20/11/2013 05:32 GMT | Updated 23/01/2014 18:58 GMT

Bank of England Struggles as Forecasts Move More Than Credibility Demands

Regular readers of this blog will know that I've always had a theoretical problem with forward guidance. Telling people that rates are going to stay lower for longer can have two undesirable consequences, ironically of a diametrically opposed nature. On the one hand, some people will think that if the Bank of England has such a downbeat assessment of the economy and its prospects, then they had better put off that purchase or that investment which they were planning. At the other end of the spectrum, some people will borrow far more than they should, because they believe the rate guidance, and we all know what will happen if the guidance is 'wrong' and interest rates go up much sooner and faster.

But, I hear you say, surely the Bank of England has the finest brains at its disposal and its forecasts will therefore be rather accurate. Mmmm, well no, not usually. In fact hardly ever, if their performance with regard to inflation forecasting is anything to go by. Mark Carney's predecessor, Sir Mervyn King, was forced to write no fewer than 14 explanatory letters to Chancellors, starting with Gordon Brown in 2007, explaining why inflation had risen above 3%, when the Bank's target was 2%. Now that refers to actual inflation outcomes, rather than forecasts, but forecasts presumably play a significant role in helping the Bank achieve its objectives, as monetary policy must usually, by definition, be set with a medium-term perspective.

The Old Lady's latest Inflation Report contained really very large changes to its expectations for both unemployment and inflation. Let's compare this report to the previous one, released in August. At that time the median prediction was that unemployment would still be 7.3% in Q3 2015, but in the November Report, "The Committee's latest projections, assuming that Bank Rate rises in line with the market curve, imply around a two-in-five chance that the unemployment rate will have reached the 7% policy threshold (for rate rises) by the end of 2014. The corresponding figures for the end of 2015 and 2016 are around three in five and two in three respectively ." This represented a shift forward in time of nine months for the time at which we might reach the 7% threshold!

There is also a key phrase in that quote on which one should focus: "assuming that Bank Rate rises in line with the market curve". So, even this new optimism is based on an expectation that rates will rise above 0.5% before then, as predicted by the market's interest rate curve, but in a recent speech (in Nottingham) Carney told us that the only thing that affected the economy was the overnight rate and that it certainly wasn't going to rise until unemployment was down to 7%, so surely even this revised forecast of when we might reach the threshold is still actually pessimistic?

In the real world Carney may feel that forward guidance, and its initial implied assurance that rates were going to stay low for a long time, has managed to retain some of its credibility because the Bank also had to dramatically lower its forecasts for the near-term path for inflation which it now projects will be 0.7% lower in Q4 2013 than it did just in August! It also lowered from 42% to 33% its view of the probability that CPI will be above the 2.5% 'knockout' in 18-24 months time.

All-in-all, I retain my suspicion that forward guidance is a flawed policy, feel that the Bank is still underestimating the strength of the recovery and finally, have even greater fears for its credibility in the light of these rapid and sizeable changes to its forecasts.