Even experienced performers can get nervous when a leading light is observing. Imagine hooping in front of Michael Jordan, singing in front of Taylor Swift, or acting in front of Meryl Streep. Trying to chin the high bars that they have set and fearing their subsequent judgments would be very stressful.
Imagine, then, the apprehension that must have filled the halls at the Bank of England (BoE) this month. Ben Bernanke, a Nobel Laureate with a place on the Mount Rushmore of central bankers, had been engaged to opine on the efficacy of the BoE’s forecasting process. His critique was not kind, but the lessons he offered are worthy of reflection far beyond central London.
Forecasts are foundational to the conduct of monetary policy. Because changes in interest rates (or balance sheet strategy) work with a lag, projections of where growth and inflation will be in future quarters are essential.
It goes without saying that forecasting economic outcomes is hard. The underlying data used in this endeavor can suffer from imprecision; inflation is a particularly challenging concept to quantify. Relationships between variables are not completely stable, even in more settled times. Nonetheless, models using thousands of equations authored by armies of PhDs have been employed to anticipate the future.
When a tail event occurs, past patterns are a poor guide to future performance. Supply shocks produced by the pandemic stressed inflation far more than anticipated. An advancing myopia made it difficult to set effective monetary policy. British inflation ultimately exceeded 11%, the highest peak seen in a developed country.
This cost British consumers dearly in purchasing power. The rapid rise in interest rates that was required to quell inflation brought economic growth to a virtual standstill. Problems in forecasting created very real costs for the country.
In response, the BoE commissioned a review of its forecasting process and engaged Dr. Bernanke for the exercise. Earlier this month, his team issued their findings. Among them:
- The infrastructure supporting the forecasting process must be current, so that more advanced techniques (like AI) can be employed. Special attention needs to be paid to the quality and organization of data needed to perform analysis.
- Active engagement between model operators and subject matter experts is essential to good results, especially during times of rapid change. Economic rules of thumb like the Phillips Curve can lose their effectiveness over time, threatening the accuracy of projections. Keen observers of conditions can initiate changes to code in an effort to keep algorithms current.
- Forecast errors should be studied transparently and should guide potential changes to models. Throughout 2020 and 2021, the BoE was underpredicting inflation, but projection approaches weren’t adjusted sufficiently to correct variances.
In a statement, the Bank of England said that it “is committed to action on all…of the Review’s recommendations.” In the meantime, it behooves all of us who run models to read the report and consider whether its observations might be worth following up on. In particular, the dynamics that drove economic outcomes through 2019 have changed considerably since then; models must adapt to the new reality.
I couldn’t imagine what it would be like to have Ben Bernanke review the models we run here at Northern Trust. You talk about intimidating…I would much rather warble “Shake It Off” on stage during the Eras Tour.
Information is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Under no circumstances should you rely upon this information as a substitute for obtaining specific legal or tax advice from your own professional legal or tax advisors. Information is subject to change based on market or other conditions and is not intended to influence your investment decisions.
© 2024 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S. Products and services provided by subsidiaries of Northern Trust Corporation may vary in different markets and are offered in accordance with local regulation. For legal and regulatory information about individual market offices, visit northerntrust.com/terms-and-conditions.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our videos.A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out our most recent market outlooks.
© Northern Trust
Read more commentaries by Northern Trust