For centuries the Bank of England has been the cornerstone of the UK with a strong international influence. The so-called “Old Lady of Threadneedle Street”, situated in the heart of the City of London, continues to lead markets on indicators such as GDP, inflation, interest rates and much more. However, in light of Mark Carney’s effectively lacklustre tenure, there are serious concerns about the quality of economic forecasting.
Carney was effectively headhunted by the UK government/Bank of England when Governor of the Bank of Canada between 2008 and 2013. His tenure as Governor of the Bank of England extended from 2013 up to 2020. He arrived with an unblemished record and left with one undoubtedly less influential, leaving more questions than answers. He is not the first, and he certainly won’t be the last to have their reputation questioned.
Andrew Bailey is the current Governor of the Bank of England, the 121st in the bank’s history, beginning his tenure in March 2020. So, what awaits Mr Bailey?
Challenging scenarios, past and current
We will now look at some of the more challenging situations that have faced the Bank of England and how their forecasts have often confused and sometimes misled the markets.
Historically, the Bank of England has used the Retail Price Index (RPI) to measure changes in the cost of living – inflation. However, under the guise of “not recognised on the international stage”, RPI has been side-tracked in favour of the Consumer Price Index (CPI). While there are several similarities between the two inflation measurements, the RPI includes mortgage costs, council tax, and an array of other charges not used in the CPI calculation. Is this relevant?
The graph below shows the RPI has traditionally been higher than the CPI, except during the financial crisis of 2008/9. As of August 2021, the CPI shows an annual growth rate of 3.2% while the RPI stands at a significantly higher 4.8%. By 2030, all use of the RPI in the UK, used as a measurement to increase pension annuities, index-linked government bond interest, rail tickets, etc., will be phased out. Is the CPI misleading?
Admitting defeat on forecasting the next financial crisis
If we look back to 2017, Gertjan Vlieghe was a member of the influential Monetary Policy Committee (MPC) and gave a fascinating interview to the Financial Times. When asked about the Bank of England’s ability to forecast the next financial crisis/recession, his opening gambit shocked many people:
“Our models are just not that good”
The MPC has access to some of the latest forecasting technology, including four different forecasting tools:
- ONS Data
- COMPASS Suite
- Statistical Suite
- Inflation Report
There is also the depth of experience amongst MPC members and their contacts within the UK and international financial community. So, if the Bank of England cannot identify a potential financial crisis/recession until it is on our doorstep, what chance do we have?
Bank of England forecasting for a different world
In January 2019, Richard Murphy wrote an incisive piece about the Bank of England’s forecasting prowess. He believes that the forecasting issues experienced by the Bank of England are part of a long-term systemic problem. Using macroeconomic modelling, based on general equilibrium analysis, there are several questionable assumptions:
- People are rational
- Markets adapt
- Markets react to economic stimuli
- Perfect competition prevails
Richard Murphy makes the perfectly valid point that the Bank of England is forecasting for “a perfect world”. However, they only have to “look out of their windows” to realise the world is not the one they are modelling. Whether these comments are unfair or balanced is debatable, but they highlight several issues with “perfect world” financial forecasting tools.
How could the Bank of England get Brexit so wrong?
In January 2017, Andrew Haldane, the Bank of England’s chief economist at the time, admitted the bank misjudged the impact of the Brexit vote. While the Bank of England had many different scenarios under consideration, there was no mention of a strong recovery in the UK economy in light of Brexit. Indeed, the Bank of England said there would be a massive collapse in the UK property market immediately after confirmation of a Leave win.
History shows this collapse did not occur, as demonstrated by the following graph:
Source: UK House Price Index
Yes, there was a dip in house price growth, but it still remained in positive territory even during the darkest times in the aftermath of Brexit. For many consumers and investors, this was the straw that broke the camel’s back, reducing the influence and reputation of monumental bodies such as the Bank of England. Many had been terrified at the prospect of facing negative equity and their own personal financial crisis.
The final word left with Mark Carney
As we touched on above, Canadian Mark Carney arrived at the Bank of England with a gold plated reputation. His “capture” was the focus of much joy and excitement among the financial and political elite. He would lead the way, inject a much-needed degree of stability and enhance the reputation of his predecessor Mervyn King. However, to say these plans did not work out is something of an understatement.
City Quarterly Inflation Report June 2014: “Doveish” comments suggesting no plans to increase interest rates
Sunday Times interview, days later: “The bank might raise interest rates before growth in earnings has caught up with inflation”
City Quarterly Inflation report May 2014: Bank of England rules out an interest rate rise before 2015
Mansion Speech just a few weeks later: “Markets should take the possibility of a 2014 increase more seriously”
These are just two of many similar scenarios encountered under the governance of Mark Carney. They may seem petty and irrelevant to many people, but at the time, the markets were heavily influenced by the Bank of England. Consequently, his contradictory statements caused concern and confusion within the money markets.
Will the Bank of England ever regain its reputation?
One thing stands out head and shoulders above anything else. No economic forecasting tool can account for the “irrational” behavior of investors, consumers and businesses. The more that the Bank of England tries to influence markets, with often perfectly rational forecasts, the less notice investors take.
The current inflationary crisis engulfing the Bank of England is a prime example of the difficulty in forecasting economic indicators during a crisis – in this case a pandemic. Also, the switch from the RPI to the CPI has not received the publicity it deserves. Is the CPI really more reflective of changes in the cost of living, or is the RPI simply too high and difficult to control?