MNI INTERVIEW:Credibility Key To "Table-Mountain" Rates Pledge

Central bankers should be able to adopt a “table-top” strategy of keeping rates flat at peak for a sustained period so long as markets believe the starting level is credible, but new economic models should factor in the variability of credibility over time, Oxford professor and former senior Bank of England economist Michael McMahon told MNI.

While the Bank of England may soon be in a position to signal an extended pause at a relatively high plateau, with a possible 25-basis-point hike this week set to take Bank Rate to 5.5%, close to the 5.45% cycle top suggested by market-pricing, McMahon noted the contrast with last October, when Deputy Governor Ben Broadbent, citing the Bank’s internal Optimal Policy Projections, suggested that investor expectations at the time for a 5.25% peak were more than 125 basis points too high. In McMahon's view, the Bank did not at that point have the credibility to be able to deliver a lower peak given that markets thought it was understating inflation pressure and fiscal policy had been undermined by a disastrous mini-budget.

“The models that they use for this type of exercise assume and build in full credibility. So in a time when you’re fully credible, three-and-a-half might have been enough. But the entire problem that the Bank, and the wider UK, faced from September last year was a lack of credibility,” he said.

BERNANKE REVIEW

Former Federal Reserve chair Ben Bernanke has been commissioned to review the Bank’s forecasting procedures following widespread criticism of its projections, including the Optimal Policy Projection, which seeks to identify the policy path that would achieve the best outcome for inflation and the output gap.

“If the Bank really wants to do a review and have better models, I think ones that take into account credibility that can evolve over time are needed. Credibility can evolve with how the market thinks they're doing, with how the data has been relative to forecast and with how their communications are received. Academic literature doesn't have such models fully up and running yet, but there is progress even if it's a really hard nut to crack,” McMahon said.

Some members of the BOE’s Monetary Policy Committee, including Chief Economist Huw Pill and Swati Dhingra, think the Bank will soon have hiked enough for it to switch to the “table-top” or “Table Mountain” approach, though Catherine Mann has indicated she thinks rates may still have to rise more to tame inflation. At the same time, the Bank has insisted that its recent decisions have been “data dependent,” a line which some have speculated might be incompatible with a pivot towards a table-top. (See MNI INTERVIEW:Flat Rates Fit With Data Dependence-ExBoe's Bean)

But McMahon said it was valid for MPC members to use multiple factors, including the assessment of the economy and the impact of previous tightening to build their central case.

“I mean, what the hell would it mean if monetary policy were not data dependent?” he said. “I think monetary policy will always be data dependent. So then the question is about can you do the sort of the table-top approach and the answer is yes – if the level you hold rates at is appropriate for the economy.”

The BOE should also be up front in its communications about its decision-making process, he added.

“I think the MPC should be perfectly happy to acknowledge that some members think there's a lot of action from the interest rate rises still to come. Others think they're still behind the curve,” McMahon said. “Market participants who need the information can read more than one line.”