Tomasz Wieladek is chief European economist at T. Rowe Price and former adviser to the Bank of England’s Monetary Policy Committee
Former Federal Reserve chair Ben Bernanke’s testimony to the UK Treasury select committee on May 15 revealed the Bank of England’s interest in publishing an interest rate path. The Bank of England would publish an interest rate path conditional on the assumptions made at the time of the forecast.
The rationale is simple: by publishing a rate path, the BoE can send a strong signal of its policy intentions based on the forecast. Financial markets would reprice interest rates across the yield curve and reinforce monetary policy transmission. Firms and households can make financial plans based on the published rate path. Indeed, the Norwegian and Swedish central banks already follow such an approach.
This approach can work well when shocks to the economy are small. Although the BoE’s Monetary Policy Committee would stress the conditionality of the rate projection, it would likely be interpreted as an unconditional promise. This misinterpretation isn’t a big deal when shocks are small and hence eventual policy deviations from the published rate projection only minor. But it can lead to significant credibility losses when interest rates follow a very different path to what was published.
Credibility is important for central banks. Public expectations that the central bank will return inflation to target can help to achieve this goal faster. This channel is more powerful when central bank forecasts have credibility with the public. Public satisfaction with the BoE’s monetary policy is already close to historical lows. The loss of credibility from large deviations from the published rate projection would therefore make the MPC’s job significantly more difficult.
There are also important financial market consequences. The BoE may be forced by circumstance to repeatedly significantly deviate from the published rate path. After all, the BoE doesn’t know the size or persistence of future shocks at the time of the forecast. But such an outcome would lead financial markets to put less weight on the published rate forecasts, which would partially defeat the purpose of the exercise to begin with.
In recent years, the UK economy has experienced very large shocks in succession, leading to significant volatility in inflation and real gross domestic product growth. Had a rate path been published during this time, very large deviations and credibility losses would have been inevitable. The economy may eventually return to an environment of low economic volatility when interest rate projections could be a successful policy tool. But it’s hard to know when that will be.
When combined with scenario analysis, policy rate projections will lead to greater volatility in rates markets. The bank rate projection in each scenario will become an anchor point for expectations. Data outturns that are inconsistent with one scenario could lead financial markets to price another one instead.
This could be intended. However, data often provides a muddy picture of economic reality. It is hard to disentangle which shocks hit the economy in real time. This means that market participants could easily and frequently switch between multiple scenarios, based on only a couple of data points. This rise in uncertainty about the path of the policy rate would eventually lead to pricing of greater term premia and hence higher gilt yields. This is undesirable, especially in the current fiscal environment.
Scenario analysis that provides an almost mechanical link between certain variables and the bank rate projection would exacerbate these effects. For example, scenarios could be used to illustrate the bank rate response of a sudden rise in the oil price. Financial markets will certainly take note and the priced path of interest rates will vary with the oil price. This would import the greater volatility of oil prices into the gilt market.
In the current macroeconomic environment, the risks that rate projections raise gilt term premia is therefore significant. From a cost-benefit analysis point of view, this is not the time to introduce bank rate projections.
That said, the MPC can use scenarios without rate projections to improve communication, as recommended by the Bernanke review. They should be mainly used to highlight potential future risks. This will help the MPC to convince the public and financial markets that it is prepared to bring inflation back to target in a wide variety of scenarios. That would be a significant improvement to the BoE’s current communication approach.
