The not-so-subtle art of policy making

Another month, another Bank of England rate hike.

Since the BoE’s meaty 50bp rate rise in June – following a period of complacency earlier this year – inflation data has relented somewhat. The Monetary Policy Committee opted for a less aggressive 25bp rise at its August meeting, taking rates to 5.25%. 

Yet the Bank does not seem confident – or clear – on what comes next.

An outlier

One thing I read recently with interest is that the BoE is an outlier when it comes to how it communicates forecasts.

The Fed publishes a dot plot which shows where individual members of the FOMC predict rates will go in the future (anonymised, obviously). The ECB also produces its own independent forecasts.

But the BoE is different. It produces forecasts based on where the OIS market is currently predicting rates to end up. So, if the market thinks rates will come down, the Bank will forecast that inflation is going to come down, and won’t raise rates as high.

Excel would throw out a “circular reference” error if it saw this! It’s why the BoE has consistently underestimated the extent of the UK’s inflation problem, and it’s right that the Bank should be launching a review of the situation.

Helicopter forecasting

Last week the BoE asked former US Federal Reserve chair Ben Bernanke to review its economic forecasting after it came under heavy criticism for underestimating the precipitous rise of inflation in the British economy.

Indeed, the bank has admitted that there are “very big lessons to learn” after it failed to forecast high and persistent inflation, which reached a peak of 11.1% in October 2022.

Bernanke’s involvement is interesting, not because of his specific success in predicting the future, but because he was the one that presided over the Fed when it introduced the “dot plot” – predictions for the path of interest rates made by individual members of the Federal Open Market Committee members based on their own research and forecasting.

Art versus science

Bernake’s appointment suggests that the BoE wants to do more than conduct a stewards enquiry into its economic modelling – it wants to review (and presumably overhaul) its entire communication strategy.

Monetary policy is as much art as science, as second-order inflation effects (workers demanding wage increases in compensation for inflation, fueling it further) seem to be as much down to inflation-expectations as “inflation-reality”.

Getting communications right is almost more important than getting policy right. Arguably, Draghi “saved” the Euro with 3 words more than with any specific policy prescription (“whatever it takes”). “Sufficiently restrictive for sufficiently long” doesn’t have quite the same ring (or oomph) to it.

Oak-paneled rooms

Right now, there is a lack of transparency in how the BoE thinks about rates; a perception of hushed conversations amongst market grandees in oak-paneled rooms. 

The market is forced to play a high stakes guessing game which risks further damaging the UK economy at a difficult time for consumers, businesses, and indeed politicians. Gertjan Vlieghe, a former external member of the committee, spelled out the problem in 2019 when he said:

“If we want people to understand what we, the MPC, think is the necessary path of interest rates to achieve the inflation target, why not just tell them?”

In markets, communication is (almost) everything. This is something the BoE needs to learn, and fast.