A FEW years ago, when the “Ken and Eddie show” ran the British economy, Diane Abbott, a left-wing Labour MP, accused Eddie George, the governor of the Bank of England, of being “an inflation-nutter”. It did him no harm. In 1997, Gordon Brown replaced Kenneth Clarke—the other half of the show—as chancellor and promptly made the Bank independent to set interest rates in order to meet an annual inflation target of 2.5%. Now new research presented to this week's conference of the Royal Economic Society suggests that Ms Abbott may have been right all along.
Since Britain was turfed out of the European exchange-rate mechanism in 1992, the Bank has been charged with producing a quarterly inflation report which forecasts the outlook for inflation, contingent on the prevailing interest rate. In 1996, the Bank introduced the innovation of presenting the forecast as a probability distribution, in order to highlight the risks to the central forecast. These forecasts, which are agreed by the Monetary Policy Committee (MPC), are called “fan” charts because the expected outcomes spread out in bands from the most likely path of inflation to cover 90% of the probability distribution.
It is these fan charts, quickly nicknamed rivers of blood, that Kenneth Wallis, an economist at Warwick University, has put under the microscope. Examining the Bank's record since 1997, he finds that beyond the initial three months of a forecast, they “fan out too quickly; positive inflation shocks have occurred much less frequently than the MPC expected, and on average inflation one year ahead has been overestimated”.
The implication is that interest rates could have been lower and the economy could have grown faster. In effect, though Mr Wallis does not say this, the Bank has been acting like an “inflation-nutter” even though it had an express remit to hit the chancellor's target for inflation. The fact that inflation has generally been below 2.5% in the past three years suggests there might be something in the charge.
However, the Bank's average error in over-forecasting of inflation—just 0.2%, a year ahead—is trivial. Furthermore it has a ready defence: the high pound which rose further in the late 1990s and stayed higher than it or anyone else might have expected. If the pound stays stronger than expected, then a forecast is likely to turn out to have been too gloomy about inflation, since import prices will not be pushed up by a depreciating currency.
The more serious issue raised by the analysis is that the charts fan out too much. “They've been telling us there's a lot of uncertainty and the evidence is there's much less,” says Mr Wallis. Something has clearly changed. When the Bank was made independent, it seemed highly likely that the governor would have to write a letter to the chancellor, as he is obliged to if inflation misses the target by more than one percentage point either way. But inflation has remained astonishingly stable, so no such letter has been written.
The question is whether this stability is likely to persist. Mr Wallis thinks there has been a “regime shift” and that the outlook for inflation is less uncertain than in the past. The Bank is likely to take a more cautious stance.