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By John Kemp
LONDON Nov 2 David Stockton's gentle review of forecasting at the Bank of England, published on Friday, does not hide the cultural problems which have caused systematic errors in the central bank's inflation predictions and undercut the credibility of its forecasting regime over the last five years.
Despite employing dozens of the brightest economists in the country, and spending more than 66 million pounds ($106.5 million) on monetary analysis last year, the Bank has consistently over-predicted growth and under-predicted inflation since 2007.
Its performance is worse than private forecasters, as Stockton -- once of the Federal Reserve -- noted.
"Fundamentally, the forecast process and the associated forecasting tools employed by the Bank in support of its monetary policy decision-making are sound," according to Stockton, a former director of research and statistics at the Federal Reserve in Washington engaged to conduct a review of the Monetary Policy Committee's forecasting capability.
"Potential for improvement should not be read as an indictment of the current forecast process at the Bank of England and the MPC," Stockton wrote.
The evidence presented in the report suggests a much deeper malaise.
The report contains a useful review of the factors the Bank believes have thrown its forecasts off course, and a welter of sensible recommendations for improving the forecasting process and presenting the outcome to the public. In many ways, the Stockton report is a model "lessons learned" exercise. But it skates around the two fundamental problems:
(1) Did over-centralisation of power in the Bank, especially the dominant role played by its intellectually brilliant governor, Mervyn King, promote a culture of "group think" within the MPC and among Bank employees that discouraged anyone from challenging the views of the governor and the "best collective judgment" of the MPC even when proved (repeatedly) wrong?
(2) Were the Bank's inflation and output forecasts adjusted to justify policy, rather than the other way around? Did the Bank massage its predictions to show its strategy would work, rather than reconsider its strategy in the light of incoming data and changes in the likely outlook?
Stockton's review contains some useful recommendations. But the real problems stem from the Bank's culture. If the Bank is to improve its forecasting performance, it needs an extensive shake-up of senior personnel and a new, much more open and introspective mindset.
Stockton explains that the Bank's forecast errors have been much worse in the five years following the eruption of the financial crisis than in the first decade after it was given operational independence in 1997, and significantly worse than private sector forecasters.
Insiders blame a series of unusually large shocks. Stockton accepts those explanations as "persuasive" though he questions whether "the serial persistence of the MPC's recent errors represents only a string of bad luck, points to some slowness in responding to these errors as they became apparent, or reflects a deeper flaw in the analytical framework".
But the really significant thing about the errors is that they were all in one direction (too much growth, too little inflation). If the Bank's forecasts were really unbiased, upside and downside errors on growth and inflation should have been much more evenly distributed.
At times, senior officials have suggested the over-run in inflation was due to a series of unforeseen shocks. At other times they have suggested the Bank has deliberately "looked through" price increases and been prepared to "tolerate" a limited overshoot to pursue other goals.
The first set of explanations suggests the overshoot was an accident, the second that it was a deliberate by-product of policy.
The inconsistent explanations have contributed to a sense the Bank's flawed forecasts were a cover for a strategy policymakers had already settled on: massive monetary stimulus and a willingness to accept an inflation overshoot to balance a programme of tax rises and spending cuts.
All the Bank's errors were in the same direction because officials believed their own strategy would succeed in restoring growth, while inflation would quickly return to target without the need for any rise in interest rates or lessening of asset purchases.
Would a genuinely independent forecaster, who had no responsibility for formulating policy but only in assessing likely outcomes, have made the same errors as consistently, and been so slow to change their predictions?
In the area of tax and spending, policymakers have accepted the need for greater separation between policy formulation and the assessment of its likely effects, with the creation of the independent Office for Budget Responsibility.
But in monetary policy, forecasting and policy choices remain uncomfortably commingled.
Reviewing the process among the major central banks, Stockton notes: "One nearly uniform feature of the published forecasts is that they are "owned" by the policy makers and not by their staff (the one major exception is the ECB).
"This seems generally as it should be -- policy actions ought to be conditioned on the views of the policymakers."
However it is not just politicians who may be tempted to tweak forecasts to justify their strongly held beliefs.
The MPC seems to have been slow to adjust its forecasts when its strategy did not deliver intended outcomes, instead arguing the plan would work eventually and should be given more time.
Stockton's recommendations would build up more professional expertise among the Bank's forecasting staff by slowing the pace of rotations "to develop a staff with enough experience and analytical depth on forecast-related issues to challenge members of the MPC in a constructive manner".
The unstated implication is that the staff are not sufficiently robust in challenging the MPC at the moment.
More tentatively, he suggests the staff might be encouraged to produce its own forecasts, which might be published "with a lag of sufficient length so as not to distract from the forecast" of the MPC itself.
"Knowing that the staff forecast would eventually be published could very well sharpen the focus of both the staff and the members of the MPC," Stockton explains. It would be a form of internal discipline.
"Some cultural adaptations would be required by the Bank," according to Stockton, which is an understatement. "The development of a staff forecast would be a very big step."
Therein lies the problem. It would imply a uncomfortable decentralisation of power away from the MPC and towards the professional staff, and away from the governor and to more junior but specialised officials. It would reverse the strong centralising trend evident over the course of King's governorship.
Dissenting votes within the MPC have fallen sharply, especially among the five Bank insiders, and especially in the last few years. Despite the huge uncertainties over the outlook, the Bank's insiders voted as a block as never before. King's two deputies appear to have been particularly unwilling to challenge their boss.
If the top of the Bank is affected by group think, staff in more junior positions can hardly be expected to demonstrate more independence.
The selection of a new governor to replace King when he retires next year was outside Stockton's remit. The basic choice lies between continuity (promoting Bank Deputy Governor Paul Tucker) and change (appointing any of the outside candidates for the job, led by Adair Turner, currently chairman of the Financial Services Authority).
Tucker has given King unswerving support over the past five years. Supporters will argue that the sometimes uncomfortable job of the deputy is to support the boss. Detractors will counter that Tucker has not sufficiently challenged the governor and is deeply implicated in the forecasting errors of the last five years.
Tucker remains the front-runner. But if he is promoted, it is hard to see how he can bring about a radical improvement in the forecasting process, given how closely he is associated with the failures of the past.
It would be better to use King's retirement to conduct an extensive reshuffle of the Bank's leadership and change its overly conformist culture in a bid to improve its performance in future.