By Paul Hannon
The Bank of England will place more stress on developments that could upend its expectations for the U.K. economy and future interest rates as part of an overhaul of forecasting and communications recommended by Ben Bernanke, a former chair of the Federal Reserve.
Published Friday, the Bernanke review is one of the first steps taken by a leading central bank to understand why it underestimated a surge in prices that began in early 2021 and dented living standards.
Bernanke concluded that the BOE performed no worse than its peers in anticipating the inflation surge, and that errors were unavoidable given the size of the shocks that hit economies during the Covid-19 pandemic and its aftermath.
"Given the unique circumstances of recent years, unusually large forecasting errors by the Bank during that period were probably inevitable," Bernanke said.
However, he delivered a scathing verdict on the bank's forecasting machinery, concluding that it was deprived of needed resources and judging that the baseline economic model--known as COMPASS--has significant shortcomings and should be thoroughly revamped.
Bernanke said the forecasting process makes the central bank slow to recognize big changes in the economy, such as those that occurred during the pandemic. He recommended that the bank explore alternative scenarios to the most likely path for the economy, both in its forecasts and its communication with the public. This is a practice that has already been adopted by Sweden's Riskbank.
"The publication of selected alternative scenarios would help the public better understand the reasons for the policy choice," Bernanke said.
Bernanke also recommended that policy makers should be exceptionally clear when they don't believe in the assumptions that underlie their forecasts. The Monetary Policy Committee's forecasts for growth and inflation are based on the assumption that the interest rate they set changes as investors expect.
But policy makers often have a very different view of how rates should change, and that can lead to confusion. In late 2022, for example, the BOE forecast that the U.K. economy would enter a deep recession, but that assumed rates were going to rise more sharply than policy makers intended. What they were actually doing was signaling that they wouldn't raise the key rate as rapidly as investors expected, but business and consumer confidence may have been weakened by the recession call.
"The MPC should de-emphasize the central forecast based on the market rate path," Bernanke said.
He also suggested that the MPC base its forecasts on its own expectations for interest rates, as do the Swedish and Norwegian central banks, but stopped short of making that a formal recommendation.
"That change would be highly consequential and this report recommends leaving decisions on this issue to future deliberations," he said.
The former Fed chair was more definitive in dispatching another enduring element of the BOE's forecasting and communications process, concluding that fan charts that aim to show the probability of inflation differing from the central forecast have outlived their usefulness.
"They should be eliminated," he said.
The BOE said it would follow Bernanke's guidance.
"This is a once-in-a-generation opportunity to update our approach to forecasting, and ensure it is fit for a more uncertain world," said BOE Gov. Andrew Bailey. "We are committed to taking action on all of Dr. Bernanke's recommendations."
The U.K.'s annual rate of inflation peaked at 11.1% in October 2022. It has fallen steadily since then, to 3.4% in February. The BOE raised its key interest rate in a series of 14 steps to 5.25% in August 2023 from 0.1% in December 2021. That was its highest level since early 2008.
The challenges of forecasting inflation accurately continue to bedevil central banks, including Bernanke's former employer. Policy makers at the Federal Reserve expected inflation to ease this year, opening the way for a series of rate cuts. But recent inflation readings have been hotter than expected, putting those expected cuts in question.
Write to Paul Hannon at paul.hannon@wsj.com
(END) Dow Jones Newswires
04-12-24 0742ET
