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The use of the equilibrium interest rate, key to much recent central bank analysis, appears out of favour as a guide to regular policy setting at the Bank of England, where internal divisions over the pace of tightening are centring around a more data-based approach in which the effect of policy changes are assessed as they are enacted.
Talk that the BOE might publish regular assessments of the level of long-term equilibrium rate, known as R-star, have come to nothing, and such calculations seem to be playing little role in divides on the Monetary Policy Committee, which split 5-4 over whether to hike by 25 or 50 basis points at its February meeting. While R-star, which former Monetary Policy Committee member Gertjan Vlieghe said has fallen substantially in recent years, is embedded in Bank models, policymakers see it as too difficult to measure to provide much practical guide to decisions.
In a speech on Wednesday, BOE Chief Economist Huw Pill spoke against over-reliance on R-star, and the associated Y-star estimate of potential output. The size of the output gap is uncertain, due to problems in assessing potential supply, he said, arguing that policy makers are less likely to make mistakes if they focus on changes, rather than levels, in key economic variables.
Similar points, supported by research by former European Central Bank official Athanasios Orphanides and the Fed’s John C. Williams, were made in the past by Pill’s MPC colleague Silvana Tenreyro, who, like the chief economist, voted for a 25-basis-point hike.
DIVIDE OVER WILLINGNESS TO RISK A POLICY REVERSAL
On the currently more hawkish side of the MPC backing a 50-basis-point increase, Vlieghe’s replacement Catherine Mann has also published work casting doubt on output gap calculations. In public explanations of her policy stance, she has relied on concerns over firms' pricing intentions and the rise in inflation expectations, rather than on the need to move swiftly to an uncertain equilibrium rate.
Disagreements on the MPC have taken a more practical tinge, as policymakers differ in their willingness to risk having to change course later after hiking early and aggressively. But members agree that policy should be assessed by looking at the economic data as policy is adjusted, rather than trying to take aim at a theoretical neutral rate.
In its February report, the MPC’s projection based on the market path for interest rates showed inflation substantially undershooting target at the end of the three-year forecast horizon.
If the re-opening from Covid runs smoothly and supply chain disruptions largely disappear, but demand growth is not particularly strong, a reversal of an early rapid tightening would be perfectly possible, in line with a trial-and-error approach. But any internal BOE projections showing the potential for such an about-face would not see the light of day.
Unlike the case with its Nordic counterparts, which publish collective rate paths, or the Fed with its dot plot of individual policymakers’ projections, the preferred policy paths of individual BOE policymakers remain shrouded in mystery, though, in addition to the market path, it also publishes a projection based on unchanged policy.
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