COLUMN-Time for a reset at the Bank of England: John Kemp
(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON Aug 12 (Reuters) - The Bank of England could usefully borrow the concept of a "reset", popular in international relations, to restore credibility to its inflation forecasts and bridge differences among members of the rate-setting Monetary Policy Committee.
The current global slowdown provides a unique opportunity for a fresh start.
Under a reset, Chief Economist Spencer Dale and external member Martin Weale would acknowledge a growing recession risk has undercut the need for an interest rate rise to tackle inflation and drop their votes in favour of an immediate increase.
In return, Governor Mervyn King would reconfirm his commitment to actually meeting the inflation target within a reasonable and plausible timeframe, and promise to support rate rises if the threat of recession lifts and inflation fails to show sufficient convergence with the target in H1 2012.
External Member Adam Posen would agree to drop his dogged insistence on more money creation if inflation fails to converge sufficiently in H1.
Resetting would provide an elegant way to break the year-long stalemate that has paralysed decision-making and led to the Bank's increasingly error-prone inflation forecasts being derided by investors.
CONVICTIONS TRUMP EVIDENCE
According to the Bank's website, the nine members of the MPC meet each month to review the latest data on the economy and hear explanations of recent trends and analysis, including information about business conditions gathered by the regional agents.
Once a quarter they update forecasts for growth and inflation over the next two years. The results are published in the "Inflation Report" as probability density functions or fan charts.
It is meant to be an empirical, evidence-based approach. Members are individually accountable and expected to explain their reasoning through parliamentary appearances, an annual report and speeches to audiences around the country.
But in an empirical process there should be much more vote shifting as new information about the state of the economy becomes available, and some adaptation of the forecasts in the light of experience about past errors.
Instead, forecasts always show inflation converging to the target in two years time, whatever the starting point today, even though such convergence has not happened over the last five years. And members continue doggedly voting the same way month after month whatever new data filters in about the health of the economy and inflation.
Forecast parameters change but the policy prescription stays the same.
Dale, Weale and before them Andrew Sentance consistently vote for an immediate rate rise, whether growth speeds up or slows down. Posen seems to think the answer is always to print another 50 billion pounds whatever the inflation rate.
King and the remainder of the committee sit stubbornly atop an odd sort of fence in which risks sometimes tip slightly one way or the other, but always remain finely balanced, justifying continued inaction. Defying the laws of statistics, uncertainty is always more than normal encouraging the committee to hold on for more information in the hope it will somehow resolve the problem.
There are good theoretical arguments for all these views. But a cynical observer might detect more than a hint of pride and stubbornness.
One day all members will be proved right; the economy is cyclical so there will be a time for interest rates to rise and a time for more stimulus. In the meantime inflation wanders further away from target and the Bank has no idea when the storm of rising prices will eventually blow itself out.
As for the forecasts, the fans have become so wide they now cover every conceivable eventuality from roaring growth and inflation to recession and outright deflation. "The Bank's fan charts are fanning out so much it's ridiculous," as the Financial Times' Alphaville blog noted Wednesday.
It is all an elegant pictorial way of admitting the Bank isn't able to forecast two years ahead, and it hasn't been able to do so for some years now.
MODELS COLLIDE WITH REALITY
Most committee members ignore information about current conditions as irrelevant given the lags in policy and focus on setting rates based on their forecasts for inflation and growth in two years time.
But since there is no evidence the Bank or individual members can divine anything about conditions at that time horizon, this approach amounts to junking empiricism in favour of policymaking by model leavened with a touch of instinct.
The problem with forward policymaking by theory is there is no way to judge whether it is right or wrong, no means for members with different instincts and theories to reach any sort of agreement, and no way to correct errors arising in the process. The different camps talk past one another, each hoping one day to be proved right, while never admitting to have been wrong in the past. The target for being right gets pushed repeatedly back.
Outside observers have increasingly concluded that the majority at the Bank has in fact topped trying to meet the inflation target, suspending it for the time being to focus on reviving growth. In support of this view, it has become almost impossible to think of any inflation rate which might prompt Posen, King and the majority in the middle to raise rates or drop the insistence on more QE if the trade off was a slowdown.
Unfortunately, decisions that are really about growth and jobs are still being publicly justified in terms of the inflation fan -- which has brought the whole process into disrepute because the forecasts and stated policy intentions do match the Bank's (in)actions.
It is no way to make policy. Net satisfaction with the way the MPC does its job has more than halved over the last decade, from more than 50 percent in 2001-2002 to around 20 percent in 2011, according to the Bank's inflation attitudes survey.
Some sort of amity inside the committee appears to have returned with the departure of Andrew Sentence, and his replacement by Ben Broadbent; disagreements are mostly polite in public. But former members of the committee snipe from the sidelines and the committee's competence and inflation-fighting determination are increasingly questioned.
The committee clearly needs to reset both its internal voting relationships/blocs and its forecasting. Ironically the current deterioration in global growth prospects provides an opportunity.
Empirically-minded policymakers would recognise that the global slowdown has begun to ease upward pressure on inflation in the short term, partly through falls in commodity prices, partly by the implied slowdown in export-related and domestic demand.
Dale and Weale should respond by dropping their insistence on an immediate rate rise. It would provide a face-saving way out and ease pressure on the embattled governor.
But in return they should extract a commitment from the governor and the majority to a more evidence-based (as opposed to theory-based) policy in future -- including a more definite timetable for raising interest rates if inflation does not fall as the governor and his allies predict.
The Bank needs to overhaul its forecasting process and either improve the accuracy or admit that it is unable to predict inflation and growth two years out, dropping that as the policy guideline.
Finally, the Bank should come clean and admit that it has (temporarily) stopped targeting inflation to focus on other economic goals in exceptional circumstances, but explain openly how long such suspension will last, and the conditions under which the inflation fans will once again guide policy.
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