Unfortunately for the Bank of England, although its historic record here has been good, forecasts in recent years have been shown to display a steady underestimation of inflation, according to a recent study of the Centre for Policy Studies. Some say it’s ‘wishful thinking’.
A fact sheet released by the Centre for Policy Studies shows how the Bank’s forecasting has deteriorated over the past ten years. In the twelve inflation reports from August 2001 to May 2004, the Bank’s forecast had an average error of just 0.1 percentage points, with the forecasts almost spot on.
In the next twelve quarterly reports from August 2004 to May 2007, there was an average underestimation of outturn inflation of 0.4 percentage points. “Optimistic, but still within forecasting margins”, says Ryan Bourne, the Economic and Statistical Researcher at the Centre for Policy Studies.
But for the forecasting period in the inflation reports from August 2007 to May 2010, the average outturn has been 1.3 percentage points higher than the average forecast, and inflation has been above the 3% upper inflation limit for two of the past three years.
“Now, there are good reasons to suggest why the forecasts may not have been so accurate for this period. We went through a deep recession, and there have been multiple shocks both to the global financial system and commodity prices”, says Bourne. “But what is interesting is the sustained direction of the bias – consistently underestimating inflation. Indeed, the forecasting figures for two years ahead give similar results.”
“I suspect that the Bank genuinely believes that deflationary forces will prevail in the medium-term, and am not necessarily advocating that a rise in rates would be good for the health of the economy – it is easy to see the benefit of low rates for business and consumer confidence.”
According to Bourne, the MPC’s remit is explicit in stating inflation targeting as its primary aim. Any further considerations around economic growth and business confidence are secondary, as the Bank operates independently from government.
The current low rates and moderate inflation are not politically neutral, with low rates helping to maintain confidence, he says. “In addition, it is almost in the interest of government for reasonable levels of inflation to allow real depreciation of both Government and bank debt.”
“The issue for the Bank surrounding its forecasting record is therefore about credibility. Do the public and the markets maintain trust in the Bank to be acting independently of government aims? Its poor forecasting record over the past few years is undermining the case it has made for low rates. And if credibility completely evaporates with persistent high inflation over the next 12 months, there is a risk that inflation could begin to spiral further as expectations adjust.”