Clarity plays confusion

Those regular readers of this blog will be familiar with my frequent criticism of the OBR and the Bank of England’s Monetary Policy Committee (which is charged with setting interest rates in the UK consistent with delivering the inflation target of 2%) principally because, as the record shows, their forecasting records are very poor. This means the decisions they make in the case of the MPC, or the guidance they give to the government on fiscal policy in the case of the OBR, is not as good as it could or should be. It appears I am not alone, at least with respect to the Bank of England, which came in for some serious criticism earlier in the year from Ben Bernanke, the ex-FED governor, who was asked to look at the Bank’s forecasting record by the Court of Directors of the Bank of England.

He concluded that there were “deficiencies in the Bank’s forecasting infrastructure” and was very critical of the Bank’s baseline economic model, COMPASS, which he said had “significant shortcomings.” In a very long and detailed report, he also said that the objective was to help the Bank make better policy decisions and effectively communicate those decisions to the public.

Hear, hear! Albeit that we are still waiting for that day to arrive. I suspect this month may be another when our attention should be focused on both institutions' continued failure to accurately forecast what is happening in the economy. In October, both organisations will be opining on the outlook for the UK economy. Significantly, I suspect that they will still have very different forecasts, but both will also have to yet again upgrade those forecasts.

The OBR’s institutionally negative perspective on UK growth (both real and nominal) and, in turn, the quantum of tax revenue it will generate will have to be revisited, and the Bank of England’s even more negative perspective will similarly have to be substantially revised up. It should be quite a spectacle and begs the obvious question: which one should we believe?

I will let you know as the month unfolds and ends with Rachael Reeves’ first budget on the 30th.

However, returning to the Bank’s communication of policy, I was struck again this week by a stark contrast between the impenetrable ramblings of the MPC’s policy updates (the next is due on November 7th) and the clarity and simplicity of those coming from the current governor of the Federal Reserve, Jerome Powell.

For example, in an interview at the National Association for Business Economics meeting in Nashville this week, Mr Powell said the rate-setting body (the FOMC) will make its decisions based, in part, "on information they haven’t yet received”. He went on to say “Ultimately, we will be guided by the incoming data. And if the economy slows more than we expect, then we can cut faster. If it slows less than we expect, we can cut slower.”

Crystal clear.

Ironically, Bloomberg reported from the same meeting quoting a member of the MPC, Megan Greene, who is a highly respected academic economist. She decided to talk, amongst other things, about her concerns that a consumption-driven recovery in the UK could set off a renewed bout of inflation (interesting that on the same day, the British Retail Consortium reported shop prices falling in September at 0.6% rather than the forecast 0.3%). But then she added that more interest rate cuts are likely as prices are moving in the right direction.

As a relatively informed observer, I am already confused. Which one is it, Megan? Higher prices or lower? This is especially relevant now as we appear to be seeing lower prices on the high street while the economy is delivering growth higher than the MPC forecast, principally because consumer spending is growing more strongly than forecast.

My confusion worsened as I read more of Megan Green’s comments. She said that “the neutral rate of interest had risen since the inflation shock,” but she did not specify the number. (The neutral rate is the level at which a central bank’s policy-setting neither stimulates nor restricts economic growth.)

This subject, loved by academic economists, is one of my favourite hobby horses. To cut to the chase, I think it’s more confusing theoretical mumbo jumbo. Here’s why I think this, starting with some UK data.

Between 1998 and 2007, inflation averaged 1.5%, and Bank Rate averaged 5%. Growth averaged 1.9%

Between 2010 and 2019, inflation averaged 2.25%, and Bank Rate averaged 0.5%. Growth averaged 1.9%

My point is that in a parallel universe if an academic economist were to transport themselves back to 2010 and was told to set interest rates in the UK to deliver about 2% inflation and 2% growth, my guess is that based on the last 13 years of history that academic economist would believe that the neutral rate of interest would be somewhere close to 5%. I am not sure anyone would have suggested that the right answer was 0.5%. In other words, the neutral rate of interest is only apparent after the event and not before.

So, my advice to members of the MPC is to think more clearly about how to message policy. Jerome Powell does it with precision and clarity using very easily understandable language. I would also leave theoretical economics where it belongs, in the lecture theatre.

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