Copy of 2022-11-03T123130Z_1144562949_RC2BEX9SLMFZ_RTRMADP_3_BRITAIN-BOE-1667632499394
The BOE was obliged to produce a grim forecast because its convention is to use market rate projections rather than its own. Image Credit: REUTERS

London: Some of Britain’s top economists warned that the Bank of England risks making a bad situation worse by publishing forecasts for a recession based on a path for interest rates that it has no intention of following.

On Thursday, the BOE said the UK faced the longest recession on record - a 2.9 per cent contraction that would be as deep as what the UK suffered in the 1990s. That assumed the BOE’s key rate reaches 5.25 per cent and remained above 4 per cent into 2025. At the same time, it disowned those projections and suggested a shorter, shallower downturn was more likely.

The BOE rarely warns of recession, and raising the prospect of one can “produce a negative amplification of the shock,” said Jagjit Chadha, director of the National Institute of Economic and Social Research. “Households may rein back expenditure and businesses could slow investment.”

That risk of causing a self-fulfilling slowdown should give the BOE reason to pause, particularly when it disagrees with the assumptions used to build the forecast.

On Friday, BOE Chief Economist Huw Pill said rates need to rise above the current 3 per cent rate to bring inflation under control - but not to 5.25 per cent, which was the implied market rate when the forecasts were being prepared. He said such a hike was unlikely “precisely because it would produce a slowdown in the economy that is bigger than we need.”

Chadha said, “they are publishing a forecast that they don’t believe and no one believes.”

The BOE lifted rates by three quarters of a percentage point to 3 per cent on Thursday and said the economy would shrink 1.7 per cent even if policy remains steady. Its dovish stance was seen as confirmation of a “pivot” to focusing on recession fears rather than inflation. It’s a signal that rates policy is at or near an inflection point, where instead of tightening rapidly policy makers are looking for the time when they can shift to making no change.

The forecasts produced mixed reactions from economists.

HSBC on Friday cut its projections and now expects rates to peak at 3.75 per cent in February, down from 4.5 per cent. Allan Monks, a JPMorgan Chase & Co. economist, said he was unconvinced by the pivot.

“The BOE has also spent most of the past year underestimating how much tightening it would need to deliver to control inflation,” Monks said.

‘Totally flakey’

Andrew Sentance, a former BOE rate setter, said the BOE’s messaging on Thursday had been confused.

“To say this is going to be the longest recession since World War I is a totally unsubstantiated view -” it is not based on data but a market forecast for rates that is totally flakey,” Sentance said. “The risk is that it makes people more nervous and unsure than they need to be.”

The BOE was obliged to produce a grim forecast because its convention is to use market rate projections rather than its own. That practice contrasts with what other central banks do. The US Federal Reserve and Sweden’s Riksbank are central banks that use their own rate path to avoid confusion when producing economic forecasts.

The convention means the BOE had to “play a game with the markets rather than tell people what they really think will happen,” Chadha said. “If your instrument is the policy rate, why not be clear about where that should go? It’s logical really.”

This week’s problem was particularly acute because market rates are elevated due to the turmoil caused by former Prime Minister Liz Truss’s promise of unfunded tax cuts. Those cuts were reversed when she stepped aside, handing power to Rishi Sunak.

An alternative convention would be to follow the Fed’s example and produce “dot plots,” under which each of the nine members of the Monetary Policy Committee reveal how they think the rate path will evolve. Gertjan Vlieghe, a former MPC member, argued for such an arrangement at the BOE.

Last month, Ben Broadbent, the deputy governor for monetary policy, published something like a dot plot in a speech in which he pushed back against the market path.

His alternative was based on “optimal policy projections” that the BOE uses internally to model the best stance to return inflation to target with the minimal damage to growth. The OPP is used internally as a counterpoint to “inform communications.”

The BOE declined to comment. Sentance said he would continue to use the market path for the forecasts as he approved of the principle of keeping assumptions objective. But it requires clear communication, he said.