The Bernanke review is only a starting point

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Few central banks have emerged from the past three years of inflation fighting with the same credibility they had before. The Bank of England has had a particularly hard time. Net public satisfaction with the institution is in negative territory, and the proportion expecting inflation to be above 3 per cent in the long term has also picked up since 2019. If another shock comes along, it may be harder to keep inflation expectations anchored.

Ben Bernanke’s review, released on Friday, was an opportunity to start addressing the central bank’s recent shortcomings. Importantly, the former US Federal Reserve chair shone a light on its “out of date” methods, and made some sensible recommendations that should help improve its forecasting processes and communication. But just how transformative this “once in a generation” review proves to be will largely be determined by how far the BoE decides to push Bernanke’s proposals.

Regarding the BoE’s recent performance, there are two areas of concern — its economic analysis and communication. On the former, Bernanke called for an overhaul of its main economic model and a modernisation of the software it uses for data analysis. These are core pillars for any central bank’s operations. That there were notable deficiencies here is a concern. The BoE should now be given the resources to make the necessary improvements.

Yet, the past few years have been characterised by a series of unprecedented shocks — the pandemic, war in Europe and a slowdown in globalisation. In that sense, the BoE’s models were unlikely to be the main factor in its recent poor forecasting record. But that does not absolve it. A lot comes down to judgment, including when to ignore and how to weigh what the models say. The bank raised rates too slowly, and stuck too long to the narrative that price growth would be transitory.

The review did, however, stress some important points on how to improve on these “outside the model” considerations, including greater attention to supply-side factors, and more comprehensive assessment of price-wage dynamics. What matters now is how this is applied to the forecasting framework.

On communications, there were sensible suggestions. Here, the BoE’s record has been poor. In this tightening cycle, it has often indicated that rates would not need to rise as far as the market was pricing, but has then gone on to raise them further than those expectations. Bernanke’s recommendation to use more scenario-based forecasting is welcome. It gives the BoE the scope to articulate its reaction function, risks and uncertainty better. The proposal to can its famous fan charts — which display the uncertainty around its forecasts — was inevitable. The public has often found it more confusing than informative.

There are limits to relying on scenarios to help the market understand what the bank might do. A significant flaw in its communications is that it predicates its forecasts on the markets’ expectations for bank rate. As former MPC member Gertjan Vlieghe noted in 2019: “We communicate about what we think we may do, by showing you a forecast of what will happen if we do something else.” But the review suggested de-emphasising the central forecast alongside further deliberations, instead of recommending that the BoE uses — and shares — its own projections for interest rates. This sidesteps and defers a key issue.

The BoE must now assess how much it needs to overhaul its model, how it will apply scenario analysis and how transparent it should be about its interest rate path. This review shows there is ample room for improvement. But how it is acted on is what matters most.

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