By John Kemp
LONDON, May 16 (Reuters) - Governor Mervyn King has finally admitted that the Bank of England can no longer accurately forecast inflation, as the tremendous amount of uncertainty renders the quantitative forecasting techniques employed before 2007 obsolete.
“The difficulty of predicting the precise impact of these influences means that the (Monetary Policy Committee) places more weight on the broad shape of the inflation outlook than its exact calibration,” a subdued governor confessed at a news conference to present the latest revisions to the bank’s inflation fan charts.
King urged a more qualitative assessment of the risks to inflation and growth. While insisting the committee’s decisions about interest rates and quantitative easing are still guided by the inflation outlook, he urged his listeners to focus on the bigger picture.
“Rather than focusing on quarter-to-quarter movements in output or inflation which are impossible to predict, the MPC focuses on the bigger picture,” King said. “That bigger picture is of a gradual recovery in output and of subdued domestic cost pressures, meaning that inflation is likely to fall back as external influences fade.”
It ends a long period when the bank tried to justify all its immediate policy choices through the twists and turns of the fan charts, which proved about as accurate as a fortune teller’s crystal ball.
Unfortunately the bigger picture is more gloomy than the governor and his colleagues thought only six or twelve months ago.
King dwelt on the external threat to the recovery from the continuing crisis in the eurozone. Like other British policymakers, King sometimes seems happier lecturing foreigners, especially Europeans, about the inadequacies of their policies than commenting on structural problems at home.
But it is the performance of the domestic economy which is disappointing policymakers the most.
Until recently, a majority on the MPC seemed confident there was substantial cyclical slack in the UK economy. If the bank could only spark a recovery, the economy could manage a period of above-trend growth without risking a pick of domestically generated (as opposed to imported) price rises.
But even that is no longer certain. Pass-through from commodity prices and the exchange rate has proved far greater than the Bank expected. “We were too swayed by the experience of the UK economy in the early 1990s, when sterling’s fall did not feed inflation,” admitted Charles Bean, the bank’s deputy governor for monetary policy.
Domestically generated inflation is also proving stubbornly high, leading the bank to ponder aloud about whether the economy’s supply side performance has deteriorated, leading to a less favourable trade off between growth and inflation.
“There is no obvious reason to believe that we can’t get back to the level of output that we were on the pre-crisis trend path,” the governor said, “but it may take 10, 15 or maybe even 20 years to get there,” which was not very reassuring.
“It doesn’t follow from that that over the next two or three years that there is a vast amount of spare capacity that you can just put your foot on the accelerator (and) use up in order to expand output.”
With that terse explanation, the governor buried four years of bank forecasts, which assumed spare capacity could be relied on to keep domestic cost and price pressures under control, while the Bank could do nothing about the imported kind.
The big problem for the Bank is that spare capacity (however much there is) has not brought price increases under control nearly as fast or as much as the members of the committee have been forecasting for the last four years.
Even in the face of spare capacity and falling real wages, businesses and retailers have proved surprisingly capable of pushing through price rises.
Some have been automatic under Britain’s system of inflation-plus price regulation for utilities like water, rail services, and other goods and services with administered prices. But others are testament to the surprisingly strong pricing power of the country’s retailers and other businesses to push through price rises to protect their margins.
The result is that inflation has consistently overshot the Bank’s forecasts since 2007 (with one exception in 2009).
“A gradual easing in the impact of external price pressures, together with a continuing drag from economic slack, should lead inflation to fall back to around the target,” the governor said in his prepared remarks.
The bank continues to blame external factors for most of the inflation overshoot, though it has no ready answer about why Britain has the worst inflation and growth track record of the major advanced economies in the last few years.
But in a note of caution, the governor admitted “The prospects for inflation remain uncertain, not least because it is difficult to gauge with any precision the current strength of underlying inflationary pressure.”
“The path of inflation will also depend on the growth in companies’ domestic costs, which will be heavily affected by the pace of productivity growth and the extent to which slack in the labour market limits wage growth”.
“The degree to which companies seek to restore their profit margins by raising prices will also have an important bearing on inflation,” he added.
With the quantitative forecasts thoroughly discredited, the Bank has bowed to the inevitable and embraced a more qualitative approach to presenting its policy decisions. It is at least an honest acknowledgement that the old system was not working.
The bank should capitalise on King’s new-found humility and transparency to make one final admission: the inflation target is no longer in effect, and has not been for some time.
Rightly or wrongly, the bank has made a conscious decision since 2010 and especially 2011 that tolerating higher inflation is a price worth paying to avert higher unemployment. In making that choice, it has enjoyed quiet backing from most of Britain’s financial and political establishment, including finance minister George Osborne and the opposition Labour Party.
In effect, the bank has substituted the “bigger picture” for the narrower one of hitting a 2 percent inflation target.
King and his colleagues have sought to avoid formally suspending or abandoning the 2 percent target by claiming their mandate has always included an element of flexibility, to avoid undesirable volatility in output, and means seeking a return to 2 percent over the longer term rather than immediately.
But rather like the inflation fan charts, it is a pretence that has worn through. The bank has reverted to the more discretionary approach which characterised policymaking in the early 1990s and especially the 1980s and 1970s.
Building on its new spirit of openness, it is time for the bank to concede inflation targeting has outlived its usefulness, and will need to be modified in future. The question for policymakers and economists is how to replace it with something more effective.