An hour or so ago, Mervyn King recognised that the Bank of England’s communication of its forecasts could be improved. This is a big step forward for transparency and the Bank of England governor deserves to be heartily congratulated.
He had been digging himself deeper into a hole defending the existing fan charts, but in a lecture to the Royal Society today, he stopped digging. This shows courage and intellectual honesty that is rare among the heads of powerful institutions such as central banks.
As readers of this blog will know, I have been extremely critical of the Bank’s fan charts, particularly the published forecast in February which failed to convey the message the MPC wanted, and critical of the governor for refusing to acknowledge their weaknesses. I suggested alternative presentations, to meet both my needs as someone in the business of wholesale information dissemination and to meet the Bank’s needs of conveying uncertainty in its forecasting. The Bank is thinking along the same lines as I suggested.
Let’s look at what is being proposed. Go to page 18 of the speech. The first 17 pages are extremely interesting, but not new. Remember, the test of the new presentation is that it must display uncertainty and be able to show little difference in the overall forecast between February and the previous November. As Charlie Bean, deputy governor, put it:
“The big picture here is that, if you like, the average picture across growth - across the whole of the distribution – is about the same now as it was in November and that’s equally true for the inflation projection.”
The fist suggestion Mr King said was putting the existing distributions side-by-side as in the following chart:
I don’t think this chart works very well in showing that the mode is lower but the offsetting balance of risks is skewed to the upside. I would guarantee the reaction to this chart would be that the Bank is considerably more confident of lower inflation in future. The problem is that the chart is centered on the mode of the distribution and it remains impossible to know, for example, what probability the Bank attaches to inflation being above target.
Mr King seemed to recognise the problem with this presentation in the difficulty he had in explain its significance:
“This chart shows that the most likely outcome in the dark red band has shifted down compared with the earlier forecast. But that change in the most likely outcome is not reflected to the same degree in the rest of the fan chart – and that is because there has been an offsetting upwards shift in the balance of risks. This is most clearly seen by noting how the dark line is flatter than the light one on the right hand side of the chart, and steeper than it is on the left”.
The next suggestion uses the probabilities the bank calculates in its forecast compared with the inflation target. The governor creates the following chart, which is wonderful in its simplicity and content.
From the chart it is possible to show that the Bank is almost certain inflation will be above target in 2010, but that the chance of exceeding the target falls rapidly and only rises back to 50:50 at the start of 2012. The change between November and February is not great. I like this chart. It can be explained simply and I do not see the difficulty Mr King raises: “It still has the problem that it assigns a precise probability to a given outcome”.
But I can do better. To solve Mr King’s problem, additional lines or shading could show the probability of inflation being within the 1 per cent to 3 per cent range, as I have mocked up below.
All-in-all, this was a really thoughtful speech by the governor and a joy to read him addressing one weakness within the Bank, rather that dismissing criticism. Well done. The challenge now is to put the good intention in practice – perhaps even using ideas that the Bank has not thought of so far.
