Rachel Lomax: Inflation targeting in practice - models, forecasts and hunches
Speech by Ms Rachel Lomax, Deputy Governor of the Bank of England, to the 59th International
Atlantic Economic Conference, London, 12 March 2005.
I am most grateful to Jens Larsen, James Bell, Fabrizio Zampolli and Robin Windle for research support; and to Charlie Bean,
Peter Andrews, Spencer Dale, Phil Evans, Laura Piscitelli and other colleagues at the Bank of England for helpful comments.
* * *
Introduction
Five and a half years ago in his Monnet lecture Charles Goodhart1 was able to talk with some
confidence of the features that particularly distinguished the UK's approach to inflation targeting.
Today with over 20 countries, in every habitable continent, formally operating some variant of inflation
targeting and many more adopting some parts of the framework, all actively sharing experience and
best practice, I suspect that most aspects of our approach would find a counterpart somewhere else in
the world. But Charles's focus on the Monetary Policy Committee's (MPC) personal engagement in
producing a published inflation forecast still seems to me to capture the essence of the UK's approach.
Today I want to talk about the role that forecasting has come to play in helping the MPC to take and
communicate its decisions. In what sense does the Committee really 'own' the published forecasts that
go out under its name? How much use do we make of models, and what models do we use? How far
do our forecasts appear to drive interest rate decisions? And is there any evidence that this has
helped to make policy more or less predictable? Finally I want to end by commenting on some of the
issues raised by forecasts as a means of communication.
Why the MPC has always been involved in forecasting
The MPC's early involvement in the forecast process is firmly rooted in the kind of committee it is, as
well as the nature of the remit it has been given.
The objectives of UK monetary policy have been expressed in terms of an annual inflation target since
1992, but responsibility for achieving the target initially lay with the Treasury, acting on the Bank's
advice. In 1997, as part of a wide ranging restructuring of the Bank of England's role, decisions about
interest rates were delegated to the Bank's new MPC. Its nine members - five internal Bank officials
and four external members chosen for their relevant knowledge and experience - are individually, and
publicly, accountable for meeting the inflation target.
The Government remains responsible for setting the annual inflation target, within the context of
legislation that requires the Bank of England to achieve 'price stability and subject to that to support
the government's objectives for output and employment'. Under its current remit, the MPC is required
to achieve 2% consumer price inflation 'at all times'. If inflation deviates from target by more than 1
percentage point, the MPC has to write a public letter to the Chancellor to explain why, and what it is
doing to bring it back.
These arrangements remain relatively novel and unusual in UK constitutional terms. Prior to 1997, a
longstanding objection to Bank of England independence was concern that such arrangements would
be inconsistent with Ministerial duty to answer to the House of Commons on major matters of policy. A
high level of transparency and openness about MPC decisions has been a critical aspect of meeting
expectations of parliamentary and public accountability as well as an effective way of enhancing the
credibility of monetary policy.
In fact greater openness about monetary policy was part of the package of changes that were made to
restore credibility after the UK's exit from the ERM in 1992. The Bank played its part by introducing a
new quarterly Inflation Report, which by 1997 had won widespread respect for its objectivity and
professionalism. Against this background, the 1998 Bank of England Act required the new Monetary
Inflation
Policy Committee to sign off the Bank's Report. In practice, the MPC's sign off has been far
from a formality, though the Inflation Report formally remains the Bank's report.
It is not that surprising that a committee of experts whose external members are based in the Bank
and who devote at least 60% of their time to monetary policy should get deeply involved in preparing
and debating the forecasts that they sign off. It may be more remarkable that nine economists,
labouring under the burden of individual accountability, have so far succeeded in signing off 31
Inflation
editions of the Report, and found ways of dealing with the inevitable range of views.
The nature and role of the forecast
Nowadays the forecast has two related roles in the monetary policy process. First, it helps the
Committee to set monetary policy by organising, informing and focusing its discussions. And second,
it provides transparency about the Committee's thinking and plays a key part of its public
communication strategy.2
Helping the MPC make decisions
Monetary policy needs to be forward looking, because interest rates act with a lag. No monetary
policymaker can avoid taking a view on the future. That view needs to be coherent and disciplined,
and informed by the best information available. But it also needs to reflect a realistic appreciation of
the massive uncertainties inherent in any forecast.
The MPC spends many hours discussing the projections that go into the Inflation Report and the text
that accompanies them. Although the process has been somewhat streamlined since Charles's day
(when the committee spent a gruelling ten meetings a quarter on the forecast on top of the usual
monthly decision meetings) the forecast round is probably still the largest single commitment of the
Committee's time.
Why? An important reason is that the forecast is not just an occasion for agreeing a set of projections
for the inflation outlook. It has come to provide an organising framework for assessing all the relevant
information, and an opportunity for a deeper discussion of economic developments. Since I have been
on the Committee, we have spent at least half our allotted forecasting time debating longer term
issues, such as the effect of structural change in the labour market and the relationship between
house price inflation and consumption. Sometimes the outcome of those discussions has had a
material influence on our thinking about risks, even when the direct impact on the central projections
has been relatively minor.
What role do formal economic models play in the forecast? No set of economic projections - least of
all one owned by a committee of nine experts - can ever be the outcome of a purely model-based
operation. Judgement always plays a large role - although different people frame their judgements in
more or less model-based ways. But it is difficult to make a forecast without using models: they
provide an organising framework for ensuring intellectual and accounting consistency in generating
baseline projections, and for considering alternative scenarios and risks.
What sorts of models does the Committee find useful?
In his peer review of the Bank's use of economic models3, Adrian Pagan suggested that economic
modelling may involve a trade off between theoretical consistency (good economics) and data
coherence (a good fit); our goal should be to ensure that we are positioned on the efficient frontier
between the two.
Any model we use should in principle be on this frontier - but we want to be able to move along the
frontier and use different sorts of models for different purposes.
For example, if, as I have suggested, we want to use models to facilitate discussions about
fundamental economic issues, we clearly need models with rich economic structures - structures that
reflect the Committee's views on the way the economy works. The Bank's new Quarterly Model
(BEQM)4 has been developed with this function very much in mind. But we also use other and smaller
models with rich economic structures to look at specific issues as part of our suite of models.
We also want to quantify the likely impacts on inflation and output of a range of pieces of data news as
accurately as possible. The numbers matter, so empirical performance is important, too. We have
worked hard at ensuring that BEQM does well in this dimension, but we have also, within our suite,
been developing more statistically based models. We may use these models on their own - as stand
alone forecasting tools - or to inform the judgements that we make in using BEQM.
Let me say a few words about both the main model and the suite.
The motivation for the BEQM project was to help with the 'intellectual framework' role of the forecast.
Without losing empirical performance, we wanted to improve upon the previous main model's
articulation of the underlying structure of the economy, to make it more explicitly consistent with the
Committee's beliefs.5 This was made possible in the light of recent advances both in economic
understanding - particularly the emphasis on providing coherent micro foundations in macroeconomic
models - and in sheer computational power (both in terms of computing power and the techniques
applied).
BEQM is a large scale model by the standards of most academic research, but it is small scale
compared with traditional macro-econometric models. Compared with the latter, it is also more of a
general equilibrium model with an emphasis on internal consistency. Households and firms optimise -
they are forward-looking and they use available information efficiently. Unlike our previous model,
things add up: flows add to stocks, profits are allocated, and so on. There is a high degree of
simultaneity in the way the model is solved. It no longer makes sense, nor is it at all easy, to consider
the model equation by equation.
This provides a greater degree of discipline on Committee members and staff, who are now forced to
confront the full implications of their judgements more explicitly. If someone wants to change one of
the economic relationships, they need to say why, and acknowledge the possible implications for other
behavioural relationships. If, for example, we want to assume that the trend rate of labour productivity
growth has changed, the model requires us to recognise that there are implications for both demand
and supply. Faster productivity growth will increase productive capacity, but income will also grow
faster. So what might that mean for demand now?
This is a definite advance - providing the general equilibrium mechanisms in the new model do in fact
reflect our ideas about how the world works. But it also makes for a more demanding discussion.
There are no easy fixes, and it can be difficult to accommodate views that differ from the model's
paradigm. As an example, the model is firmly rooted in the rational expectations tradition. And we
have assumed that monetary policy is credible. Both are perfectly reasonable, arguably essential,
modelling assumptions. The fact that the new model makes them explicit can be intellectually helpful.
But it doesn't make it any easier to provide answers to questions about expectations and credibility.
What if some agents base their decisions on simple rules of thumb? BEQM has features that allow us
to accommodate such questions when we are forecasting - but in a more ad-hoc way that requires a
substantial degree of judgement.
We are still learning how to exploit all BEQM's possibilities. But it clearly represents a move towards
the 'Pagan frontier', offering a higher degree of theoretical coherence without losing empirical
performance. A number of other central banks are working on similar models - the ECB, Bank of
Canada, FRB, Norges Bank and Bank of Finland - as well as the IMF. The international modelling
community is an exemplary forum for the exchange of ideas and experiences, and we have learnt -
and will continue to learn - a lot from the experience of others.
No model can do everything. All models oversimplify drastically. The trick is to identify an appropriate
degree of simplification for the task in hand. So the Committee has never been prepared to rely on one
model. This has led to attempts to develop a suite of models.
The suite takes two forms.
One is a range of models that are complementary to the core forecasting model. These hold up a
magnifying glass to particular parts of the economy, and allow us to take account of the influence of a
wider range of factors in more detail than could be accommodated in the main model. These (sub-)
models might be geared towards analysing particular policy issues (e.g., supply chain pricing models,
the future development of household and corporate gearing, productivity growth in the distribution
sector). Or they might also provide the interface between our very short-term conjunctural analysis,
and the 2-3 year forecast.
Second, we have a set of statistical models. The MPC attempts to process a huge amount of
information before each monthly decision. The Committee already uses some data-driven forecasts
(for example, forecasts that uses many variables to forecast in an a-theoretic way, statistical models to
produce near term forecasts for key data such as CPI, and small models that filter ONS first releases,
to handle the inevitable data uncertainty associated with early releases6). But it is a herculean task to
absorb and analyse all the data. So, responding to the needs of the MPC, but also to suggestions by
Pagan, the staff is in the process of developing and evaluating more models geared towards empirical
forecasting accuracy and finding ways of combining these forecasts in a statistically efficient way.
This is very much work in progress, with the aim of helping the MPC to form judgements both about
the most likely outturns and the uncertainty surrounding them.
Handling uncertainty and disagreement
Even armed with a range of economic models to aid structured discussion and enforce a degree of
intellectual discipline, how is it possible for a group of nine individually accountable economists to
reach sufficient agreement to publish a forecast which is described as reflecting their best collective
judgement?
An important part of the answer lies in the use of formal techniques to capture uncertainty and risk.
These antedate the MPC. The Bank of England started publishing fan charts for its inflation
projections in February 1996, following an early experiment with what might be called 'trumpet
charts'.7 The motivation was purely to illustrate the uncertainty inherent in all economic projections.
While trumpets consisted of a single shaded area around a central projection, corresponding to
average absolute forecast errors (see Chart 1), fan charts (see Chart 2) were graduated to show the
full distribution of possible outcomes.8
Chart 1. November 1995 RPIX inflation Chart 2. February 1996 RPIX inflation
projection - symmetric error bands projection - fan chart
Nowadays, each Inflation Report includes fan charts for inflation and output which reflect the
Committee's views on the full distribution of possible outcomes. While the width of the fan bears some
relation to the size of forecast errors over the past decade (the distribution of past forecast errors
provide a benchmark calibration), its main features - the moments of the underlying distribution -
change with each forecast to reflect the Committee's best judgement about the balance of risks
around the outlook for inflation and output and the degree of uncertainty. While many other central
banks now publish fan charts, the MPC is still relatively unusual in basing them on the policymakers'
subjective view about the distribution of risks, rather than staff views or historical/statistical measures
of past errors.
The MPC's approach to constructing fan charts can help the members come to an agreement on the
substantive issues, while retaining their individual views. This is because the risks are often where the
major differences of opinion amongst members lie. And while the members may be able to agree on a
collective view of the overall outlook including the degree of uncertainty and balance of risks, it might
be for slightly different reasons. To be sure, there have been times when differences of view about the
central projection have been too significant to be handled within the ambit of the fan chart and on
Inflation Report
those (few) occasions the has included material illustrating the minority view. But, as
the MPC's preface to the Inflation Report notes, the fan charts reflect the Committee's best collective
judgement about the most likely paths for output and inflation and the uncertainties surrounding the
central projections, while recognising that members may have slightly different views about the
underlying assumptions.
Forecasts and interest rate decisions
How influential is the forecasting process when it comes to the actual business of taking decisions
about interest rates?
Inflation Report
One yardstick might be whether the MPC is more likely to change rates in months.
There is no necessary reason why this should be so: information accrues relatively evenly over the
year, and the Committee goes through the same decision taking process every month. On the other
hand, the MPC might be more likely to change rates after a systematic and full review of the inflation
outlook, rather than in response to the news on the month. On this argument, ready-reckoners may
give a rough indication of what the impact of new data may be, but they are no substitute for a full
Report
analysis. So in non-Inflation months the MPC may sometimes decide to 'wait-and-see' - to
postpone a possible interest rate change until more evidence has accumulated.
As it happens, market economists have tended to think that interest rate changes were more likely in
Inflation Report months. Since 1998, Reuters have asked a group of economists (initially around
2030, now 40 or more) to attach probabilities to a range of different outcomes for interest rates, so we
can calculate a mean and a mode expected interest rate change across individuals. Panel B in Chart
Inflation Report
3 split the months in which the mode is for a (25bp) change into and non-Inflation
Report months. According to this measure, markets have consistently thought that changes were
Inflation Report
more likely in months.
The data on interest rate changes provide mixed evidence. Over the period since 1997 as a whole, the
Inflation Report
Committee has displayed a preference for changing rates in months. But it showed no
such tendency in its early years. The picture since 2001 is very different, with almost two thirds of
Inflation Report
rates changes taking place in months, compared with the one third that would be
expected if rate changes were evenly spread over the year. And no fewer than six of the last eight rate
Inflation
changes have coincided with the publication of an Report. (See Chart 3 and Table 2 for
details).
Chart 3. Proportion of actual and expected interest rate changes occurring in Inflation Report
months.
(B) Expected changes
(A) Actual changes
Percentage of interest rate changes Percentage of interest rate changes
100
100
90 90
80 80
70 70
60 60
50 50
40 40
one-third one-third
30 30
20 20
10 10
0 0
1997-2000 2001-present whole period 1997-2000 2001-present whole period
IR months Not IR months IR months Not IR months
What - if anything - should be read into the MPCs apparent change in behaviour? On the face of it,
the evidence might suggest that the re-evaluation of the outlook undertaken during the quarterly
forecast has become more influential. But there are a number of possible explanations.
Most obviously, it could be a reflection of the shocks that have come along in the last 4 years. These
may have required fewer changes in the policy rate than in the pre-2001 period. Alternatively, the
required adjustments in rates might have been bigger in the early days, and if the MPC had an
inclination to change rates in small steps, perhaps because it had good reasons for proceeding
cautiously, then larger desired adjustments might have required more frequent changes: of the 16
changes in the first period, 7 were back-to-back, while in the second period, only 4 out of the 14
changes happened in consecutive meetings.
The turnover in the Committee's membership since 2000 might provide a different kind of explanation.
The present Committee contains only one member (the present Governor) who has been there from
the outset, and some of the early members served short terms. Might the latter day tendency towards
changing rates only after a forecast reflect a generally less activist approach to setting rates?
Table 1 provides an unscientific guide to Committee members' degree of activism: it is arranged with
the most 'activist members' (identified as those voting proportionately most frequently for a rate
change) at the top.9 If personal preferences played no role, we might expect to see a relationship
between activism and 'MPC vintage' - if MPC members responded to the same shocks, or their
behaviour was affected by some other common factor, there would be clusters. Keen MPC watchers
will no doubt find some support for the view that personality matters. But, in general, the members
are
who voted for the most rate changes associated with the earlier years of the Committee,
consistent with the idea that the MPC may have needed to respond more frequently during that
period.10
Table 1: MPC members' voting statistics from January 1998 (current members in red)1
% of months Number of
% of changes voted
voted for a rate meetings
for that were in IR Time of membership
change attended since
months
Jan 1998
Willem Buiter 79 36 29 1997-2000
Sir Alan Budd 65 30 17 1997-1999
John Vickers 61 29 28 1998-2000
Charles Goodhart 52 36 29 1997-2000
Sushil Wadhwani 51 37 37 1999-2002
Christopher Allsopp 49 44 37 2000-2003
DeAnne Julius 46 47 41 1997-2001
Stephen Nickell 41 50 58 2000-date
Mervyn King 39 41 87 1997-date
David Clementi 37 43 57 1997-2002
Ian Plenderleith 33 44 54 1997-2002
Sir Andrew Large 34 40 29 2002-date
Kate Barker 33 53 46 2001-date
Sir Edward George 30 45 67 1997-2003
Richard Lambert 29 67 21 2003-date
Marian Bell 28 56 32 2002-date
Charles Bean 28 60 54 2000-date
Rachel Lomax 25 80 20 2003-date
Paul Tucker 24 63 33 2002-date
1
Up to and including the February 2005 MPC meeting.
Has the publication of regular forecasts, which are seen to bear a close relationship to the decision
taking process, helped to make the policy decisions themselves more predictable? The test is whether
markets are less likely to be surprised by interest rate changes, given full knowledge of all the relevant
economic news.
We ran some simple statistical tests on two measures of 'market surprises'. One is based on the
Reuters poll of economists. The surprise measure is the difference between the actual repo rate
change and the mean expected repo rate change. The other surprise measure is a bit further out
along the yield curve: changes in the implied three-month forward LIBOR rate.11
Both measures suggest that interest rate surprises have become significantly smaller in the post-2001
period than previously (Table 2 Panel C), consistent with improved policy predictability. But,
intriguingly, there is also some tentative evidence that surprises in Inflation Report months tend to be
relatively large.12 What are we to make of that?
11
More precisely, this is an implied 3-month Libor forward rate at a constant horizon of 3-months, where the constant horizon
is calculated by linear interpolation of adjacent futures contracts. The results are largely invariant to using six or twelve
month horizons.
12
This could, of course, be entirely driven by the expectation that there would be no move in non-Inflation Report months: in
the extreme, if the distribution of surprises in those months is degenerate (i.e. so that no one expected a change in rate and
this was what actually happened) then the statement that surprises are bigger in Inflation Report months is no different from
the statement that rates are only expected to change in these months. The closer the distribution comes to being
degenerate, the more weight should be attached to that interpretation. But both the average surprise and its variance are
significant.
On closer inspection, this finding seems to relate to the decision in Inflation Report months - not the
Report
publication of the itself a week later, or the minutes the week after that (Panel E shows that the
market reaction to the policy decision is, on average, significantly bigger than the reaction to the
Report and the minutes). This might imply that it is the rethink during the preparation of the Inflation
Report that counts. But, once announced, the decision itself (and the accompanying press notice, if
rates have changed) provides most of the information the market needs to understand the
Committee's approach. This would be consistent with a fairly high degree of policy predictability.
It is worth emphasising that the observed tendency for interest rate changes to coincide with the
publication of an Inflation Report does not imply that interest rate changes are tied in any mechanical
way to the central projection for inflation. The assessment of risks is always a material factor in
determining policy, as well as an important aspect of the presentation of the forecast. For example in
Inflation Report
our latest we published a central projection which showed inflation rising gently but
steadily above the 2% target, assuming a nearly flat profile of interest rates out to three years. But the
Report
noted that the balance of risks was to the downside and singled out some key near term risk
areas, such as the household sector. This provided a nuanced background to the MPC's February
decision to hold rates unchanged.
Forecasts and public communication
All inflation targeting central banks use their forecasts as a communication tool. They provide a
coherent statement of policymakers' thinking about the economic outlook and the policy stance.
Together with the minutes of the policy meetings (in our case published with individual votes after two
weeks), this helps to discharge the Committee's democratic duty to explain itself, as well as supporting
Inflation Report
its credibility and helping to anchor inflation expectations.13 The plays a central role in
the Committee's communication. Since August 2003 the Governor has fronted the regular Inflation
Report
press conference, and the MPC's appearances in front of the Treasury Select Committee has
been (loosely) linked to the Inflation Report cycle.
This brings me to a much debated question: how much information should a central bank provide?
Academics have tended to press the case for more transparency, while practicing central bankers
have been more cautious, (though much more predisposed to openness than they would have been
twenty years ago). Don Kohn14 argues that "more is not necessarily always better, and at each step of
the way central banks have needed to take account of the potential costs as well as the benefits of
greater transparency". In particular it is argued that the publication of some kinds of information could
make it more difficult for policymakers to do their job, with discussions of the possible path of future
interest rates being seen as particularly hazardous, if they appear "as a firmer pre commitment than
they were intended to be".15
Arguably these should not be a first order issues for central banks with a transparent inflation targeting
framework. The objectives of policy are clear, and outside commentators should have access to
enough information to work out the future direction of rates for themselves. Nevertheless there has
been a closely related debate about how transparent an inflation targeting central bank should be
about the interest rates on which its forecasts are based. An obvious reason for wanting more direct
information about the 'preferred' path is to get direct evidence on the interest rate strategy. (How
quickly will rates rise? What are the advantages of a 'wait-and-see' approach?)
The MPC has long published forecasts on two different interest rate assumptions. On one - the
constant rate assumption - interest rates are held constant over the entire forecast horizon. On the
other, interest rates evolve in line with rates expected by financial markets. Until August 2004, the
presentation emphasised the forecast based on constant rates. Since last August we have reversed
the presentation, to emphasise the market rate assumption.16
The constant interest rate path is obviously a stylised assumption, which conveys limited information
about future policy intentions. The message is that the MPC makes interest rate decisions one at a
time, and that it has not made up its mind about what future path of rates will be consistent with the
inflation target. The market interest rate path too is a conditioning assumption, not the MPC's
prediction about future rates. The difference is that, to the extent that the market rate curve embodies
the market's guess about where the MPC will take rates, forecasts predicated on the market rate are
more easily interpreted as a comment on that view.
So how much significance should be read into our change of conditioning assumption? Did the switch
to market rates represent a tentative step towards providing more guidance on the future direction of
policy?
The fact that interest rates were historically very low in 2003 and early 2004 has some bearing on the
matter. Many academics, notably Lars Svensson, have argued persuasively that the use of an
unrealistic conditioning assumption makes it more difficult for the public to interpret the MPC's reading
of the economic outlook. As Charlie Bean has pointed out,17 this is certainly true if interest rates are
some way off 'normal' levels or if for other reasons, they are expected to increase or decrease
substantially over the forecast horizon - and the longer the time horizon of the forecast, the more force
this argument has.
Our decision to shift the focus of the presentation to market rates was coupled with a decision to
publish forecasts for three years, rather than two, as was previously the case. This did not reflect a
change in policy horizon - we are required to meet our 2% target 'at all times'. But it did provide useful
context for interpreting the gradient of inflation forecasts at the two year horizon, and hence a clearer
indication of future policy, if the economy evolves in line with the central projection.
The shift to using a market rate assumption was a very modest step towards greater transparency. At
a technical level, it is a non trivial task to translate any market rate yield curve into a conventional
forecasting assumption which is a genuine reflection of market expectations of future official interest
rates.18 And markets are themselves uncertain about the path of future rates so we publish a fan chart
for market interest rate to help quantify that uncertainty, based on options prices.
There is a big difference between a conditioning assumption and a commitment, not least because
there is a big gap between anyone's current guess at where rates might need to go to meet the
inflation target, conditional on the data available at any point in time, and where the MPC will actually
take rates given the information it may have in the future. But the MPC was conscious of the risk of
misinterpretation, so the transition was made gradually - with the Governor reflecting on the market
Inflation Report
curve in his remarks at the February and May press conferences, and the MPC
referring to the market curve in the minutes during the spring. By the time the switch was introduced
Inflation
in the August Report, MPC and markets understood the nature of the conditioning
assumption, and the change itself was seen as the marginal improvement that it is.
Chart 4. Market beliefs about future interest rates
- Inflation Report February 2005
Different inflation targeting central banks have evolved their own ways of communicating. At one
extreme, the Governor of the Reserve Bank of New Zealand publishes his own forecast of future
interest rates - though he is the sole decision taker in that regime. And at the Norges Bank, staff
produce material that explicitly sets out possible strategies for interest rate decisions in the form of a
range of interest rates for the next 3-4 months, and invite the interest rate setting committee to
endorse them, and provide a commentary on market expectations of future interest rates. As Charles
Goodhart has argued, it is diffic