MNI POLICY: Models, Forecasts Out Of Focus As BOE Tilts To Cut

The Bank of England’s tilt towards a possible near-term rate cut in its June minutes suggests that it is de-emphasing the role of forecasts in policy setting, in line with recommendations from former Federal Reserve chief Ben Bernanke. 

The dovish signalling came despite recent activity data which was markedly stronger than the Monetary Policy Committee had anticipated, services inflation which was a touch higher and remains elevated and at a time when labour market data is fraught with uncertainty. In August, when many expect the MPC to cut, it will have to publish new three-year forecasts, but while Governor Andrew Bailey and colleagues are no longer going out of their way to downplay the importance of their projections, nor are they likely to place much emphasis on their precision as they justify their policy move.

Rather, with the MPC currently split three ways, the case for a cut will depend on how much weight is given to particular data points, and on the bigger picture of long policy lags as inflation heads back to target. (See MNI POLICY: BOE Split Over Measures Of Inflation Persistence)

While some MPC members continue to be troubled by signs that services inflation is holding up, those voting for a cut in June, and those leaning towards one later, have backed variations of the argument that the sector is not a good predictor of inflation persistence. While it makes up four-fifths of output, it reflects a myriad of factors including regulated cost changes, such as the rise in the National Minimum Wage and energy costs, rather than providing a purer measure of pay pressure than goods prices. (See MNI INTERVIEW: Services Inflation Poor Policy Guide - Vlieghe)

GROWTH FASTER THAN EXPECTED

The Bank’s forecasts again fell short as it underestimated the strength of economic activity in the first half of this year. GDP rose 0.7% on the quarter in Q1, 0.3 percentage point stronger than had been expected in the May Monetary Policy Report, while Bank economists revised up their Q2 quarter-on-quarter forecast to 0.5% from 0.2%.

The BOE’s failure to anticipate the surge of inflation during the pandemic, coupled with its slow policy response, meant that Bank officials spent late 2022 and the first half of 2023 pushing back against charges by lawmakers that their models contained unrealistic assumptions, such as inflation expectations reverting to target, and that that they relied on data from recent decades of low inflation. 

In parliamentary hearings and speeches, officials were forced to hammer home the message that they did not place great weight on the projections, with Deputy Governor Dave Ramsden once calling them merely "a baseline scenario." But the Bank also commissioned the former Fed chief to report back on its forecasting.

Now, with inflation back to target, criticisms have eased and, while the BOE has launched a lengthy re-working of its forecast process in line with Bernanke's recommendations, officials have ceased to publicly distance themselves from the projections. This is not, however, the same as saying members believe them, and the central projection is only the one that MPC members least disagree on, with plenty of dissent around it.