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Taking money and moods into account

Taking money and moods into account
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First Published: Fri, Aug 15 2008. 12 35 AM IST

Updated: Fri, Aug 15 2008. 12 35 AM IST
It’s a wonder, really, that the Bank of England’s forecasts get any attention at all. The UK central bank failed to anticipate either high inflation or low growth. But then few experts have done any better.
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It’s particularly easy to trace the bank’s mistakes from its quarterly inflation report. Once a year, it even includes a page looking back at its record. The August report, published on Wednesday, shows a big miss.
What actually happened to growth since February 2007 was considered highly improbable then, and the actual inflation pattern was considered close to impossible.
The longer-term record looks better. In its decade of looking two years ahead, the bank has been more or less right—within its 50% probability band—71% of the time on inflation and 62% on growth.
That’s largely due to the weatherman effect: “more of the same” is usually right. The predictor’s big test comes when the pattern changes—and it’s there the bank failed.
The economists on Threadneedle Street can take comfort in their distinguished company. It’s hard to think of any central bank, government bureau or leading private sector firm which anticipated the global burst of inflation, even after commodity prices started rising five years ago.
So when it comes to the key question right now—how much will the credit crunch squeeze growth?—your guess is probably as good as any expert’s.
The easy explanation for this widespread failure is that the future is unknowable, especially when it is different from the past. But the economics profession has a particular paradigm problem with its prognostications. The models that forecasters use don’t take two important factors fully into account.
Some central banks, including the Bank of England, pay lip service to the importance of the availability of money and credit in determining prices.
Their macroeconomic models, however, basically ignore the financial system. And the model’s assumption that consumers basically ignore temporary troubles makes them prone to underestimate the severity of shocks.
Taking money and moods into account won’t make economic forecasts perfectly accurate. But they could make forecasters look a little less foolish.
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First Published: Fri, Aug 15 2008. 12 35 AM IST