By David Milliken
LONDON- When the Bank of England’s chief economist was asked to explain why its forecasting models had failed to anticipate runaway inflation, he sought to manage expectations.
“All economic models are wrong, but some are useful,” Huw Pill concluded in a letter to lawmakers last June that laid out the limitations of prediction methods.
Britain’s central bank was nonetheless unable to escape the censure of economic experts in parliament who judged its “inadequate” projection models and a narrow outlook had frustrated its efforts to rein in rampant inflation in the wake of the COVID pandemic and Russian invasion of Ukraine.
The report in November turned a public microscope onto the arcane world of economic forecasting, a combination of science, art and guesswork that aims to divine the future state of the economy and guide central bankers in adjusting interest rates.
“We should really be thinking of economic forecasts in terms of probability distributions,” said Stephen Millard, deputy director of Britain’s National Institute of Economic and Social Research, who spent more than 26 years at the BoE.
“They are like weather forecasts – along the lines of ‘there is a 20 percent chance of rain’.”
The BoE has called upon a Nobel Prize winner, former Federal Reserve Chair Ben Bernanke, to review its methods. His report is expected in April and heralds what Pill said this month was a “once in a lifetime” chance to shake-up the central bank’s forecasting and communication methods.
While Bernanke himself declined to be drawn about his review, Reuters interviewed eight leading economists, including current and former members of the BoE’s interest rate-setting Monetary Policy Committee, who identified some of the main weaknesses of the Bank’s approach and changes they envisioned.
Michael Saunders, who stepped down from the MPC in 2022, described a sometimes dysfunctional internal process where rate-setters disagreed with their central bank’s own projections for key indicators like inflation and growth.
“The problem that needs solving is that the Bank publishes a forecast which many MPC members – often the bulk of MPC members – don’t think is a realistic description of what the economy’s likely to do,” he said.
One radical option to resolve this would be a shift from the BoE producing single forecasts to a system where each of the nine MPC members anonymously gives their own projections, which are then collated into charts called “dot plots”. Bernanke introduced this system at the Fed over a decade ago.
A more broadly supported reform among the economists interviewed was a move to publish a series of alternative scenarios alongside the main forecast.
Saunders said that if he were still on the MPC, he would want to consider scenarios around global shipping costs staying high for six months versus two years, and also for wage growth failing to slow as forecast.
There is also a communications element.
Current MPC member Jonathan Haskel backed a wider use of alternative scenarios, telling Reuters they could help people outside the bank understand how the BoE’s modelling worked and the “reasonable parameters” for uncertainty.
Many of the economists stressed that the BoE’s forecasting was on a par with other major central banks, including the Fed and European Central Bank.
The banks have all faced similar criticism for failing to anticipate that the end of COVID lockdowns followed by the Ukraine war would presage runaway inflation, and that they were too slow to raise rates.
The BoE and its peers were not expected to predict the pandemic or war. They nonetheless faced criticism from politicians and investors that they failed to foresee the scale of the surge in inflation in 2022, or how slowly it would fall.
British inflation peaked at a 41-year high of 11.1 percent in October 2022, after Russia’s invasion of Ukraine in February that year caused European natural gas prices to leap.
Yet inflation was already 6.2 percent in February 2022, triple the BoE’s forecast just a year earlier, as central banks underestimated the scale of supply-chain difficulties and labor shortages after the pandemic.
Inflation was also slower to fall in Britain than in other countries, hovering around 10 percent in the second quarter of 2023 compared with a BoE forecast in May 2022 it would fall below 7 percent .
One major challenge that has faced the BoE and other central banks is that it has been decades since inflation last leapt as high as it did in 2022, and most economic models are not based on historic data going that far back.
While models can be recalculated to include this data, many aspects of Britain’s economy have changed since the 1980s – such as union membership, energy sources and trading partners – making it hard to draw valid comparisons. -Reuters
