The Bank of England’s economic forecasting system has “serious shortcomings” that need to be modernized, according to a study.
The independent report by Dr Ben Bernanke, former head of the US Federal Reserve, found that staff are using outdated systems that need to be overhauled or replaced.
He discovered that there was a serious underinvestment in the Bank’s software.
But Governor Andrew Bailey said updating the Bank’s systems was a “high priority”.
The former head of the Federal Reserve said a “material degree” of underinvestment had led to staff using a “complicated and unwieldy system.”
This prevents staff from making useful analysis of what might happen to the economy, he said.
Updating and modernizing the way the system handles economic data should be completed “as a high priority” and “as quickly as possible,” Dr. Bernanke said in the critical review.
He was asked to carry out the review last July after Britain’s central bank came under fire from MPs for failing to anticipate the size or duration of inflation – which measures how prices rise over time – in the past two years.
Responding to the Bank of England, Governor Andrew Bailey said: “Substantial investment is being made to develop our infrastructure and update our system. It is a high priority.”
Governor Bailey was criticized by lawmakers and independent economists for allowing a rise in inflation worse than that of both the US and the Eurozone.
Dr. However, Bernanke said central banks around the world were facing the same problems, with forecasting models disrupted by unprecedented economic shocks.
Inflation began rising above the Bank of England’s 2% target in the summer of 2021 as the global economy recovered from the pandemic and the supply of commodities from petrol to food struggled to keep up with resurgent demand.
This was exacerbated by Russia’s invasion of Ukraine, which cut off supplies of raw materials from gas to sunflower oil and further pushed up prices.
In the UK, inflation peaked at 11.1% in October 2022, putting severe pressure on the budgets of both businesses and households.
Mr Bailey said repeatedly in late 2021 and early 2022 that the Bank’s Monetary Policy Committee (MPC), which sets interest rates, believed the rise in inflation was “transitory”.
However, the inflation spike turned out to be more durable than expected and started to translate into higher wage increases.
Between December 2021 and August 2022, the central bank raised interest rates fourteen times in a row in an attempt to control inflation.
Mortgage shock
Higher interest rates have caused millions of mortgage borrowers to experience “payment shock,” with their monthly payments jumping to much higher levels as fixed-rate mortgage deals come to an end.
Further upward pressure on inflation came from an unexpected shortage of available labour, partly due to the effects of long-term illness such as long-term Covid-19. That prompted private sector employers to raise wages to attract and retain workers.
Governor Bailey has admitted that the Bank’s forecast models have failed to anticipate this, leading to a tighter labor market and therefore greater sensitivity to inflation.
Dr Bernanke’s report recommends that the Bank thoroughly update its entire framework for forecasting the economy and revise or scrap its existing software, known as Compass (Central Organizing Model for Projection Analysis and Scenario Simulation).
He said the models must take into account how higher prices can lead to higher wages – and vice versa.
He also said the Bank of England’s forecasting models need to pay more attention to factors such as labor supply and supply chain disruptions.
And he said the Bank should put less emphasis on its “central forecast”, where it justifies moves in interest rates based on what it sees as the most likely path for inflation over the next one or two years.
Scenarios that could prove the forecast wrong should also be published, he said, such as supply chain disruptions, and that more reliance should be placed on one’s own forecasters rather than city traders.
Sanjay Raja, chief UK economist at Deutsche Bank Research, suggested more work would be needed to get the Bank’s forecasting systems up to scratch.
He pointed out that there would be some adjustments to the MPC’s communications to improve transparency about how it makes interest rate decisions.
But the review would not be a “game changer for the way policies are implemented,” he added.
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