That’s because it’s the job of policy to respond to things that are unpredictable, in order to offset their effects, as best we can. So even if it’s the MPC that sets interest rates, in some narrow sense, it’s ultimately the economy that determines them. And our forecasts are intended not as some reliable guide of a particular policy path, but to help people understand how we see the nature and distribution of economic risks over the future. 1  Broadbent (2014). BIS central bankers’ speeches  5  Chart 3 Policy decisions better correlated with economic growth  Chart 4 Controlling for growth, IR forecasts uninformative about policy  Source: ONS, CBI, Markit Economics, Bank calculations. Source: ONS, CBI, Markit Economics, Bank calculations. The “excess” volatility of bond yields One way to think about the unpredictability of the future is to look at financial markets. Prices of financial assets are in many ways the embodiment of forecasts: they depend critically on how people think the future will evolve. So every time the price of an asset changes, someone’s forecast has gone wrong, or at least has had to be revised 2. And as you know, asset prices change a lot! In fact, if anything, as the economist Robert Shiller observed many years ago 3, they appear to move too much.
They all kick off with the same unwelcome economic conditions, presumably caused by some prior, off-stage shock to costs: inflation is 2% points above the target, output’s 1% point below potential and official interest rates are at (what is assumed to be) their “neutral” rate, which is assumed not to change. All three simulations also have inflation back at target two years later. But each involves a very different means of getting there. In the first, the policymaker – call it Committee A – hikes Bank rate immediately and aggressively, by 2% points. This rapidly pushes the economy into recession, making the output gap even larger. But it does at least succeed in bringing inflation back to target pretty promptly, well within the two-year point. Indeed, inflation then falls somewhat below target thereafter, and interest rates fall back sharply, to a level below where they started. Perhaps “A” stands for “austere”, or (hyper) “activist”. Committee B – “balanced”, maybe? – is a little gentler in its approach. Recognising that a significant existing output gap will do some of the work in reducing inflation it raises rates only a touch. Inflation therefore takes longer to come back to target. But it just about gets there by the two-year point and, in the interim, the real side of the economy suffers less and interest rates are less volatile. Finally, just for effect, I’ve added a Comedy MPC (Committee C).