MNI: BOE Needs More Varied Scenarios - Bean, McMahon

The Bank of England should publish scenarios portraying materially different paths for the economy, including a recessionary outlook in which the neutral rate is markedly lower than the Bank's central estimate, former BOE Deputy Governor Charles Bean and Oxford Professor and former BOE economist Michael McMahon told MNI.

While the Bank published upside and downside scenarios in its November Monetary Policy Report, both implied rate paths were very close to its central projection. At the same time, Monetary Policy Committee member Alan Taylor has spoken of the mounting risk of a recession, in which Bank Rate, currently at 3.75%, could fall by as much as 100 basis points toward his estimate of the neutral rate, or r*.

This type of view could be worked into a more informative alternative scenario, McMahon said.

"If you think there's 50 or even 100 basis points difference in r* over the three years that we tend to project forward ... in any macro model, that level of tightening policy maintained for that length of time would have material effects on the outlook. So to me, that would be that would be a natural one," he said. Such a scenario "is definitely one where you would get chunky numbers." 

Scenarios, according to McMahon, can be deployed as a communication tool when " you think people aren't able or aren't forming the right view on the quantum of risk or quantum of damage that could be done, and you therefore use it ... as a signal: 'we are thinking terminal r* could be much lower than most people think.'” (See MNI INTERVIEW: Secular Stagnation Author Says Debt Raising R*)

Speaking at a recent NIESR roundtable on monetary policy communication also attended by McMahon, Bean called the BOE’s cautious use of scenarios an example of "the narcissism of small differences." (See MNI INTERVIEW: Put Fiscal Coordination In BOE Remit  - NIESR)

RECESSION SCENARIO

"There is no reason at all why scenarios shouldn’t include different r*s, though the scenario would actually be one where [the savings ratio] is higher and/or investment is structurally lower, which then implies a lower r*,” Bean stated in response to an MNI question. “r* is not some deep, fundamental constant.”

"Presumably, in this instance, you would also want to include the assumption that the MPC mistakenly thinks r* higher, leading to a ‘policy mistake’ at least initially. In any case, there is certainly no problem having a scenario incorporating a recession – recessions do occur, so we should certainly encompass them in a scenario!" he added. 

Bean noted that it was only relatively recently that the Bank's central projection involved a shallow, but long-lasting, recession.

McMahon said that the Bank’s forecasting architecture is creaking, making producing substantially different scenarios hard. Former Fed Chair Ben Bernanke’s report into BOE scenarios highlighted “how inadequate the Bank's forecasting machinery had become ... It's not a nimble system,” McMahon noted. (See MNI INTERVIEW: BOE Needs To Update Forecasts For New Scenarios)

BEST COLLECTIVE JUDGEMENT

Another point of contention is whether the Bank, in implementing Bernanke's recommendations, is making things better or worse by moving away from a central forecast based on the best collective judgement of the Monetary Policy Committee to a staff projection that the majority of the MPC agrees is a reasonable baseline, to which Governor Andrew Bailey committed in a speech in Reykjavik

"They should go back to an agreed (or rather majority-owned) central forecast (‘best collective judgement’). Having a staff-generated ‘reasonable baseline’ that a majority of MPC members can dissociate themselves from makes it pretty worthless as a communication device,” Bean said. “Outsiders are ultimately interested in what MPC members think, not what the staff think. And it can make it difficult for outsiders to evaluate the news in data releases if they don’t know what the Committee were expecting.”

McMahon’s view, however, differed "a bit" from Bean, because a forecast is “always some kind of compromise” between the views of the staff and the MPC members. “Does it matter that that compromise is coordinated by the staff more directly than [in] the process of the best collective judgement.”