The Bank of England has finally accepted that it needs to react to the growing criticism of its failure to either predict or control the persistently high rate of inflation.
In response to demands from the Treasury Committee of the House of Commons, the Bank has decided to commission a broad external review of its “forecasting and related processes during times of significant uncertainty”.
The approach which dominates macroeconomic modelling is known as New Keynesian. It has scarcely been possible to be appointed to the MPC over the past few years without subscribing to its precepts. But the current inflationary crisis is by no means the first time that this conventional wisdom in macroeconomics has come unstuck.
In August 2008, for example, Olivier Blanchard, then chief economist of the IMF, published a paper for the Massachusetts Institute of Technology (MIT) entitled “The state of macro”. He concluded “a largely shared vision both of fluctuations and of methodology has emerged…the state of macro is good.” Three weeks later, Lehman Brothers collapsed.
The New Keynesian approach has a wide range of variants, all of which share a high level of mathematical sophistication. They also share two fundamental economic features. First, in essence, the quantity of money in circulation does not really matter as far as inflation is concerned.
Last June, for example, Huw Pil, the Bank’s chief economist, felt able to dismiss the concerns of monetarists. He wrote in his paper: “Some monetarists expressed concern that the expansion of central bank balance sheets via QE during the financial crisis would trigger inflation. This fear proved mis-founded”.
To be fair to Pil, overall his paper is very thoughtful. But on the question of inflation, in June 2022 the Bank’s chief economist argued that there was no need to worry that the rapid expansion which had taken place in the money supply would cause inflation.
The second common feature of New Keynesian models is rather intriguing. They offer what is basically a Peter Pan theory of inflation. If we all believe in fairies, Tinkerbell will live. And if we all believe in the Bank’s New Keynesian model, inflation will never get out of control.
According to these types of models, inflation in the current period depends upon the current level of output and the expectation of inflation in the future. So if people expect inflation to rise, it will actually go up in the current period. But it is controlled by a neat trick.
The expectation of future inflation is influenced by the decisions of the central bank on interest rates. The bank will raise interest rates if either output is above its trend or inflation is above the bank’s target inflation rate.
If inflation is expected to be above target, the Bank will be expected to raise its interest rate in the next period. This will reduce output, which in turn will reduce inflation. And if inflation in future is expected to be lower, inflation in the current period will also be lower.
This line of reasoning is why the Bank of England in recent years has placed so much emphasis on “anchoring” expectations of inflation. It may seem esoteric, but it has been of great practical significance.
But the whole approach has a fundamental flaw. For it to work, we all have to believe that the Bank’s model is the correct description of the economy. It may well be that many people believe in Tinkerbell. But it has become apparent that very few believe in the Governor of the Bank of England.