BOE’s Big Mistakes in Forecasting Warrant Inquiry: Economy
The Bank of England’s forecasting capabilities have deteriorated in the past five years, resulting in “large” errors, and officials should investigate the reasons for such shortcomings, an independent review said today.
The report by David Stockton, a former Federal Reserve official, sets out options including encouraging “more assertive” staff to challenge the central bank’s “house view” and incorporating financial-stability risks into forecasts. It said the latter should be “high on the agenda.”
The review is one of three commissioned by the central bank’s governing body following a lawmaker push for an inquiry as the BOE prepares to take on unprecedented powers to regulate the financial system. The bank also released reports on its framework for providing liquidity to the financial system and its emergency support to banks.
“The Monetary Policy Committee’s recent forecast performance has been noticeably worse than prior to the crisis, and marginally worse than that of outside forecasters,” Stockton said. “The bank and the MPC need to introspect more deeply and more systematically about the lessons that can be gleaned from episodes of large forecast errors.”
Bank of England Governor Mervyn King and deputy governors Charles Bean and Paul Tucker said in a statement the reports “have given us a great many ideas to consider that could improve the bank’s performance.” Andrew Tyrie, the head of the Parliamentary committee that scrutinizes the BOE, said the reports are a “step forward,” though he criticized the central bank’s management.
“A comprehensive review should already have taken place,” Tyrie said. “The fact that it took so long to obtain even these reports illustrates the bank’s defective governance.”
The MPC’s projections for growth and inflation were too optimistic, Stockton said. The explanations for the errors, such as underestimates for the inflationary effect of the depreciation of sterling, or the scale of the squeeze in credit provision, are “persuasive,” he said. Still, the “serial persistence” of errors needs fuller analysis.
“That persistence could simply reflect a string of bad luck, but it also could reflect some inertia imparted by the forecast process or point to problems with the paradigm underlying the bank’s forecasts,” he said. There has been a “lack of systematic, detailed quantitative analysis undertaken by the bank to interrogate its forecast errors.”
The Bank of England will have new forecasts at its policy meeting next week that it will publish on Nov. 14. The National Institute of Economic and Social Research cut its 2013 U.K. growth forecast today to 1.1 percent from 1.3 percent. The London-based group said the economy will shrink 0.1 percent this year, less than the 0.5 percent expected previously.
U.K. construction unexpectedly expanded in October, according to a report today from Markit Economics. It said its gauge rose to 50.9 from 49.5 in September. In the euro area, a factory index by Markit fell to 45.4 from 46.1, where readings below 50 indicate contraction.
Later today, a U.S. Labor Department report may show the nation’s jobless rate rose to 7.9 percent in October, according to a survey of economists by Bloomberg News. Payrolls grew by 125,000 workers last month following a 114,000 gain, the survey showed.
Stockton’s observations on the BOE revealed “no deep structural problem” and nothing that requires urgent action. His 21 options to improve the forecasting process include doing more to retain staff, providing more data to support the projections and publishing individual MPC members’ projections.
Stockton said the value of individual forecasts “might be especially large when risks were mounting sharply and different views were emerging among members of the committee.”
While none of these recommendations would have allowed the BOE to fully predict the impact of the financial crisis, improvements “could increase the probability of detecting and responding in a timely manner to emerging economic and financial developments,” he said.
In the other reports, ex-MPC member Ian Plenderleith and Bill Winters, a former head of JPMorgan Chase & Co.’s investment banking division, examined aspects of the BOE’s provision of liquidity to the financial system. Winters said that while the central bank’s Sterling Monetary Framework was lacking before the crisis, it is now “robust” and “broadly fit for purpose.”
He also said that crisis measures such as the Special Liquidity Scheme and the Funding for Lending Scheme, as well as acting as a market-maker of last resort, shouldn’t necessarily be considered temporary.
“It appears that markets and the role of banks in markets may have changed structurally, so these operations should not be regarded as extraordinary,” Winters said.
One criticism was that the BOE did not fully consider banks’ exit from the SLS, most likely because it didn’t expect financial conditions to be unsettled for so long. Banks faced material difficulty refinancing SLS funding and may be “reluctant to fully participate” in future programs, he said.
He also said the bank should consider ways of reducing the stigma associated with accessing facilities such as the Discount Window Facility. On governance, Winters said while the governor regularly consults his deputies and other senior staff on the liquidity framework, it appears to be discretionary and this process should be formalized.
Winters also found that there appears to be a tendency among less senior staff to “filter recommendations” so that senior officials will find them more palatable. This risks reducing the range of views put forward and could lead to less- effective policy, he said.
Plenderleith’s review, which looked into the central bank’s specific Emergency Liquidity Assistance program in 2008 and 2009, said it was an “essential plank” that helped the financial system to return “to a degree of stability.”
He recommended that the BOE maintain its swap lines with other central banks to ensure it can provide aid in foreign currencies if needed. Both he and Winters said the central bank should also consider making some liquidity facilities available to non-banks, such as central counterparties, as they have become “increasingly important” in financial markets.
The Treasury committee said in a statement it will take evidence from Plenderleith and Winters on their reports on Nov. 20, and will question Stockton “in due course.”
“The reviewers have provided us with a large number of constructive recommendations and options for further consideration,” David Lees, the chairman of the Bank of England Court, its governing body, said in a statement. “That meets our original objectives.”
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