Do central banks ever check their forecasting record?

The best analysts work with what they know, and minimise forecasting. Assessing a company’s strengths and the price paid for shares usually beats making projections. So why, when it comes to the economy, is this discipline set aside? The Bank of England has now worked with forward guidance for more than a year, with little measurable success. Yet it continues to make forecasts without a reality check. Should investors pay any attention to the Bank’s glowing self-assessment or its interest rate predictions?

The recent Bank of England quarterly inflation report had the air of a pupil marking his own homework. The conflict inherent in reviewing one’s own predictions seems to escape the Bank. The UK economy might be back to where it was in 2008, but GDP on a per capita basis is still down 4%. Even France has done better over the period. UK unemployment has fallen sharply, but that was not what the Bank expected when it started forward guidance. Within months that looked like the wrong target, despite an expectation it would guide till 2016. Deftly moving on to new indicators, policy now focuses on spare capacity, which looks like anyone’s guess. The MPC itself admits to a “wide range of views” on the slack in the economy.

Each quarter, half the MPC’s metrics disappoint, but there is still no acceptance that this might reflect a long period of sub-trend growth. Instead, the Bank sees bubbles ahead, without recognising that house price rises need not trigger a generalised inflation. In fact house prices can exert deflationary pressures on other expenditure: most feel no better off as residential prices rebound. The UK economy now has weak wage growth with a negligible increase in productivity. Looking for bubbles everywhere has distracted the Bank from the big picture; a low quality recovery, with deflationary risks.

The MPC projects that the UK economy will expand at close to or above its historical average rate for much of the next two to three years. Confidence, indeed. Yet, since the May report, the Bank has downgraded its 2014 GDP forecasts for the Eurozone and US, reflecting geo-political tensions and trade friction. Yield curves have flattened, suggesting subdued inflation and growth expectations. Export demand continues to disappoint. Despite cutting forecasts for productivity and business investment since May, the Bank still expects a gradual revival on productivity and real income to underpin a sustained expansion and private sector spending.

Self-serving biases in assessing performance are well known to psychologists. Individuals and groups tend to protect their self-esteem by favourable interpretation of the data. The bigger the ego, the more likely undesired outcomes will not be admitted. Yet there appears a lack of independent critique of the MPC’s forecasting record. It is a reminder to be cautious on the wisdom of “experts”, and to recognise our weakness for a good story with a smattering of facts thrown in. Forecasting without independent feedback is fraught with danger.

Within 12 months, we have had two versions of forward guidance. Yet the Bank itself may be regretting this approach. The “guidance” word count peaked at 60 in February this year, but the word appears just 11 times in the most recent inflation report. And, the word “wrong” does not appear at all. Guidance seems to be used much as an expert employs narrative – to embellish and give spurious credibility to questionable forecasts.

There are lessons for investment analysts. They should question experts and forecasts. And, they should focus most effort on company accounts and updates: not on the prognostications of confident central bankers. Above all, this very public forecasting failure should remind investment managers of the danger of self-assessment. Teams work best when they offer independent critique of each other’s work.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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