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Briefing Notes in
Economics
‘Helping to de-mystify economics since 1992’
Indexed with the Journal of Economic Literature – ISSN 0968-7017
Issue No. 92, November 2016
____________________________________________________________________
What should we (not) expect from central banks? 1,♣
JEL Codes: E58 and E47
Paul Fisher♪
Dr. Paul Fisher, Visiting Professor of Finance and Economics, Richmond School of Business, Richmond
University, Queens Road, Richmond, Surrey TW10 6JP, UK..
First version received September 2016
Introduction
Over the past 3 decades, central banks have acquired significant powers over the setting of
macroeconomic policy. That is mostly a direct result of high and rising price inflation in the
second half of the twentieth century and the costs of controlling it. One of the developments in
economic theory, in response to those episodes, was to develop the proposition that an
independent central bank would have more credibility, and hence effectiveness, than politicians
in promising to keep prices in check. The subsequent policy experiments were successful in
controlling inflation in many countries – astoundingly so in some cases, although understandably
less well in some developing countries – and it has now become the accepted best practice.
Economic theory as a subject has a relatively short history and seldom has it been so effective in
changing the way we all live for the better.
Central banks are also acquiring other, related powers. In some cases - notably the UK - control
over macro-prudential policies has also been delegated to the central bank to ensure stability of
the financial system as well as the stability of consumer prices. But the point of this lecture is
that I also see expectations about what central banks can and should achieve becoming
excessive. In some quarters, central banks are being held responsible for many aspects of the
1
An earlier version of this paper was delivered to the Wellbeing Research Centre, at the Richmond School of
Business, at Richmond University on October 5th 2016.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 2
economy that are actually beyond their remit or capabilities. In particular I want to cover four
dangerous ideas:
•
•
•
•
That the central bank can control house price bubbles;
That the central bank should be held responsible for the real rate of output growth;
That the central bank balance sheet can be used to target social objectives;
That a central bank – or anyone else for that matter – should be able to accurately predict
the future path of the economy to within small fractions of a percentage point on inflation
or growth.
The Housing Market
Let me start with whether the Bank of England can control house price bubbles. One could be
forgiven for thinking so, particularly when the Chancellor states in a formal speech:
'I want to make sure that the Bank has all the weapons it needs to guard against risks in the
housing market.'2
In fact, that statement –and the speech surrounding it - was carefully worded in talking about
financial stability risks, and not mentioning house prices in themselves as the direct source of
risk.
The Bank has never said it could, or even wished to, control house prices. Indeed Governor
Carney and other senior officials have many times stated the exact opposite. The Bank had, and
has, objectives for overall price inflation, for financial stability and for prudential regulation. It
has recognised that there are risks arising from excessive personal borrowing/lending against
housing assets that could fall in value. Hence its action, after very extensive analysis and
quantification, to seek to limit the flow of lending by banks in cases where loan-to-income ratios
were high.
That is a far cry from trying to control house prices. But suppose that had been the objective,
what would a policy maker need to do?
The UK housing market has had periodic boom and busts in house prices for the most basic
economic reasons: there is constant growth in the demand for houses that outstrips the limited
supply.
Demand reflects several factors including population growth and social trends towards smaller
households. And it reflects expected financial returns, in part because there is a very significant
tax break for owner occupation, given that there is no capital gains tax on one's main residence.
2
George
Osborne,
Mansion
House
2014.
Text
can
be
found
here:
https://www.gov.uk/government/speeches/mansion-house-2014-speech-by-the-chancellor-of-the-exchequer. Or on
YouTube about 19 ½ minutes in.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 3
On the supply side, the small quantity of land where building is permitted in this crowded island
of ours is a large factor. Also, when one visits other world cities, casual empiricism would
suggest that the prevalence of apartments in high rise blocks in or near foreign city centres,
allows a much higher density of housing than one sees in London.
What could a central bank do about such factors? The Bank of England does not build a single
house. Nor does it - thankfully - control the tax system. Nor could it set the various social
policies that might encourage families to live in larger groups. Nor can it set planning
arrangements to increase the availability of building land or the density of housing.
Whilst it can have some influence on mortgage financing, there is no prospect of the Bank ever
having sufficient powers to allow it to 'control' house prices – nor should it in my view. Why so?
There are many powers that could be wielded to limit house price bubbles - and nearly all of
them do and should lie with the government or its various other authorities. They include the tax
system, the benefits system, the planning system and rules on foreign investment in UK property.
All of these could be used.
Notwithstanding the government’s responsibilities for the relevant policies, all the talk in recent
years has been about the Bank of England controlling housing risks through the indirect channel
of mortgage finance or, as a last resort, interest rates being raised to curb the housing market.
Which, incidentally, has never worked satisfactorily in any previous housing cycle. It’s true that
raising interest rates enough would induce a recession and that such a recession could pop a
house price bubble, but that is clearly not a particularly desirable approach.
Given the level of public debate, it would hardly be surprising if, despite all the protestations of
the Bank to the contrary, the general public had exaggerated expectations of the Bank's abilities
and intentions in the area of house prices.
The Real Rate of Growth
The second, more general issue, is expectations of central banks globally in terms of stimulating
output growth. It has been well established for many years that monetary policy has limited
effects, if any, on the sustainable real rate of growth. The main benefit from prudent monetary
policy is in avoiding the adverse distributional and welfare costs associated with high and
variable price inflation.
In the short term, monetary policy can help create conditions that allow growth to return to its
underlying sustainable rate, but the effect of good monetary policy on output is probably only a
little more than smoothing out the actual real growth rate over the cycle. That is worth having,
as there are likely to be some negative hysteresis effects3. The classic example of hysteresis in
economics being the tendency of the long-term unemployed to lose touch with the labour market.
3
Hysteresis effects are when the future path of the economy depends in a persistent way on particular events in the
past or, to put it slightly differently, on the path by which one reaches that future state. An example to make the
point would be the historical decision for cars in some countries to drive on the left and others on the right. This
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 4
That means that an effective, quick easing of monetary policy which smoothed out a slowdown
in growth, could have persistent benefits to the supply of labour. That can be particularly
important after a large shock such as the Great Financial Crisis of 07-09. There may be similar
hysteretic effects on the cumulative stock of investment.
Beyond that, well managed policy of any sort might just have a small influence on the long-run
potential growth rate by reducing the risk premium, hence creating more confidence in planned
investment, particularly from overseas.
But most of the time, an assumption of zero impact from monetary policy on the sustainable
growth rate, would be a reasonable first approximation. Indeed one of the earliest propositions I
can remember learning about macroeconomic policy was that the main objective should be to
avoid doing harm to growth by changing interest rates or fiscal policy at the wrong time – which
is what politicians were thought to have done in the 50s and 60s.
On the other hand, there are a variety of government policies that could be used to improve at
least the level of output and employment, and also maximise the sustainable growth rate by
operating on the supply side of the economy. Again these include the tax and benefits systems to
improve the labour market and a variety of policies that encourage investment or improve
industrial organization and market competition. And government policies can be employed to
reduce carbon emissions or otherwise make sure that a social agenda is pursued to improve
overall welfare for a given level of growth.
But the vast majority of these options are political and should be wielded by governments not
central banks.
Why then, is there so much pressure on, for example, the European Central Bank to take action
to stimulate growth in the euro area? The euro area manifestly needs a massive programme of
supply side reforms, different in each country, to improve the working of labour markets; make
tax systems and government expenditures more efficient; including reforms of labour markets
and benefits systems. Political systems in some countries are dysfunctional and need change.
The European system - in some parts - has clearly led to a distortion of markets and substantial
misallocation of capital, often as a result of ill-advised interventions for political purposes.
This could be rectified. Germany had a big rise in its unemployment rate post reunification. But
it undertook a series of reforms, starting in the 90s, which eventually dramatically lowered its
unemployment rate, falling from a peak of over 11% in 2005 to just over 4% in 2016 – which is
lower than its 1990 level.4 Admittedly it had the benefit of an undervalued exchange rate
following the creation of the euro, but if the largest and richest democracy in the euro zone can
organise itself so as to take the painful measures needed to implement supply-side reforms, so
too could others.
now imposes some quite serious costs but is not reversible. The outcome today reflects choices that were made long
in the past.
4
France, over the same period eschewed much supply side reform and its unemployment rate went from around 9%
in 2005 to just over 10% in 2016 - so this was not common across the euro area.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 5
But my question is why, in the absence of substantial supply-side reforms, would anyone expect
stagnant or consistently weak growth to strengthen, or structurally high levels of unemployment
to fall, as a result solely of monetary policy actions?
It is surely the case that slow growth in the euro area reflects fundamental issues in its real
productive potential. Slow growth is not a result of overly tight monetary conditions – they have
been easy and supportive now for many years. In my view the ECB has been the subject of a lot
of inappropriate criticism for inaction, despite taking extreme monetary policy actions and
stretching its mandate to the limit. Something similar has happened over a much longer period
in Japan.
Over-expectations of what central banks can achieve is dangerous to the sustainability of the
system. If central banks are seen to have failed because growth is insufficiently strong - or on
some other objective for which they have neither the responsibility nor the instruments to
achieve - that could threaten their monetary independence, which has proved so successful.
It also takes the spotlight away from those other authorities, political or not, who should be held
accountable. Governments could take a wide variety of measures - albeit quite possibly
politically unpopular ones5 - to raise potential growth and to correct fundamental problems such
as those in the UK housing market, or indeed deal with distributional or other social issues. The
UK has done this in the labour market in the not-too-distant past, which is why the UK
unemployment rate is relatively low now. But productivity growth has been weak and perhaps
there is more to be done in terms of industrial or market organization. For example, measures of
competition in UK markets often show very high concentration of market share with the leading
firms in each sector (eg the top four banks having around three quarters of the market, depending
on the precise measure used).
So we should stop worrying about whether interest rates should be changed by another 10 basis
points and we should look at the real policy choices that would permanently raise living
standards or improve the distribution of income.
Central Bank Balance Sheets and Social Objectives
I want to move on now, to a more specific and technical matter, which has been bubbling away
in the background. Central banks which have engaged in quantitative easing - including the
ECB, the US Federal Reserve and the Bank of England - have massively expanded their balance
sheets by buying financial assets. In the Bank’s case from around £75bn to over £400bn. The
possibilities aroused by this have not gone unnoticed. If central banks can do that, people say,
why can’t they expand their balance sheets and invest the money on other things such as
'people's QE' or 'green QE'. It turns out this is a very good question that does need answering.
5
I have heard it said that European governments know full well what they need to do to improve their supply side
economies – they just don’t know how to get re-elected afterwards! The point being that correcting each supply side
imperfection in the economy most often means attacking a vested interest. Do that sufficiently and you have upset
the majority.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 6
First a technical basic: buying assets to hold on one side of the central bank balance sheet
automatically creates liabilities on the other side. Those liabilities represent central bank money:
either banknotes or the value of commercial bank reserve accounts at the central bank6. If central
bank money can simply be created, without taxation, or borrowing, why not use it to buy some
social assets such as hospitals, schools or green energy?
This balance sheet expansion, interpreted with some justification as 'printing money', has not led
to the high rates of inflation that textbooks – and some commentators - suggested. So why not
print even more to finance social spending? That would be politically very attractive in some
quarters.
Personally, like many other people, I have a lot of sympathy for the social objectives behind such
ideas. But they are deceptively dangerous.
I don't have time today for a full technical exposition but I will put what I see as the main
arguments as to why using a central bank balance sheet to finance social spending would be a
bad idea.
The size of the central bank balance sheet is not a completely free policy choice. The liabilities
of the central bank basically reflect two things: the size of the note issue - how many banknotes
people want to hold - and the quantity of cash that commercial banks need to hold in accounts at
the central bank – their reserve accounts. Notes and these commercial bank reserve holdings are
inter-changeable so I won’t say anything more about notes other than that their number depends
solely on the public’s demand for hard cash.
The demand for reserve accounts is determined today in part as it always has been, by payments
flows, so that commercial banks can settle their net daily transactions between each other across
the books of the central bank. The amount required for this purpose is relatively small – it was
under £20bn pre-crisis.
More recently, the demand for reserve account holdings has greatly increased. I believe that this
is predominately because of new regulatory requirements that mean banks must hold more liquid
assets.
Central bank reserve accounts are a highly liquid but low yielding asset for commercial banks.
Profit maximizing imperatives should mean that banks seek to shift any excess into higheryielding assets if they can: for example, illiquid loans such as mortgages normally generate a
much higher rate of return. Indeed that is one of the channels through which QE could have
worked, although not a channel that the Bank emphasized: by buying assets, the central bank
increases its monetary liabilities and hence commercial bank reserves, inviting banks to expand
credit.
6
It is possible to create central bank bonds, loans or other liabilities, but these are usually negligible relative to notes
and cash balances.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 7
Whatever the channel, we know from history and from economic theory, that if the central bank
'prints' enough money that inflation, much higher inflation, is the inevitable result.
That has not happened since the Crisis for two main reasons. First, tighter regulations mean that
most big banks have been capital constrained, especially the large banks. Even those that wanted
to, couldn’t have expanded lending very quickly. Second, there has been a tightening of liquidity
requirements – in the UK that dates back to FSA action in 2010. In the wake of recession, there
may also have been limited opportunities for profitable lending.
My best guess is that reserve account holdings are probably now not in excess.
How would we know that the desired level of reserve accounts has risen so much? When I was
the Bank of England Markets Director7 a few years ago, we asked the banks for their best guess
of what their desired holdings of reserve accounts were at various times. After the UK’s second
batch of QE finished in 2012, the banks indicated a collective demand for somewhere around
£150bn as the new desired total level – nearly ten times the level pre-crisis. Ten times. And
consistent with that, because the Bank had expanded reserves by nearer twenty times, there was
no demand by banks to borrow more via the Bank’s routine lending operations.
That has obviously now changed. In the past year or so, the banks have actually started to borrow
from the Bank of England again in reasonable size, implying that the current level of reserve
accounts is probably once again close to the desired level.
It is difficult to prove that it has been regulation which has caused demand for reserve balances
to rise in this way. But I can see no other rational explanation.
If I am right, these countervailing forces have soaked up a lot of what would have been the
inflationary consequences of so much QE. Or, one can view it that QE has prevented the
deflationary forces that could have been the consequence of tighter regulation. In part that also
explains why QE has turned out to be so much bigger than most people originally expected as
the inflationary stimulus was being partially offset by other factors.
Let me be clear – I am not saying that these tighter regulations were in any way wrong or that the
level of QE wasn’t right. Making banks safer, whilst offsetting the negative consequences
through looser monetary policy, looks to me like just the right policy combination. But it has
become somewhat clearer what the forces at work are, at least in my mind.
But if that explanation is correct, then central bank balance sheets in the US and Europe, even if
static, will be of a much larger size than they were pre-Crisis – and for the foreseeable future.
And likely very much bigger than ever before, given the latest developments in respect of capital
and liquid asset requirements for commercial banks. But given that regulations must eventually
settle down, the Bank’s balance sheet can’t keep expanding without limit. At some point the
balance would tip and monetary control would be lost, causing much higher inflation.
7
I quoted this estimate in public on several occasions at the time, although it did not get much attention.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 8
Even so, given that the expansion of the balance sheet that has happened to date is likely to
persist and that the central bank could, in principle, buy any asset to hold to match the desired
size of its monetary liabilities, the question of buying social assets hasn’t gone away, even if we
agree that there is a limit. That limit would still be quite high!
So let us return to the direct question: to the extent that there is a large asset portfolio at the
central bank why not buy socially useful assets that cannot be funded by other means? In
principle it could and in days gone past, it has.8
But my contention is that it is not necessary for the central bank to make those decisions and not
in any way desirable that they should. The real question comes down to this: Given a certain
amount of QE, who should decide what the monetary expansion is really invested in? I want to
focus on the technicalities, as I think the political economics of the answer are self-evident.
Assume that the central bank only buys government bonds for the asset side of its balance sheet.
Then, for a given level of government debt held in the market, the government can itself choose
to spend an equivalent amount of money however it chooses, whether on social assets or
temporarily increasing other spending, or on cutting taxes. Or indeed the government could
choose to keep less debt in the market9. Those are the normal full range of choices that
governments have to make all the time. The central bank pursuing conventional QE creates a
funding opportunity for the Government but does not change its range of choices.
Suppose the central bank were to try to take on the mantle of the government and decide to buy a
variety of socially useful assets itself? Under what mandate - technical or political - would they
be acting? It is surely not the responsibility of unelected central bank officials to decide between
building hospitals or schools or aircraft carriers. That is manifestly the job of the political
government of the day.
Not only does a central bank not have the legal or political mandate to allocate resources in the
economy this way, it actually does not have the skill set needed to evaluate, make and execute
those judgments.
And most importantly, political criticism of its choices could completely destroy its technical
independence for setting monetary policy.
Then there is the question of losses. If the central bank buys government bonds, then any market
gains or losses are - and should be seen as - part and parcel of the normal cost of funding the
government, which most people would not bat an eyelid at.
But social assets generally have a credit component. Again, one must ask who should take the
political responsibility for potential credit losses. When the Bank of England starting buying
unsecured corporate bonds and commercial paper in 2009 my biggest concern as Markets
8
Forrest Capie in his 2010 history “The Bank of England, 1950s to 1979’, details some of the assistance given by
the Bank to Fairfield Shipbuilding and Engineering, originally making it a loan in 1932.
9
I am abstracting here from the benefit of reducing the interest rate at which the Government borrows. If QE is
reversed, that benefit can be reversed also and only time will tell precisely how that works out.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 9
Director at the time was that one or more of the companies who’s bonds we had bought would
default – potentially bringing the whole QE programme into disrepute.
Fortunately that didn’t materialize, as investment-grade corporate Britain, outside the financial
sector, was reasonably sound at the time. Indeed large profits were made on that portfolio and
are due to the Treasury as part of the overall QE P&L. That is right and proper, as the Treasury
had underwritten the financial risks of the whole QE programme. But the few billions we
invested in private paper were much more of a risk concern to me than the hundreds of billions
spent on government debt. Those concerns were mitigated by an extensive risk management
regime that limited what the Bank would buy to be of the highest quality - but the risk
management of such purchases had to be learned quickly as it was outside our previous skills and
experience.10
The main reason for advocating the use of QE to buy social assets must surely be that it is seen
as a costless way of financing public expenditure. It appears at first sight that no one would have
to pay more tax, nor do future generations get loaded with extra debt. But this is, of course, a
complete mirage created by mistakenly treating everything else as being held constant; and a
restrictive hypothecation being assumed.
The use of QE proceeds for one purpose is entirely interchangeable with others. Even if the
central bank were only to buy government bonds, the fiscal authority could choose to issue new
bonds to replace those bought - and then could spend the resultant funding in any way it chooses.
So any decision by a central bank to make a social investment via QE would be to make an
implicit choice between that and, say, a temporary tax cut.
But even that choice would not, in fact, be fully binding on the government. To the extent that
the central bank bought social assets for example, the government could simply choose to do less
social investment itself and spend the equivalent funds some other way. Any hypothecation of
QE to social assets can thus be fully offset by the fiscal authority.
So the proceeds from an expanded central bank balance sheet are directly interchangeable with
other government expenditures and revenues, and it must be for the elected government of the
day, supported by the finance ministry, to make its choices and to be held to account for them.
That includes the option of simply having less debt in the market and leaving spending
unchanged.
In practice, the decision is unlikely to be a marginal one as the counterfactual is unknowable.
The Chancellor must simply decide in the light of his own forecasts and any action taken by the
central bank, how much to borrow, spend and tax, and the composition of those elements.
I hope that simple explanation makes the point but let me recap: the size of a central bank
balance sheet must be determined by monetary and financial conditions, not by the desire to fund
any particular form of government investment or expenditure. To the extent that the monetary
policy-driven size of the balance sheet does create a funding opportunity, albeit unreliable, that
10
The Bank has said in its latest Market Notice that the risk management regime is now being put back in place as it
plans to buy more corporate bonds.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 10
could and should be used by the fiscal authority as it sees fit. That choice is a political one and
should not rest with the central bank.
To expect the central bank to address political and social ills through the use of its balance sheet
would be to make a technical, unelected body responsible for political choices way beyond its
remit and its competence. And the unfortunate consequence of asking the central bank to act
outside its remit would be to risk monetary credibility and the hard-earned gains in controlling
inflation. And let me clear about the social consequences of that - the biggest sufferers from
high inflation are the poor, especially those who depend on incomes or benefits fixed in nominal
terms.
These first three issues lead to one conclusion: please don't expect the central bank to do the
government's jobs of maximising potential growth or addressing social matters. Rather the
central bank should be held to account for the objectives it is formally set by government for
monetary and financial stability. Not only are these tasks technically difficult enough, they can
only be undertaken successfully if the central bank is, and is seen to be apolitical and credible.
That independence and credibility was the primary motivation for giving those responsibilities to
the central bank in the first place.
The Accuracy of Macroeconomic Forecasts
I also want to address briefly one further issue today that has been nagging away at me for some
time. The extent that we should expect macroeconomic forecasts – whether by the Bank or by
anyone else - to match the outturn. I will use the context of Bank forecasts although the analysis
applies to all forecasters, who are also policy makers, everywhere.
The Bank recently published a report by its Independent Evaluation Office into the accuracy of
its forecasts11. An excellent professional job was done quantifying the Bank’s forecast errors
using state-of-the-art techniques, aided by excellent academic assistance. I have no complaints
about what was done technically in that report which was almost entirely a statistical comparison
of the forecasts with the out-turn. But in my view, and as I shall explain, that was the wrong
question to ask!
Let me step back and consider what one is trying to do with a macroeconomic forecast. The
central projections – in this context - are some sort of best guess of the potential paths for
inflation and output over the next few years.
Consider just how difficult that is by contemplating today what might happen over the next two
or three years to affect inflation and output.
•
•
•
11
We have little or no idea how negotiations over Brexit will turn out in substance.
We may think that Clinton will win the US election – but how would a forecast need to
change if Trump were to win?
What if some of the tensions in the world suddenly broke out into serious armed conflict?
http://www.bankofengland.co.uk/about/Documents/ieo/evaluation1115.pdf
Briefing Notes in Economics
•
•
Issue No. 92 – November 2016 Page 11
What if China or Saudi Arabia saw large-scale internal instability?
How many completely unexpected events – ‘black swans’ – will occur in the next couple
of years?
We don’t even know for sure what the new UK government leadership will do with domestic
fiscal policy. And yet the central bank is expected to forecast inflation, 2 years ahead to within a
small fraction of 1 percentage point and similarly track the path of GDP!
We expect them to do this using a combination of statistical models, theory and judgment.
Statistical models are all calibrated one way or another using past data – which is itself highly
uncertain being subject to definitional problems, measurement errors and revisions.
When I was estimating equations myself for the Bank’s models – albeit some time ago now and
using different methods – my very best equations, for example on CPI or non-durable
consumption, had standard errors of just under half a percent12. That is over the past, with all the
assumptions about other factors made being treated as known outcomes, the average absolute
size of an error would be about half a percentage point for a one quarter ahead, within sample
forecast. Compare that with wanting to forecast inflation 2 years ahead to within say 0.1 or 0.2
percentage points of the out-turn – based on models and data alone we should have no chance.
None.
The one thing we know with certainty is that our macroeconomic forecasts will be wrong. The
forecasting literature came to this conclusion many years ago, thanks to the writings of David
Hendry and others, but that result doesn’t seem to have penetrated popular perceptions.
So if the forecasts are going to be different from the outturn, to a degree that is potentially
important for policy decisions, should the Bank stop producing them? No. Monetary policy
must be forward looking because of how long it takes monetary policy to have its full effect, and
some kind of forecast process is implicit in setting a forward-looking monetary policy, however
we frame it. And there is not yet a better accepted way of communicating why monetary policy
is being set as it is, than by couching it in a forecast.
In fact, given the inherent uncertainties affecting actual inflation we should probably be surprised
about how well inflation forecasts have turned out. But in part that’s because the central bank
can alter policy with the intention that inflation in a couple of years time is 2%. It would be
pretty difficult for the Bank to explain a medium-term forecast significantly different from its
target when it has the capacity to change policy to bring the central expectation back to that rate
within the forecast horizon. So a forecast 2 or maybe 3 years ahead should always be close to
the target and the ‘forecast errors’ measured after the event should be very close to the deviation
of actual inflation from the target. If the target is hit on average, the forecast error variance
should be close to the data variance.
This a slight re-statement of a well-known property – that in the long-term, and under some
fairly gentle assumptions, forecast error variance should tend towards the unconditional data
12
The standard error is the square root of the error variance, and so is not the same as the mean absolute error. But
the magnitudes are usually very similar.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 12
variance i.e. there will be virtually no information in a long-term forecast outside the mean of the
series. And that’s even if our model accurately represented the true functioning of the economy!
For output forecasts, there is no central bank target, although Inflation will be most likely be
stable when real demand and supply are in balance. So one might expect that achieving the
inflation target on average would also mean pushing actual growth towards the underlying
sustainable growth rate. In that case, the medium-term growth forecast errors should be about the
same as the variation in growth around its potential. For a stable trend in potential output that
means that medium-term forecast errors will tend to be close to the de-trended data variance.
In summary, if policy is reasonably successful, the inflation forecast errors for 2 or 3 years ahead
should end up with a variance pretty close to that of the data. Output forecast errors at that
horizon should also be pretty close to the de-trended data variance, at least over periods when the
underlying economy is well behaved. And most forecasters should, and do end up in a similar
place.
In which case the size of the Bank’s forecast errors are of hardly any interest at all.
What about the other properties of forecast errors? For example if some errors are bigger than
‘normal’ for a period, or if they appear to be repeated. Well, it has been known for round 30
years, ever since a very clear exposition by Ken Wallis in the1980s, that if (1) one has the perfect
model of the economy and it is dynamic (in the sense that what happens in one period depends
on what has already happened) and (2) there are random unforeseeable disturbances (stuff
happens), then the dynamic forecast from the perfect model will have errors which do indeed
appear to repeat and have changing size. And, as noted already, out-of-sample, the variance
should rise until it is equal to the (unconditional) data variance.13
The Bank’s study reported as a major finding – as if it were a revelation - that there was evidence
of 2-year ahead inflation forecasts being less accurate than one year ahead. Well, they should be.
That’s precisely what the statistical theory predicts. The surprise would be if it weren’t the case.
So, once one understands the problems, the purely statistical approach just isn’t that interesting.
So let’s consider other approaches.
The Bank, from the very first Inflation Report in February 1993 onwards, tried hard to get its
readers to think of the full probability distribution around the forecast, not just the central
projection i.e. one should consider all of the possible outcomes and their likelihood. When
deciding on monetary policy the MPC really do look at all the risks in the distribution that they
can think of and see how those risks play in to the policy choice. The iconic fan chart was
originally introduced in the 90s with exactly that in mind.
13
In statistical terms, even when one knows the (dynamic) data generation process with certainty, successive errors
fin a multi-period forecast will be serially correlated and hetero-skedastic. And that is true even within sample! It
follows straightforwardly from the fact that the n-step ahead error in a dynamic forecast reflects all n-1 previous
errors, and n grows over the forecast period.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 13
But despite the fan chart, commentators and journalists from the start simply got out their flexicurves14 to work out a central projection and judged the forecasts on that, ignoring the wider
probability distribution. This has been very frustrating.
So I would like to try to offer a different perspective15. What is a forecast really? None of us
actually knows anything very much about what will actually happen in the future – there is no
crystal ball. Rather a forecaster does what we all do in our everyday lives: we extrapolate based
on the things we think we know today including our past experiences.
In the context of an inflation or output forecast there are many factors that are relevant to the
current state of inflationary pressure. Indeed there are so many factors at work that one needs to
combine and reduce the information into a sufficiently small set of numbers that makes it useful
in making and explaining a policy decision. That’s the point of a forecast: to summarise our
current knowledge of inflationary and growth pressures.
One can feed a forecast with whatever information one has. In the case of a macro forecast
usually there are no limits: one should make use of all the data that one has, all the statistical
procedures and other models that one can bring to bear; all the economic theory; all the business
anecdotes and a large dollop of judgment if (when) it doesn’t feel right without.
Note that a forecast does not, and cannot have in it, any genuine knowledge of the future - unless
the laws of time are different from what we think! Rather, a forecast is a statement of the current
state of inflationary pressures based on what we think we know now, expressed in summary form
as the most likely path of inflation in the future, given no unexpected developments. And doing
this is, as far as we know, the best guide to setting policy.
One can use the available information in different ways to produce scenarios, alternative
forecasts or a full distribution. The only thing we know for sure about the future is that stuff will
happen that we don’t know about today. And that means the outturn should always differ from
the extrapolation.
It’s easiest to illustrate the problem with an example of an expected future event that we know
could be a tipping point (although in fact the real problem is from unexpected future events).
But suppose our forecast of interest is growth in the US economy. A key factor in determining
the outcome is likely to be the result of the 2016 presidential election.
If we have a forecast based on an assumption of a Clinton victory, which we might agree in
advance is the best assumption to make, it would probably turn out to be a bad predictor of the
outturn if the lesser likelihood event transpired and Trump were to win. One could alternatively
produce a Trump forecast. At least one of those forecasts would likely be badly wrong. And if
one hedges one’s bets by producing a fudged forecast which averages out the effects of Clinton
14
For those too young to recognize the term, the flexi curve was a semi-rigid bar which one could mold to a shape to
copy and reproduce a curve. I think mine was rubber over a soft metal centre. It long since disappeared along with
my slide rule and a desk-top calculator that was entirely mechanical, not electronic.
15
This perspective is actually just a standard way of characterizing a forecast in statistics as a projection on an
information set.
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 14
and Trump outcomes, then we know straight away that that must be wrong as the election result
must be one or the other. Macro forecasts are always conditional on such assumptions, and even
more crucially on assuming that nothing else unforeseen happens.
Of course, there is a consistent and familiar cognitive dissonance here seemingly accepted by
human beings. Most of us fully accept that we don’t know what will happen in the future. But
when the unexpected happens we always complain that whatever it was should indeed have been
anticipated. Usually so we can blame someone. We want a rational explanation for everything
after the event even when we could not have given it beforehand. The political world in
particular seldom accepts an explanation of any significant event that it was just some random
act of chance – even though most of the same people would accept that there would be such
random acts in future.16
But none of this means we should throw away our best forecasts – unless someone can come up
with a better way of summarizing current inflationary pressures (or growth possibilities). What I
think it means is being smarter about what we expect from them and how we analyse them.
The question of whether a macro forecast matches the out-turn can have some role to play, for
example in testing for bias, as long as one is aware of the inherent statistical properties of multiperiod dynamic forecasts.
We also know that by taking the average of different forecasts, we usually get a better forecast.
Any one particular forecaster will usually be beaten in a repeated forecast game by the
‘consensus’. The wisdom of crowds suggests that mistakes usually get averaged out across
players. That is actually just a matter of statistical logic. So comparing, say, the accuracy of the
Bank’s forecast, with the average of everyone else’s, is not an informative comparison – it would
be unusual if the consensus forecast was not better in a repeated statistical horse race.
The right way to approach an assessment of forecasts is to ask ‘Could we have made a better
forecast at the time, knowing what we did then?’ Was there some mistaken analysis, some data
we didn’t include or something else that we can learn from?
The technology for doing this actually isn’t that complicated, it was demonstrated repeatedly in
the 1980s at Warwick University’s Macroeconomic Modelling Bureau using computers that
were a tiny fraction as powerful as today’s. In my view it was a shame those questions weren’t
asked in the Bank’s recent study. What would one expect to learn from such analysis?
One can straightforwardly decompose any forecast error into various sources such as: errors in
exogenous assumptions made (e.g. about future elections, tax rates or world growth), any
erroneous judgment factors applied, any data revisions, and any errors in the models used
(usually constructed as the residual error not otherwise explained). And this does not depend on
how a model was estimated.
16
Actually I think we do often recognize random accidents in our everyday lives – but perhaps most often when we
are personally to blame and a ‘random accident’ is a more acceptable explanation!
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 15
Some examples: in the early 90s Bank of England forecasts, inflation mostly came out lower
than we expected and that was in large part because average earnings didn’t pick up as we had
expected – labour markets had changed and it was instructive by analysing our forecasts to
realize that. More recently, the Bank found that the pass-through from large exchange rate
movements to prices took longer and was therefore a bit bigger than the Bank had assumed.
So the right question in my view is not whether a macro forecast is wrong (it will be), or how
much it is wrong, but why was it wrong. Unfortunately that question didn’t seem to have been
the one addressed by the Bank’s recent analysis.
A final thought on this – the Bank’s forecasts only matter to the extent that they are used to make
or explain policy decisions. In fact the forecast and the policy decision are necessarily
intertwined to be consistent.
Looking back over all my time at the Bank, since the MPC was established, even with hindsight
I would not have changed monetary policy settings very much. A quarter point here or there
maybe, perhaps delaying or advancing some decisions by up to a few months. But broadly
speaking I would assert that policy was set pretty much where it should have been – given
everything else that happened - and would happily defend that record. But that is a debate for
another day.
If one assembled the evidence over many years, I will assert that the Bank of England’s forecasts
have almost certainly been consistently amongst the most useful and have helped the MPC set
policy correctly. But don’t expect them to be all that accurate after the event given the amount
of surprises that affect the economy all the time. Knowledge of how the economy operates is
imperfect, the data available is just an approximation and no one knows for sure what will
happen in the future. What we should and must do, is use forecast ‘errors’ to learn about how the
economy is evolving.
Conclusions
How can we draw all this together? Three points:
1. Central banks should not be held accountable for things they cannot control, are outside
their remit or are just plain unpredictable. If we do that we risk losing their credibility
and success at what they can do.
2. Central banks should be judged on their remits and whether they made the best decisions
they could have at the time. That means setting monetary policy aiming to keep inflation
in line with the target, and making the financial system robust to shocks. As far as I
know, we have surprisingly few proper in-depth academic studies of the monetary policy
decisions that have been made – we should have more, so that we can learn.
3. Slow growth in the developed world is not because monetary policy has not been
sufficiently stimulative. More monetary stimulation is not going to solve underlying real
problems such as poor productivity growth (or income inequality).
Briefing Notes in Economics
Issue No. 92 – November 2016 Page 16
4. Governments are responsible for introducing supply-side policies, correcting the
distribution of income and setting the rules to make the planet green (as well as balancing
the fiscal books). They do that through channels such as the tax and benefits systems,
planning systems and the legislative process. Pressure needs to be exerted in the right
places to get those fundamental political objectives addressed.
♣
The views expressed here are personal to the authors and do not necessarily reflect those of the other
staff, faculty or students of this or any other institution.
♪
Paul Fisher is also Chair of the London Institute of Banking and Finance and a Senior Associate of the
Cambridge University Institute of Sustainability Leadership. He was a member of the Bank of England’s
Monetary Policy Committee from 2009-2014, a member of the interim Financial Policy Committee 20112013 and briefly a member of the Board of the Prudential Regulation Authority.
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