Rachel Lomax: The state of the economy Speech by Ms Rachel Lomax, Deputy Governor of the Bank of England, to the Institute of Economic Affairs 25th Anniversary Conference, London, 26 February 2008. I am grateful to Gareth Ramsay for his help in preparing this speech, and to other colleagues at the Bank of England for helpful comments. *  *  *  When you met for this event a year ago, the UK economy had just posted its fastest rate of growth in nearly two years, buoyed by a strong world economy and ample global liquidity. Shoppers had been out in force over Christmas and the New Year, and the housing market was booming. The main concern was consumer price inflation, which had just picked up to 3%. Most forecasters were looking forward to another year of healthy demand growth, with the MPC’s central projection at the top end of the range. The consensus view was that the surge in inflation would be short-lived. And that, broadly, is what happened. CPI inflation fell back to around the 2% target by the second half of the year. Output growth for the year as a whole was in line with the MPC’s forecast. Short term interest rates now stand where they were a year ago – at 5.25% – after briefly touching 5.75% last summer. And yet the outlook for 2008 and beyond has changed dramatically. A year ago the prospect was for a modest decrease in growth, consistent with inflation staying around target.
However, over a long period of time these errors offset one another and on average good forecasts should therefore not over-estimate or under-estimate the actual events. For shorter periods it may be interesting to study individual forecasting errors in greater detail to try to analyse their causes. But even if such an analysis is valuable it cannot be used to draw general conclusions about the forecasting performance. While accuracy is very important, even more is required for a forecast to be good in a monetary policy context. A good forecast for inflation, for instance, should correspond with the forecasts for other variables. And the driving forces behind the forecasts should be explained in a comprehensible manner. Why does the forecast look the way it does? What are the mechanisms acting as a motor for this development? These qualities are also required for a forecast to function as part of the decision-making base for practical monetary policy. BIS Review 22/2008  3  Consideration to the real economy Another factor to take into account in an assessment of monetary policy is that there may sometimes be reason to deliberately deviate from the inflation target. Normally we focus our policy on attaining the inflation target within two years. This is partly due to it taking time before monetary policy has its full effect. But it also has to do with the Riksbank thereby being able to contribute to a more stable development in production and employment. However, it does assume that the inflation target is not threatened.