Since May 24, thousands of British people have had their homeowning dreams dashed by a sudden spike in mortgage rates. The immediate culprit is higher-than-expected inflation in April, which spooked markets. Underlying that, though, is the flawed way in which the Bank of England (BoE) communicates future monetary policy. The inaccuracy of the forecasts and their negative impact on the real economy suggest that it’s time to take a different approach.
“I never predict anything, and I never will”. This unwittingly funny quote, attributed to 1990s football star Paul Gascoigne, could equally apply to the BoE’s approach to forecasting. Unlike many other central banks, the BoE doesn’t provide its own forecasts of how consumer prices will evolve in coming years. Instead, Governor Andrew Bailey and the other eight members of the Monetary Policy Committee chart inflation’s path based on the level of interest rates implied by the prices of overnight indexed swaps, a type of derivative. By using OIS rates, rather than their judgement, UK policymakers de facto outsource inflation forecasting to traders.
This creates several problems. One is that markets are not perfect, so the BoE’s predictions of where inflation will be in two years’ time – its forecast horizon – are often wildly wrong. The BoE’s projections missed the actual inflation numbers by an average of 6 percentage points between December 2021 and March this year, according to calculations of data collected by Berenberg analysts. That’s a huge error considering that Bailey’s target is to bring inflation down to 2%.
Other institutions, like the US Federal Reserve and the European Central Bank, also underestimated the post-pandemic upsurge in consumer prices. But in those cases, markets can compare a higher-than-expected inflation print with policymakers’ predictions, or those of their staff, and bet on the future direction of interest rates. In the Fed’s case, they can even look at rate-setters’ anonymous views of where rates are heading, handily summarised in a “dot-plot”.
All that traders and mortgage lenders know about Bailey and his colleagues’ thoughts, however, is that their latest Monetary Policy Report assumes inflation will be 2.3% by the end of 2024. Even that is based on the derivatives-derived interest rate path, which is again no more than the market’s guess of what the Bank will do. The BoE does offer predictions based on different models, but investors know they aren’t central to policymaking.
The upshot of this relative information vacuum is that traders tend to overreact to economic surprises. The latest mortgage bloodbath is a case in point. On May 24, Britain’s statistics agency said that consumer prices in April had risen at an annualised 8.7% – well ahead of the market’s expectations of 8.2%. Before those numbers, traders were expecting one more hike to bring the benchmark Bank Rate from 4.5% to 4.75%. Some were even forecasting cuts later this year. Shortly after the inflation data, the market’s allergic reaction was such that it immediately shifted to price in up to four more hikes. That assumed rates would jump to a 16-year peak of 5.5% in 2023, with no cuts this year.
The whiplash occurred because traders had to digest the inflation shock without any interest rate guidance from policymakers. Since the BoE was still maintaining that inflation would head towards 2% in 2024, the market naturally moved to hike its own interest rate expectations, by pushing up OIS rates. Because most banks price home loans off those derivatives, it sent mortgage rates rocketing.
This system – dubbed “incestuous” by former MPC member Charles Goodhart in a 2009 research paper – is arguably causing unnecessary pain for homebuyers. Within two weeks of the inflation data banks had withdrawn more than 500 mortgage products – or nearly 10% of available home loans – because their rates were too low, according to data provider Moneyfacts. Lenders replaced them with more expensive products. The average rate for a five-year fixed-rate mortgage for buyers who borrow 75% of the price of the property is around 5.5%, Moneyfacts estimates. It was around 3% a year ago.
The BoE’s public statements suggest it’s aware there may be a problem. Bailey recently admitted that conditions were so unusual the BoE had ditched its own model. “We have taken a conscious decision to aim off (the model’s predictions),” he told a parliamentary committee last month, according to the Financial Times. Last week the central bank also agreed to launch an independent investigation into its forecasts after pressure from parliament.
Bailey could improve matters by simply copying the ECB and the Fed. First, the BoE could stop using OIS rates in its forecasts and just provide its best view of where inflation is heading if interest rates remain at current levels. That way markets, households and firms could estimate the path of monetary policy without being conditioned by traders’ guesses.
Crucially, this change would boost the central bank’s credibility. Even if price rises deviated markedly from the BoE’s forecasts, markets would be able to figure out the likely policy response – and hence the pace of inflation’s return to the 2% target.
Secondly, the BoE’s policymakers could publish their individual predictions in a Fed-like “dot-plot”. That would create an even more powerful absorber against economic shocks, limiting overreactions, because markets would know how rates are likely to move to bring consumer prices under control.
Instead of following Gascoigne’s musings on predictions, Bailey and his colleagues could learn from another famous quote, apocryphally attributed to the Roman philosopher Seneca: “To err is human but to persist is diabolical”. — Reuters
Francesco Guerrera is global economics editor for Breakingviews, based in London.
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