Change Comes (Slowly) to the Bank of England
In the past couple weeks, there have been signals that change is coming to the forecasting and monetary policy process of the Bank of England—incremental change, but change nonetheless. Last year, the Court of the Bank of England commissioned three reviews of various aspects of the Bank's performance during and after the financial crisis, which were published in late October. On March 13, the Bank announced its initial response to the recommendations and options contained in those reviews. I was the author of the review that focused on the Monetary Policy Committee's forecasting capability and its relation to the monetary policy process. Another signal of impending change was conveyed last week when the Chancellor of the Exchequer, George Osborne, transmitted to the Bank of England changes in the government's remit for the Monetary Policy Committee (MPC). The chancellor welcomed the Bank's response to the so-called Stockton review, and the remit specifically left the door open to further changes in the policy framework, some of which had been explored in my report.
My review of the MPC's forecasting capabilities presented 21 options for the Bank to take advantage of the lessons learned from the crisis and its aftermath, especially as they bear on economic forecasting and its relation to the tactics and strategy of monetary policy. I organized my review around three areas: the forecast process and organization, the integration of the forecast into monetary policy decision making, and the communication and transparency of the forecast to the public and to market participants.
Judging from its initial response, the Bank appears to be making progress in all three areas, consisting of many small steps and a few long strides toward improvement, but no bold leaps forward.
Some of the least controversial, more modest options I offered for the MPC focused on making the forecast process less insular and more open to internal and external interrogation. In response, the Bank has committed itself to a more vigorous examination of its forecast errors internally and will make its evaluation available for public scrutiny. An expanded forecast evaluation process is expected to be in place by the August inflation report.
The Bank also plans to be more transparent about the main econometric model employed in the MPC's forecast, known as the Compass model. Few people outside the Bank of England know anything about Compass, despite its importance as an intellectual organizing device at central banks. Providing opportunities for academics, outside forecasters, or other professionals to offer feedback on it to Bank staff and the MPC should be welcomed.
My review found that the Bank had not taken full advantage of its staff's expertise. In response, the Bank is opening new channels to allow the staff to challenge the MPC's forecast. More staff members will participate in the forecast process, and those with special expertise will help shape the discussion. Some cultural changes will be necessary at the Bank for these efforts to succeed, but these small steps clearly head in the right direction.
The Bank is also seeking to improve the forecast process and better connect it to setting monetary policy, as my review recommended. The Inflation Report will now include greater detail about the judgments and assumptions underlying the MPC's forecast. In my background interviews, many frustrated outside observers said it was nearly impossible to raise questions about a forecast limited by two fan charts and a qualitative narrative. More quantitative support for the forecast would significantly improve its transparency. In another helpful step, the Bank has indicated that it will employ alternative scenarios, when needed to illustrate the quantitative consequences of key influences evolving differently than assumed in the baseline forecast. This information should help the public understand the risks around the forecast.
In another improvement, the Bank has indicated that the forecast process will give greater attention to the relationship between the forecast and the development of monetary policy. At present, the MPC devotes little or no time during its forecast round to discussing monetary policy tactics and strategies. In addition, the staff provides the MPC few background materials laying out alternative policy options for dealing with forecast changes and risks. Although the Bank's response is vague on how to implement these changes, I find its recognition of the problem, and commitment to addressing it, encouraging.
For the most part, the Bank rejected or shelved for future consideration the bolder and more fundamental changes included in the Stockton Review. The review proposed, for example, the development of an independent staff forecast. The Bank appears to have rejected this option. At present, the staff mostly updates the MPC's previous forecast in light of changes in data and conditioning assumptions. Although the staff can propose changes in the forecast, the MPC is never confronted by a completely independent and unbiased view of the economic outlook from its professional staff. This approach likely contributes to at least some of the persistent errors in the MPC's forecast. A staff forecast should serve as what I call a "constructive irritant" focused on controversial issues until they are resolved by data or time, rather than being dropped without further consideration when rejected by the MPC. Creating a staff forecast would also encourage the staff to gain experience and be more assertive, thereby addressing the notable imbalance of experience between the staff and most MPC members. Confined to assisting in the MPC's forecast, staff members have little incentive to invest the effort to acquire the necessary expertise in this area. That incentive would be much greater if the staff had ownership of an independent and influential forecast product. The Bank apparently fears that a staff forecast would interfere with external communications. But that concern would be alleviated if the staff forecast were released publicly after a time lag, avoiding a diversion of attention from the MPC's own forecast.
In another departure from current practice, my review proposed that, at some point in the process, the MPC members be canvassed for their individual forecasts. Such a change would ensure that the MPC's final fan chart forecasts reflect the committee's center of gravity. To be sure, MPC members do have opportunities to express discomfort with the fan charts. But the level of disagreement that remains is never quantified. I also recommended including a quantitative summary of the individual forecasts in the inflation report. That summary could simply report the ranges of forecasts for real GDP growth and inflation as well as the medians of those ranges for the nine MPC members. This information would make the MPC more transparent and accountable by revealing internal disagreements to the public. After all, the crisis illustrated how wrong the consensus can be at times.
The Bank's reluctance to go down this path stems from a fear of compromising committee deliberations and disturbing its central message. The concerns are legitimate. The MPC forecast results from its "best collective judgment," a process designed to encourage consensus. That process is sound and should be preserved, but I am skeptical that "best collective judgment" is so fragile that internal canvassing of views would impair it. Publishing the range and median of the individual forecasts would not detract from the message unless the range of views was wide—but that is precisely the time when this information becomes most valuable to the public.
I also proposed that the Bank consider greater communication about the outlook for policy. Many other central banks do so by disclosing official forecasts for policy instruments, thresholds for policy actions, calendar-based guidance, and the like. The MPC provides none of that information in any meaningful sense. Indeed, the MPC's forecasts are conditioned on both market-based interest rate expectations and an assumption of an unchanged Bank rate, leaving outside observers to infer the appropriate, desired, or optimal policy. The Bank has indicated that no firm decision has been reached on this step.
Interestingly, this is the area of greatest overlap between my review and new remit for the MPC issued by the government last week. In addition to acknowledging the potential need to expand asset purchases, the remit requests that the MPC assess the use of intermediate thresholds in setting policy alongside the August inflation report. I recommend that this remit include assessments of a broad range of possible approaches for the Bank of England to consider, from the increased forward guidance about policy instruments to more fundamental changes in the policy framework, such as the nominal-income targeting regime favored by my colleague Tomas Hellebrandt. While the optimal path forward is not clear, several feasible options are available to improve the transparency and effectiveness of monetary policy in the United Kingdom.
Should there be disappointment that the changes undertaken by the Bank of England have not been swifter and bolder? I think not. My review was completed at the end of October, a little more than four months ago. For famously cautious central bank bureaucracies, the Bank of England has moved at lightning speed. The changes being implemented offer genuine opportunities for improvement. Moreover, there are understandable reasons why some of the options that I offered for more fundamental adjustments have not been adopted. The Bank of England will change leadership in June, and more sweeping changes in advance of that transition would not seem advisable. The incoming governor should have the opportunity to weigh in. Finally, I readily acknowledge that not all the options I put forward for consideration, upon greater reflection and with keener appreciation for institutional constraints, may prove suitable for the Bank, the MPC, and the staff. All told, progress is being made.