An economist’s job is to tell you what’s going to happen, then explain why it didn’t.
That quip goes to the heart of all economic forecasts – they are, by their very nature, flawed and will most likely be ‘wrong’. But that doesn’t mean they don’t have value if they are produced, updated and used appropriately. Given the events of the last few years, including inflation rocketing much more than predicted, the Bank of England commissioned a review of its forecasting approach and processes by former Federal Reserve Chairman Ben Bernanke. The review was published last month and certainly pulled no punches in what was described as a “brutal” verdict on the failings of the Bank’s economic modelling.
It's worth pointing out the context provided in the review, though: yes, the accuracy of the Bank’s forecasts has deteriorated significantly in the past few years, but that is similarly true of other central banks and external forecasters given the unexpected economic shocks experienced. Given the problems with the Bank’s forecasting infrastructure highlighted in the review, perhaps the fact it managed to only be as wrong as everyone else could be seen as something of an achievement!
The lengthy review also covers general background on why and how central banks produce forecasts, the construction and use of forecasts at the Bank and an assessment of these accompanied by 12 recommendations. These follow three major themes: (1) building and maintaining a high-quality infrastructure for forecasting and analysis; (2) providing a forecast process that better supports the Monetary Policy Committee’s (MPC) decision-making; and (3) using the forecast to communicate the MPC’s outlook and policy rationale to the public.
The assessment of the Bank’s forecasting and modelling may have made for uncomfortable reading at Threadneedle Street. The review found serious deficiencies in the forecasting infrastructure – the tools used by staff – with out-of-date software lacking key functionality and the economic and statistical models used to support the forecast having not been adequately maintained. The models also often don’t integrate with each other well, requiring manual processing, and ad-hoc fixes to operational problems over the years have led to an “unwieldy and inflexible system that limits the ability of the staff to undertake potentially useful analyses”. Producing the forecast each quarter is very demanding on staff, which has limited the time they’ve had to address the longer-term issues with the software and models. But these issues then mean the forecasting process takes even longer – and round and round we go! The review is clear not to criticise the Bank staff, though, who are noted for their commitment, high quality work and professionalism.
Unsurprisingly, a number of the review’s recommendations relate to these problems, including the updating and modernisation of software to manage and manipulate data (which is already underway), dedicated staff time and resources to maintaining and developing models, replacing or seriously revamping the existing modelling system and generally overhauling the forecasting framework.
Other key recommendations relate to the format of the forecast itself. It’s suggested that the central forecast should be supplemented with ‘alternative scenarios’ on a regular basis to help improve the MPC’s discussions. Related to this, it’s recommended that select scenarios are included in the quarterly Monetary Policy Reports to improve communication with the public and that the central forecasts, which assume Bank Rate follows the market’s expectations, should be de-emphasised. This seems reasonable given the convention of basing the main forecasts on market interest rates means that they don’t reflect what the MPC thinks is going to (or needs to) happen to meet the inflation target. This is a shortcoming which clients may be familiar with us commenting upon, particularly in the last few years, and indeed the review notes it “does not provide a clear rationale for policy decisions”.
Perhaps the recommendations don’t go far enough here. The possibility of the MPC using its own Bank Rate forecast is discussed but not made as a formal recommendation, instead left to “future deliberations”. While it would be a major step to take, and the infrastructure probably needs updating first, other central banks use similar procedures and it would increase transparency no end, rather than leaving economists and the market attempting to interpret the MPC runes.
Clients will be familiar with us discussing the ‘fan charts’ for growth, unemployment and inflation from the quarterly Monetary Policy Reports, long-term stalwarts of the Bank’s forecasting output designed to indicate the risks around the central forecasts. Well, we may have to wave goodbye to the fan charts as Bernanke judges them to “convey little useful information” and thinks they should be “eliminated”. Ouch. We have found them useful tools for discussions on the economy with clients over the years and although they are perhaps now outdated, a revamp could be useful rather than them being ditched completely. A simplifying of the Bank’s communication is also suggested, replacing the sometimes repetitive, quantitative commentaries with more succinct, qualitative summaries.
While the complexities and nuances of monetary policy don’t necessarily translate into easy headlines or soundbites, the Bank hasn’t been great at communicating with the public in recent years (remember the ‘unreliable boyfriend’, or the current Governor’s misjudged comments about pay rises?) and has been perceived as sending mixed messages. Given that the general public doesn’t look at the Bank’s reports in detail – or let’s be honest, at all – it remains to be seen if the suggested improvements to these make much difference to better communication out in the wider world.
The Bank has committed to ‘action’ all of the recommendations, but the review leaves the exact approach open for further consideration, so we’ll have to wait to see how they are implemented. It is certainly a complex business and will be a major undertaking for the Bank in the years to come and indeed a phased approach is recommended.
The next Monetary Policy Report is published on 9th May and we will be reporting on this, updating our forecasts where appropriate and discussing all things monetary policy related in more detail on our weekly webcasts, as usual. If you wish to discuss our UK economic and interest rate forecasting services please get in touch.
Related Insights
Is the path of UK inflation more like the US or Eurozone?