MNI INTERVIEW: BOE Over-Emphasises Expectations:Ex-MPC's Weale

--Martin Weale: Role of Price Expectations In Standard Models Too Strong 

--Highlights Shortcomings Of Rational Expectations In Models

By David Robinson

     LONDON (MNI) - Bank of England models which place a lot of weight on price

expectations may have led policymakers to underestimate the danger of prolonged

deviations of inflation from target, former Monetary Policy Committee member

Martin Weale told MNI.

     Business's price expectations had much less influence on future price

movements than standard models assume, suggesting that policymakers should not

take much comfort if firms are anticipating low and stable inflation, Weale said

in an interview.

     "There's a strong strand in economic theory that the expectation of a

firm's ability and need to raise its prices influences actual price movements,"

Weale said, "but this effect appears to be overblown in standard models."

     "While we certainly found an effect, it was much weaker than is typically

used in economic models," he said, adding that in a study with former Bank

colleagues he found that price expectations from the CBI business survey

provided a correlation of about 0.3 with actual price behaviour, compared to the

coefficient of just below 1 assumed in theory.

     "What we found was that .. there was quite a clear tendency for people

giving high price forecasts to realize lower outturns and people giving very low

price forecasts to realize higher outturns," said Weale, who first presented the

results at the Dow lecture last month at the National Institute of Economic and

Social Research.

     Had the models assumed a much lower correlation between expectations and

prices, the Bank may have been more likely to anticipate persistent deviations

in inflation from target, such as the persistent overshoot in 2008 through 2013,

Weale said.

     Bank economists keep looking for better ways to treat expectations. At a

Bank for International Settlement event last year. Francesca Monti, Head of

Modelling in the Monetary Policy Outlook Division, said that the assumption of

full information rational expectations was often questioned by the MPC and that

"the role of expectations in the distant future is too strong."

     --"WELL-ANCHORED" EXPECTATIONS UNCLEAR

     The MPC stresses the importance of inflation expectations being well

anchored to the 2.0% target, but Weale is concerned about the vagueness of the

term.

     "What I was never able to understand was how far expectations had to

deviate from target .. before I should decide they weren't well-anchored anymore

and at times it mattered," he said.

     Another strand of Weale's research looked at the BOE's sterling forecasts.

After the MPC divided down the middle on how to forecast sterling back in

November 1999 it changed its exchange rate projection to one splitting the

difference between a constant exchange rate assumption and uncovered interest

parity (UIP) and has stuck with this ever since.

     Weale's research suggests that simply assuming a flat exchange rate would

have been more accurate. At present, with rate curves near horizontal the

difference between flat and interest differentials are negligible but the choice

of methodology could matter much more in future.

     "It certainly doesn't matter much at the moment. But there might be

circumstances where it would matter and it might be an idea to be ready for

those," Weale said.

     The Bank in its August forecast round shifted from assuming that oil, gas

and electricity prices would follow the futures curves to assuming that they

would remain flat after two quarters, and it is open to question why it should

stick to its currency forecasting convention.

     "I was always a bit unsure why we made one assumption for the exchange rate

and a different assumption for commodity prices .. If you stick to simple

assumptions like flat versus following the forwards markets then these are all

things that are quite easy to check," Weale said.

--MNI London Bureau; tel: +44 203-586-2223; email: david.robinson@marketnews.com

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