Central Banks are re-examining their approach to economic forecasting after major failures to detect the latest burst of inflation.
The European Central Bank, the Federal Reserve, the Bank of England and other central banks did not understand how the end of the Covid-19 lockdown and an energy shock caused by Russia’s war in Ukraine could pave the way for the worst inflationary spiral in a generation.
After responding with aggressive rate hikes, central banks have engaged in intensive “post-mortem examinations” as they unravel the reasons for their failure.
“To learn from our mistakes”
Christine Lagarde, president of the ECB, said the central bank must learn from its mistakes. “What we should have learned is that we cannot rely only on academic textbook cases and models. We have to think with a broader horizon,” he said.
One result, officials say, is an increased focus on alternative “scenarios” for future economic developments to show how policy might react.
Huw Pill, the BoE’s chief economist, said this could be a better way of communicating to markets than through the BoE’s traditional “chart” forecast, which conveys uncertainty with a range of probabilities.
For its part, the ECB is now modeling different inflation scenarios and producing a range of sensitivity analyses, such as looking at what would happen if wages rose faster or slower than expected or if there was another shock to energy supplies.
Poor results
The problem is that so far their early efforts have had mixed results. Even the most “severe scenario” it published in March 2022, modeling the impact of major cuts in Russian gas supplies to Europe, underestimated how high eurozone inflation would rise.
It predicted that inflation would average 7.1% in 2022 and 2.7% in 2023. Last year, prices in the bloc rose by 8.4% and this year they are expected to rise by 5.4%. The BoE board assigned a review to Ben Bernanke, former Fed chairman, to look into the BoE’s forecasts and communications.
Officials believe greater use of scenario analysis will be among the options considered in the review, which is expected to be tabled in 2024.
Charles Goodhart, a former BoE policymaker, said that while central banks focus more on scenario analysis than a central forecast would be desirable, they should produce an even number of scenarios. If they were to produce an odd number, markets would immediately focus on the “central” outlook, even if it was not to be seen as having the approval of the central bank, he argued.
Lessons on forecasting go far beyond this topic. In Frankfurt, ECB staff pay more attention to how quickly changes in wholesale prices are passed on to household gas and electricity bills, which varies from country to country. They focus more on refining margins when forecasting energy prices and no longer assume that gas and oil prices will move in tandem, after they diverged massively last year.
An analysis published earlier this year by the ECB found that incorrect assumptions about energy prices accounted for three-quarters of total forecast errors for inflation in 2021, when its forecast for the first quarter of 2022 turned out to be too low by 2 percentage points .
In another change, the ECB is closely monitoring hundreds of fiscal policy changes – such as the many government subsidies for energy and food – to better control their growing influence on inflation. In addition, her staff uses a salary tracker they’ve developed and the results of consumer and business surveys to adjust the performance of their models.
The shock of the pandemic
Since missing the extent of the inflation problem in the immediate aftermath of the Covid-19 shock, US central bankers have been open not only about the huge uncertainty underlying the outlook, but also about the constraints they face in making monetary policy in a such a scene.
Fed Chairman Jay Powell emphasized the need to think beyond standard models. One link that so far seems to be breaking down is the link between inflation control and the labor market.
Many economists feared that bringing inflation down to the target would require much higher unemployment. In contrast, consumer price growth slowed significantly without a very significant rise in the unemployment rate from multi-decade lows.
This has raised expectations that a painful recession can indeed be avoided – an outcome quite different from previous inflation battles.
It is at these times that analysts must think outside the models.
