Bank of England Will Overhaul Its Forecasting After Inflation Surprises


The Bank of England said on Friday that it would overhaul the way it forecast its outlook for the British economy as part of a “once-in-a-generation” review of its process after it was criticized for underestimating inflation.

After a few turbulent years — which included a pandemic, the war in Ukraine and a surge in inflation — the central bank was accused of bungling its economic forecasts. It has since set out to find ways to convey more clearly what it thinks will happen to economic growth and inflation, especially in times of high economic uncertainty.

“We have a once-in-a-generation opportunity to update our approach, in a world that, I’m afraid, remains highly uncertain,” said Andrew Bailey, the governor of the Bank of England.

Last summer, the central bank’s governing body commissioned a rare review, which homed in on the inflation forecast, a crucial part of setting interest rates and other monetary policy decisions. The bank asked a former Federal Reserve chair, Ben S. Bernanke, to lead the review.

After eight months of scrutinizing the bank’s staff, processes and technology, Mr. Bernanke provided 12 recommendations, which included ditching some of the ways it publicly presents its inflation forecasts, reconsidering the assumptions that underpin the forecasts, evaluating forecasting errors more closely and investing in upgrading software and economic models.

The bank said it was committed to carrying out all the recommendations. It added that it would need to put in “substantial investment” to develop the data, modeling and staff to support the forecasts. The changes will take a while to put in place, and the bank will provide an update on its progress before the end of the year, Mr. Bailey said.

The central bank is charged with maintaining price stability, specifically by targeting inflation at an annual rate of 2 percent. Forecasting is critical to this process. Because monetary policy works with a lag, officials base interest rates on projections about where inflation is expected to be in a few years.

In Britain, the inflation forecast plays a large role in the bank’s communication compared with that of other central banks, the review said. Traders also react to these forecasts and expectations about interest rates by buying and selling government bonds, which influences borrowing rates for companies and households.

One of the questions often thrown at the Bank of England by lawmakers and analysts is why its forecasts were so wrong. Was the economy changing too quickly and unexpectedly, making the 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 forecasting errors by the bank during that period were probably inevitable,” it said.

Over the past few years, the Bank of England has been heavily criticized by politicians, and public satisfaction with the institution has plummeted. Its forecasts repeatedly underestimated price increases as inflation surged in 2022 to the highest levels in four decades. Then it underestimated the speed at which inflation had slowed. Policymakers were first accused of acting too slowly to quell price rises and then of not cutting rates fast enough to support the economy.

The Bank of England is not the only central bank to have come under pressure. Others, including the Federal Reserve and the European Central Bank, were criticized for predicting that inflation in 2021 would be “transitory.” Instead it has lasted for several years. And forecasting errors were large across many central banks. The Bank of England’s recent errors were, in fact, smaller than the E.C.B.’s, the review found.

But in Britain, inflation has stayed higher than it has in its neighbors in Western Europe. The bank’s models and infrastructure were “challenged by the sheer scale and unpredictability of the shocks that hit us,” Mr. Bailey said.

The central bank said Britain used to face economic shocks that were manageable within the existing monetary policy framework. But then the country had a run of bad economic events. First was Brexit, which restrained trade, then the pandemic lockdowns shut off parts of the economy and, finally, a surge in energy prices shook households and businesses. All of these led to a jump in inflation, which at its peak exceeded 11 percent, and took policymakers by surprise.

The review said that the most serious problems were in software, which was outdated, and that the main economic model had “significant shortcomings.” The problems, which created “a complicated and unwieldy system,” limited the bank’s staff from taking useful analysis, including alternative forecast scenarios.

“It’s a little bit like fixing a car while its running,” Mr. Bernanke said, because staff members still have to support policymakers while updating the forecasting processes.

Mr. Bernanke recommended that the bank put less emphasis on the so-called central forecast for inflation, which is partly based on what traders expect interest rates will be, and use alternative scenarios more frequently to show the risks and uncertainty.

At the moment, 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. That can lead to forecasts that cause confusion.

For example, in 2022, the committee raised rates, but in an effort to signal to traders that it was not going to keep raising rates as much as it expected, the bank forecast a prolonged recession. Traders changed their bets, and the recession never materialized. But the forecast tarnished the bank’s reputation.

Mr. Bernanke pulled short of recommending a more revolutionary change to forecasts that would base them on policymakers’ expectations of future interest rates. He said that would be a “highly consequential” change that should be considered later. While at the Fed, Mr. Bernanke introduced something similar with the so-called dot plots.

Clare Lombardelli, a former British Treasury official who will join the central bank as a deputy governor in July, will be in charge of putting the changes in place.



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2024-04-12 19:31:18

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