• Commentary
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The Bank of England in the City of London

In November 2011, the Bank of England’s central forecast was that annual U.K. consumer price inflation would now be running at around 1.3%.

The actual number came in today at 2.7% for September.

Nor was this a one-off error. The Bank of England has consistently forecast inflation to come in at or below its 2% target for the past five years. And for five years it has been consistently wrong–inflation has averaged some 3% over that time.

Now, forecasters very rarely get it right–as the great physicist Niels Bohr said: “Prediction is very difficult, especially about the future.”

But there are two problems associated with the Bank of England’s chronic misses.

The first is that it has systematically underestimated inflation during that period. If its errors were random, its forecasts ought to miss on the upside as much as on the downside over a long run like five years of quarterly forecasts. But the BOE has consistently underforecast. It has had plenty of opportunity to correct its models to reduce this systemic error. As recently as last November, the BOE predicted a central probability inflation would hit its 2% target by the end of this year.

So why has it been so hard for the BOE to correct this forecasting error?

Clearly it has misunderstood the stickiness of inflation and underestimated the degree to which official prices, taxes and sterling’s devaluation of 2007 and 2008 would feed through to prices as well as overestimating the degree to which the output gap would put downward pressure on inflation.

But at the same time, it has suited the BOE to have underestimated inflation. By doing so, it has had a good excuse to keep policy ultra loose and thus to support overleveraged British borrowers and erode through inflation the value of their debt.

And that’s the second problem. Because under-forecasting inflation has given the BOE flexibility to ignore its inflation target, the natural conclusion is that the BOE is doing it on purpose–whether this is the case or not.

The Bank of England was not immediately available to comment.

Still, this suspicion will make it harder for the BOE to revert to normal monetary policy in a timely manner. If people think–reasonably–that the central bank has gone soft on inflation, they will doubt its promises to stick to its 2% target in more normal economic times. Normalization of economic policy could well necessitate stepping on the brake harder than the BOE would otherwise like to in order to convince people of its intentions. Otherwise, the result is likely to be a more serious inflationary overshoot.

So far the BOE thinks it has credibility. It points to surveys of inflation expectations and what bond markets are pricing in for future inflation. These, though, may be false comfort. Inflation expectations surveys are less than reliable indicators. And heavy central bank involvement in bond markets–not just the BOE’s quantitative easing program, but those of other central banks–has distorted markets to the degree that it’s not easy to determine what exactly the prices are saying.

The BOE has been complacent about inflation for a long time. As the economy recovers and as house prices hit record levels, that complacency could well turn around and bite its policymakers. And Britons more generally.