MNI INTERVIEW: Bernanke Forces BOE Rate Path Verdict - McMahon

The Bank of England is being forced by the Bernanke Review to resolve long-running internal debates over issues such as publishing rate paths and policy rules, and while this may result in messy communications this year it should be a price worth paying, Oxford Professor and former BOE economist Michael McMahon told MNI.

“It might take six months, it might take a year until they find their way to a new place, because I think without the Bernanke Review, they would still be in the old world,” McMahon said. “I'm optimistic, because I think they're going to get to a better place.” 

The review by former Fed chief Ben Bernanke on the BOE’s forecasting and communication has "forced the Bank as an entire entity ... to think about it hard, try things internally, and then they're going to have to come out and make some decisions,” he said in an interview.

McMahon, an authority on policy communication, sees a compelling case for the Bank to replace the market rate path it currently uses for its alternative economic scenarios and for its central projection with rules-based paths. While the issue is divisive at the Bank, he said that even a bumpy transition would be worth it.

"Once they do, will we worry that May, August, November of 2025 was a period of transition?" he said, noting how in the May Monetary Policy Report the Bank published two alternative economic scenarios without alternative rate paths. (See MNI POLICY:  BOE Needs Scenario Rate Paths - Top Economists)

"If any central bank or any economic institution starts to do scenarios without having an endogenous policy response, I think they're just not really worth the time," McMahon said.

NECESSARY FOR SCENARIOS

"If you're going to have a model that also has monetary policy in it, where if the economy changes, the policy changes, the policy rule is ideally something simple that's fairly robust and fits past policy fairly well."

While rules will give results quite close to market rate paths and to the likely response of policymakers 80% or 85% of the time, the other 15 or 20% need explaining, according to McMahon.

"A reason why the simple rule is a necessity for scenarios, is because these are precisely the elements that are likely not being priced by the market," he said, adding that the rules-based approach could also be used for the central projection.

"There's … at least a strong theoretical case, that you have a simple rule for both ... So you don't use the market curve for the forecast, because then you are achieving internal consistency, while the curve and rule may overlap, we don't know and it's difficult to extract exactly the economic conditions that give rise to the pricing in the market curve," he said.

If the rule suggests that rates needs adjusting by, say, 150 or 200 basis points in response to a shock, in practice policymakers may lean towards one end of the range, he noted, "but the simple rule gets you the bulk of it, and it gives you the direction, and then it gives you a chance with your narrative to explain why you deviate from that.”

McMahon said concerns expressed by some central bankers that a rate path risks being seen as a promise can be addressed, pointing to examples such as the Riksbank, Norges Bank and the RBNZ.

"They've managed to establish enough history of doing this, and I think they're quite happy with their process and their approach to it," he said.

RULES BASED 

McMahon stressed that policy itself is not set by the rules, which tie interest rates to one or two fundamental macro time series, because data are noisy, and even identical inflation and output gaps could require different reactions in different circumstances depending on whether they are transitory or enduring.

"Once you convince people there isn't an actual rule that you use, then having a rule out there that describes the type of thing you do on average, or that you have done on average in history, isn't that dangerous," said McMahon, who also backs talking openly about the neutral rate, R-star, a view championed  by Monetary Policy Committee newcomer Alan Taylor.