MNI POLICY: BOE Needs Scenario Rate Paths - Top Economists

Influential economists are urging the Bank of England's Monetary Policy Committee to publish rate paths for the alternative scenarios that it has now started to produce but which have been criticised as providing little useful signalling for the future direction of monetary policy.

While the alternative scenarios published by the Bank in May were part of its gradual implementation of recommendations for reforming its communications made in the Bernanke Review, these were based on the market rate path. BOE deputy governor and LSE Professor Charles Bean told MNI that scenarios without policy responses were uninformative, while Oxford professor and ex-BOE economist Michael McMahon described them as useless. 

“Scenarios that don’t allow for an appropriate policy adjustment are not going to be very informative. Indeed, the whole purpose of scenarios is to help outsiders better understand the Committee’s reaction function,” said Bean. Asked if the Bank should publish alternative rate paths to accompany its scenarios, he stated "I think you have to.”

Even BOE Governor Andrew Bailey has acknowledged the inconsistency of the Bank’s publishing scenarios without associated rate paths, telling the Treasury Select Committee in June that "you cannot use the market curve, because the market curve is conditioned on a view of the world that is too far away from the scenarios."

At a recent BOE conference on transforming monetary policy the case for publishing alternative rate paths based on a policy rule was set out forcefully. While the MPC does not set policy by rules, with its individual members having diverse views, rules for the alternative scenarios could be either of the Taylor or of the loss function variety, which would automatically produce a rate path based on the different economic circumstances described. (See MNI POLICY:  Perceptions Gap Between BOE Projections And MPC)

Taylor Rules "are useful to put endogenous policy into the model. A scenario without endogenous policy is useless,” McMahon said that. “So the Bank will have to put a form of rule in, but also then communicate exactly how it is treating it.”

LOSS FUNCTION

MIT Professor, and ex-European Central Bank Governing Council member, Athanasios Orphanides, told delegates at the conference that if the MPC can agree on a benchmark policy rule ... "that is by far the most important thing to communicate, because I can use that to then assess roughly what they are going to do with policy in any scenario." 

McMahon agreed, saying that Orphanides “made the right suggestion in my view – choose a rule that is (a) simple, (b) robust and (c) fits history well."

A policy rule "should capture the basic reaction function -- say 200-250 basis points on a big shock scenario. But then I would like the MPC to discuss the factors that would mean that such a scenario would require more or less reaction," McMahon said.

A Taylor rule balances the distance from the inflation target with the output gap, but a loss-function rule, which would allow policymakers to place weight on deviations of growth from trend, would work better for the BOE’s alternative scenarios, according to Bean.

"In principle it’s better to use the latter, as that’s what Committee members implicitly do when they take the actual Bank Rate decision -- i.e. they are selecting a combination of projected inflation and output paths that 'look good',” he said.

"They should use something that approximates the MPC’s preferred reaction function as closely as possible, this would probably require some broad agreement by the Committee. It would surely be misleading, confusing to use a reaction function that is materially different from the MPC’s own," Bean added.

The concern that in-house rate paths will be viewed by some as promises lingers among Bank officials, and Bean said this perception would need to be countered.

 "I’m sure they would need to be described as being 'illustrative'," he said.

IMPLEMENTING BERNANKE IN STAGES

Another recommendation by Bernanke is to drop the BOE’s fan charts showing the probability distribution around growth and inflation, but there is widespread opposition to this among financial sector and academic economists. 

"I don’t understand the logic of dropping the fan chart. I am supportive of also using scenarios. But additionally to be using the fans a bit more fully – there are many choices that can be made," McMahon said. (See MNI POLICY: Time Needed For BOE To Make Bernanke Changes)