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The Bank of England must revamp its main economic model if it is to avoid repeating its recent failure to forecast surging inflation, former Federal Reserve chair Ben Bernanke has said.
The Nobel laureate, who was called in to review the BoE’s forecasting and related processes, found “significant shortcomings” in the bank’s baseline economic model that were exacerbated by outdated software.
He added that the Monetary Policy Committee’s current “fan charts” — which show the probabilities of different outcomes for growth and inflation under various assumptions — had “outlived their usefulness” and “should be eliminated”.
Bernanke was asked to review the BoE’s forecasting last year after UK policymakers came under fire for failing to foresee a post-pandemic jump in inflation that was sharper and more prolonged than in other advanced economies.
His recommendations suggest radical change is needed to equip the central bank for a more volatile economic environment, in which big shocks such as the pandemic and the Ukraine war may be more frequent.
The BoE said it was “committed to action” on all 12 of the report’s recommendations and would provide an update on proposed changes by the end of the year.
Andrew Bailey, BoE governor, described the review as a “once in a generation opportunity” to update forecasting approaches and tailor them to a “more uncertain world”.
Bernanke said an international comparison showed the BoE’s forecasting performance had been no worse than that of other central banks, and that “unusually large” errors were “probably inevitable” given the unprecedented circumstances.
But the review also points to big deficiencies in the BoE’s forecasting infrastructure, the way it deploys staff, and its over-reliance on a central economic forecast to explain its policy decisions to the public.
Bailey said the BoE had been “challenged by the sheer scale and unpredictability of the shocks that have hit us” but that conditions were now calmer and there was now “an increasingly positive story to tell on the economy”.
The BoE now urgently needs to invest money and staff time into modernising software, Bernanke said, before “replacing or, at minimum, thoroughly revamping” its economic model, known as Compass, in the longer term.
In particular, he argued the model should in future pay more attention to problems with productivity, labour markets and trade. It should also include detailed models of financial, housing and energy markets.
Instead of using fan charts, Bernanke said the bank should publish a range of scenarios to explain its choices, the risks to its forecast and the “robustness” of plans in the face of uncertainty.
However, he stopped short of recommending that the BoE adopt the so-called dot plot, which he introduced at the Fed in the aftermath of the global financial crisis. The chart shows officials’ differing expectations for appropriate interest rate policy in the coming years.
While he said the US model would not suit the BoE, he argued the MPC should consider publishing its own forecast for interest rates in the longer term. Its central forecast is currently based on market rate expectations, meaning the MPC does not always believe its own projections.
Any such changes would be “highly consequential”, Bernanke said, arguing that the decision should be left for “future deliberations”.
The BoE should focus first on improving its forecasting tools — which will require heavy investment — while “moving cautiously in adopting changes to policymaking and communications”, Bernanke concluded.
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