Claire Jones Monetary policy’s Catch 22

Because monetary policy acts with a lag, it has to rely on forecasts.

However, as the Bank of England’s attempts at prediction have illustrated, central banks’ forecasts, and indeed those of most economists, tend to be pretty dire.

This is what Svante Öberg, first deputy governor of Sweden’s Riksbank, refers to in a speech out today as the “Catch-22 of monetary policy.” So what’s a central banker to do? 

According to Mr Öberg, central banks’ forecasting ability for growth and inflation is “very limited” a year ahead and “virtually non existent” after that.

As a means to counter this, Mr Öberg recommends placing greater weight on what’s going to happen to growth and inflation, and therefore policy, in the coming six months. Central banks should make clear that what they think will happen after that is subject to a great deal of uncertainty.

That sounds reasonable enough. And many central banks, including the Riksbank and the Bank, already take this into account through uncertainty bands on their forecasts for inflation and growth. The Riksbank, which also publishes a forecast of what it expects to happen to interest rates, also states that this is “a forecast, not a promise” whenever it does so.

What Mr Öberg appears to be calling for, then, is a little more of the same.

But, because of the lag with which monetary policy operates, most central bankers must set policy based on where they think growth and inflation will be two or three years from now, not six months on. And the more uncertain they admit to being, the less sure-footed their policymaking will seem, and – one would assume – the less confidence the public will have in it.

More honesty in their own forecasting ability may be the better option in the longer term; if a central bank continues to act as though it knows what’s going to happen years from now, when neither it nor any-one else really does, then eventually it will lose all credibility.

But, in the short-term, there is a clear trade-off between honesty and influencing expectations of your ability to control inflation. And while some uncertainty is fine, admitting that your ability to make forecasts “is almost non-existent”, would surely raise doubt as to why central bankers should be trusted to set monetary policy in the first place.