Bank of England: ‘Serious deficiencies’ in economy forecasts, review finds

The Bank of England’s economic forecasting system has “serious deficiencies” that need to be modernised, according to a review.

The independent report by Dr Ben Bernanke, former head of the US central bank, found staff used outdated systems that should be overhauled or replaced.

He found there had been serious under-investment 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 that a “material degree” of under-investment had led to staff using a “complicated and unwieldy system”.

This holds staff back from producing useful analysis on what might happen to the economy, he said.

Updating and modernising how its system handles economic data should be completed “with high priority” and “as rapidly as feasible”, Dr Bernanke said in the critical review.

He was asked to carry out the review last July after the UK’s central bank came under fire from MPs for failing to anticipate the scale or duration of inflation – which measures how prices rise over time – over the past two years.

Responding for the Bank of England, Governor Andrew Bailey said: “Substantial investment is being made to develop our infrastructure and to update our system. It’s a high priority.”

Governor Bailey was criticised by members of Parliament and independent economists for allowing a surge in inflation worse than both the US and eurozone.

However, Dr Bernanke said central banks across the world faced the same problems with forecasting models being disrupted by unprecedented economic shocks.

Inflation began to rise above the Bank of England’s 2% target in the summer of 2021 as the global economy bounced back from the pandemic and the supply of commodities from petrol to food struggled to keep up with resurgent demand.

That was made worse by Russia’s invasion of Ukraine, which cut the supply of commodities from gas to sunflower oil and forced up prices further.

In the UK, inflation hit a peak of 11.1% in October 2022, placing serious pressure on the budgets of both businesses and households.

Mr Bailey said repeatedly throughout late 2021 and early 2022 that the Bank’s Monetary Policy Committee (MPC), which sets interest rates, believed the surge in inflation was “transitory”.

However, the spike in inflation proved more sustained than expected and started to translate into higher pay rises.

Between December 2021 and August 2022, the central bank raised interest rates 14 times in a row to try to bring inflation under control.

Higher interest rates have led millions of mortgage borrowers to face a “payment shock”, where their monthly payments jump to a much higher level as they come to the end of fixed-rate mortgage deals.

Further upward pressure on inflation came from an unexpected shortage of available workers, partly due to the effects of long-term sickness such as long Covid. That led employers in the private sector to increase wages to attract and retain staff.

Governor Bailey has admitted the Bank’s forecasting models failed to anticipate this, which led to a tighter labour market and therefore a greater susceptibility to inflation.

Dr Bernanke’s review recommends the Bank must thoroughly update its whole framework for forecasting the economy, overhauling or scrapping its existing software, known as Compass (Central Organising Model for Projection Analysis and Scenario Simulation).

He said the models should take into account how higher prices can cause higher wages – as well as vice versa.

He also said the Bank of England’s forecasting models should pay greater attention to factors like the supply of labour and supply chain disruptions.

And he said the Bank should lay less emphasis on its “central forecast”, where it justifies moves in interest rates based on what it regards as the most likely path for inflation over the next one or two years.

Scenarios should also be published which might prove its forecast wrong, he said, such as disruptions to supply chains, as well as relying on its own forecasters more instead of City traders.

Sanjay Raja, chief UK economist at Deutsche Bank Research, suggested that more work would be needed to get the Bank’s forecasting systems up to scratch.

He pointed out some tweaks to the MPC’s communications would be coming in to improve transparency around how it makes interest rate decisions.

But, the review would not be “a game change for how policy is conducted”, he added.