Bracing for the Bank of England’s forecasting review

We’ve got some big plans

is one of the scarier things for a central banker to say, but Andrew Bailey did and we’re now, like everyone, on tenterhooks for the publication of Ben Bernanke’s review into the Bank of England’s forecasting methods, which will land soon.

MainFT’s Sam Fleming spoke to the Guv’nor following the March Monetary Policy Committee meeting, with Bailey revealing that the BoE’s infamous fan charts are not long for this world:

A growing number of BoE officials are in favour of instead using projections of alternative scenarios, potentially alongside a central forecast. But analysts and officials stress that shifting to a new regime will not be easy and caution that the reforms are unlikely to be brought in rapidly. 

Here’s a reminder of how we got here: the forecasts were bad.

More specifically, the Bank consistently underestimated the future level of inflation as it went up during the recent cycle, then overestimated it on the way back down.

Here, via Rabobank’s Stefan Koopman — who has written an interesting review preview — is how those errors look as a chart:

First things first — did these errors matter? It’s a complicated question that we immediately regret posing. Net satisfaction with the BoE’s inflation-management performance fell pretty much in sync with inflation rising, and we suppose that, for a variety of practical and idealistic reasons, it’s bad for people to hold their central bank in contempt. So . . . yes?

But maybe, just maybe, once the conditions were in place for an unprecedented, multipronged supply-side shock, there never was much hope.

Regardless, Bernanke was brought in last summer to review “forecasting and related processes”. The brief terms of reference can be found here. They say:

the review should consider the appropriate approach to forecasting and analysis in support of decision-making and communications in times of high uncertainty from big shocks and structural change focussing on:

— staff processes and analysis supporting the MPC’s policy deliberations;
— the analytical framework for taking account of significant shocks and shifts on the supply as well as the demand side of the economy;
— the role of the forecast in the MPC’s policy decisions and communications, including the roles of the MPC and the staff in the development of the official forecast;
— the appropriate conditioning assumptions in projections, including the interest rate path on which the forecast is based;
— material provided to the MPC to assist the discussion and communication of the outlook and the risks around that.

There’s a lot to think about there. On the first point, MainFT reports Bailey said the changes coming will include “entail increased investment in the bank’s IT systems”.

We’re obviously not experts on Threadneedle Street’s computing infrastructure (or anything else), but this statement calls to mind a horrific fatberg of degraded systems, linchpin Excel spreadsheets, servers that have been running since the 1990s, and COBOL. In that uniquely IT-ish “everything is systems” kind of way, it’s probably actually the most important thing happening here.

The second point gets us more into the warm, welcoming economic weeds. The heart of the Bank of England’s forecasting model COMPASS (Central Organising Model for Projection Analysis and Scenario Simulation), a New Keynesian general equilibrium model. It works like this:

COMPASS is been at the centre of BoE forecasting since 2011 — officials say it is “smaller and simpler” than the older models. Part of this smallness and simplicity lies in its limited scope: COMPASS provides forecasts across just fifteen variables, such as GDP, inflation, interest rates, trade, wages and consumption.

As Rabo’s Koopman puts it:

The key mechanism of the forecasts is that the central bank ends up with output-gap-driven estimates of inflation, arising from real and nominal frictions to exogenous supply or demand shocks. These estimates then drive monetary policy.

The data sample period that underpins COMPASS runs from 1993 to 2007. Now, most of the best things come from the ’90s (ed.note: 80s) but shock-proofed foundations for inflation targeting regimes are not one of them. After all, basically nothing happened during that time.

Koopman cont. (his emphasis):

COMPASS’s out-of-sample forecasting power in the face of the UK’s three significant supply shocks (i.e., Brexit, pandemic, war) was therefore destined to be weak: the data used to estimate the model’s parameters have never seen these kinds of volatility!

Absent from COMPASS is ‘esoteric stuff’, such as financial markets, banks, shipping, energy or other systemically significant commodities, or industrial policies. But these…