors by forecasting a deep economic slump and large inflation undershoot. In doing so, though, the BOE misled the public by warning of the longest recession since the 1930s, which never happened.
The complication was caused by a convention that the BOE use the market path for interest rates as a key input into its forecast. Switching to dot plots, or imitating Sweden’s Riksbank by using the MPC’s best collective judgment of the path for rates, would remove such communication contradictions. Scenarios could also help send a message to one group without misleading the other.
“Replacing the market yield curve with a preferred interest rate profile,” said Deutsche Bank senior economist Sanjay Raja, “may be less volatile and could avoid a ‘tail wagging the dog’ scenario.”
Again, the Riksbank is seen as a standard bearer and comments by several MPC members show they are unconvinced by Fed dot plots. The BOE forecasts are already prepared using a Swedish-style model-based simulation of the optimal path for rates, Broadbent revealed in October 2022. He said that so-called “Optimal Policy Projections” can be used to “explore whether adjusting monetary policy relative to the market curve on which the forecast is conditioned can improve economic outcomes.”
On dot plots, Broadbent complained they were often misunderstood – seen as hard forecasts rather than conditional projections. Bailey told the FT there was a risk individuals on the MPC would feel obliged to reveal their personal rate paths. “I’m certainly in two minds about the dot plot,” he said.
Catherine Mann, an external member, told Bloomberg TV: “We do better than dot plots. We tell you exactly how we vote, and we give speeches and interviews to tell you why – so we give you a lot more information than a dot plot.” Megan Greene said the markets “do not understand dot plots as they are intended.”
Politicians including Jacob Rees-Mogg, the former business secretary who claimed the BOE had “let the country down” by allowing inflation to take off, are likely to be frustrated by Bernanke’s probable main finding: that the BOE’s forecasts were no worse than others.
Bailey told the FT that “everybody” got the scale of the inflationary upsurge wrong, and analysis in February by Bloomberg Economics found that the BOE’s forecast errors were of a similar magnitude to those of other major central banks. Using an inflation model developed by Bernanke last year, Jonathan Haskel, an external MPC member, showed the BOE had been right in its original analysis that price increases would be transitory.
Bloomberg Economics on Forecasting…
“Our analysis suggests it has done no worse than the Federal Reserve or the European Central Bank in recent years. But none have done well. With forecasts a crucial element of policy formulation and communication, that’s a problem.”
—Ana Andrade and Dan Hanson. Click for the INSIGHT.
One of the more complex issues the review may raise is the lack of sophistication in the bank’s modeling and data inputs. Speaking to Bloomberg TV, Mann suggested the forecast process was out-of-date and in need of an upgrade.
The BOE’s current forecast is relatively simple, “linear and symmetric,” she said. It would help to “bolt on important research that helps you understand how firms react in a nonlinear situation, or an asymmetric situation.”
–With assistance from Andrew Atkinson.
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