Threadneedle Street is mired in self-inflicted confusion

An information-heavy and over-complicated approach has damaged the Bank’s credibility just when it needs it most

The biggest surge in inflation in 40 years has revealed major flaws in the Bank of England’s monetary policy framework. An overly complex approach to forecasting and communication has resulted in policymakers reacting too late to growing price pressures and then, even after raising interest rates at every meeting since December, failing to bring inflation expectations down to a sustainable level.

According to the Bank’s own Inflation Attitudes Survey, one-year-ahead inflation expectations have surged during the past year to 4.3pc – double its 2pc target. Financial-marketbased measures of inflation expectations are similarly high. This is doubly frustrating for the Bank, which undertook a wholesale revision of its communication and policy framework in the wake of the financial crisis in 2008.

The changes implemented, including a huge increase in information published alongside policy decisions as well as forward guidance on future Bank policy actions, were designed to improve monetary policy when the economy is subject to major shocks – just as it is now.

Back in 2014, then governor Mark Carney said that increased transparency would aid monetary policy by helping to “anchor inflation expectations and to support counter cyclical movements in the policy setting”.

He further added that the newly introduced forward guidance would “reduce uncertainty about the way monetary policy will be set”.

In practical terms, this has meant a drastic increase in the sheer volume of information that the Bank supplies. Accompanying last month’s policy announcement, it published a 112-page Monetary Policy Report plus a 21-page document containing the official policy statement and the minutes from the Monetary Policy Committee’s meeting. Excluding the official statement, the minutes alone come in at over 7,000 words.

For the same meeting a decade earlier, the Bank summarised the minutes at a still-hefty 4,500 words, while setting out the economic outlook in its 56-page inflation report – the predecessor to the monetary policy report. By comparison, the US Constitution is also only about 4,500 words long.

With its May monetary policy report, the Bank also published three separate forecasts – up from the standard two. Each forecast provides useful information about the economy and policy. However, in order to come up with a reasonable prediction for the path of interest rates – which matters a lot for commercial banks when pricing loan risk, for example – one needs to judge the forecasts and their assumptions, consider which seem most plausible and then reverse engineer them in order to ascertain their policy implications. If this sounds complicated, that is because it is.

Has all of this additional information reduced policy uncertainty? Not at all.

The day before the Bank’s Nov 4 2021 meeting, the market put a 58pc probability on a rate hike – but Threadneedle Street kept rates unchanged. Then, the day before the Dec 16 2021 meeting, the market expected policymakers to hold rates with a 78pc probability. Instead, the Bank hiked by 15 basis points to 0.25pc.

In Berenberg analysis, I show that the surprise reactions in Bank-rate-sensitive markets such as Libor to policy announcements have recently been higher than during the 2008-09 period. What is more, the surprises seem to be growing.

If alterations to the Bank’s communication succeeded in reducing monetary policy uncertainty, we would expect to see smaller surprises, not larger ones.

Occasional policy surprises are no big deal. But surprises are by now so common that for several years the media and markets have dubbed the Bank an “unreliable boyfriend” owing to the regularity with which it says one thing but does another. Frankly, this is embarrassing for one of the world’s major central banks.

What is worse, many people had actually warned that the Bank had persisted with its sanguine view on inflation for too long last year.

By early last year, many analysts, including me in this column, as well as the Bank’s then-chief economist Andy Haldane had warned that the UK’S tight labour markets could produce a more persistent inflation problem unless policy reacted in order to keep inflation expectations well anchored. Had the Bank started to tighten even six months earlier, policymakers would now be much less worried about the second-round inflation effects emanating from the recent shocks. The Russian invasion and Chinese lockdowns have made inflation worse. But they are far from the original root cause.

The Bank is now playing catch-up at a time when its credibility is damaged and inflation expectations are the highest since it gained independence in 1997.

Inflation expectations are likely to remain unanchored until price pressures begin to ease due to positive global supply developments or until the Bank produces disinflation by raising interest rates well above their neutral rate – which would probably tip the UK into a recession or worsen the one that may already be under way. This is a bad outcome, to put it mildly. A well-designed policy framework should preserve the Bank’s credibility when the economy is hit by unexpected shocks. Instead, the current approach, designed during an era of low and stable inflation, has proven to be unfit for a world of high and uncertain inflation.

Inflation targeting is still the way to go, but the Bank needs to find a better way to go about it.

‘Has all of this information reduced policy uncertainty? Not at all’