- Substantial gains in forecast performance could be possible by rapidly detecting trend breaks and updating forecasting models when they occur;
- Oxford econometricians call for an amended approach to be added to the Bank of England’s suite of models, broadening the Central Bank’s inflation forecasting toolkit.
The Bank of England underestimated annual CPI as it rose rapidly from 2021 during a challenging period that coincided with a series of major shocks; including the Covid-19 lockdowns, roll-out of vaccines, global supply chain issues, and Russian invasion of Ukraine.
The subsequent Bernanke Review, commissioned by the Bank in 2023 to investigate what had gone wrong, produced 12 recommendations, largely focused on an overhaul of the Bank’s modelling.
Recent research by senior econometricians at the University of Oxford suggests that, along with the Bernanke recommendations, improvements in forecast performance may be achievable through earlier identification of structural changes and more frequent updating of forecasting models. They propose that such an approach could complement the Bank of England’s existing modelling framework.
In an analysis published in the International Journal of Forecasting, Dr Jennifer Castle, Dr Jurgen Doornik and Sir David Hendry show that earlier detection of trend changes and timely model updates could have mitigated some of the forecasting shortfalls, leading to potentially substantial gains in forecast performance.
The authors say that their analysis should encourage the Bank to consider broader forecasting approaches within its suite of models.
Detecting rapid upsurges
Explaining their approach Jennifer L Castle said:
“Our approach was developed to detect rapid upsurges as early as possible to avoid continuing large forecast failures. Other than immediately after each unmodelled shift, our forecasts are very accurate, and so to avoid future systematic forecast failure from such unexpected shifts, the Bank could usefully add this approach to its suite of models."
Paving the way for much needed changes
Sir David Hendry said that the research filled omissions in the Bernanke Review and would help the Bank of England improve its forecasting in future.
“While many of Ben Bernanke’s 12 recommendations were sorely needed, others were not well thought out, and at least equally important recommendations were missing.
“Nevertheless, his review paves the way for much needed changes, but its omissions about how to forecast are equally revealing and also need to be addressed by the Bank to improve its forecast performance facing repeated breaks.
"A trend is your friend till it doth bend. Which it has done all too frequently over the latter years, but can now be rapidly corrected."
