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The UK’s Changing Inflation Forecast

The Bank of England (BoE) has announced a significant overhaul of its economic forecasting process in response to criticism of its handling of inflation estimates. This move comes after a series of turbulent events, including the COVID-19 pandemic, geopolitical tensions like the war in Ukraine, and a surge in inflation rates, which have collectively challenged the accuracy of the BoE’s economic projections.

Governor Andrew Bailey described this review as a “once-in-a-generation” opportunity to modernize the BoE’s approach, acknowledging the persistent uncertainty in the global economic landscape. The central bank initiated a comprehensive examination last summer, focusing particularly on refining its inflation forecasts, which are pivotal for shaping monetary policy decisions such as setting interest rates.

Led by former Federal Reserve chair Ben S. Bernanke, the review culminated in 12 recommendations aimed at enhancing the accuracy and transparency of the BoE’s forecasts. These recommendations include revamping the presentation of inflation forecasts, reassessing the underlying assumptions, conducting closer evaluations of forecasting errors, and investing in upgraded software and economic models.

The BoE has committed to implementing all recommendations, recognizing the need for substantial investments in data, technology, and staff capabilities to support these changes effectively. However, the implementation process is expected to take time, with progress updates scheduled before the end of the year.

Forecasting plays a crucial role in the BoE’s mandate of maintaining price stability, particularly targeting an annual inflation rate of 2 percent. Monetary policy decisions rely heavily on projections of future economic conditions, making accurate forecasts essential for effective policymaking.

The review identified a combination of factors contributing to forecasting errors, including rapid and unexpected changes in the economy and inherent flaws in the forecasting process. It acknowledged the challenges posed by recent economic shocks, such as Brexit, pandemic-induced lockdowns, and energy price surges, which have strained existing models and infrastructure.

Key changes proposed by the review include addressing deficiencies in software and economic models to facilitate more robust analysis and scenario planning. It also advocates for reducing reliance on market-based forecasts and incorporating policymakers’ expectations of future interest rates more prominently into forecasts.

Clare Lombardelli, a former British Treasury official set to join the BoE as a deputy governor, will oversee the implementation of these changes. While the review stops short of recommending radical alterations to forecasting methodologies, it emphasizes the need for ongoing adaptation and enhancement to meet the evolving challenges of economic forecasting in a rapidly changing world.