The Bank of England’s saving puzzle
Household saving jumped late last year; a reversal would be an unwelcome boost to demand at a time when inflation is still too high
Household saving and unemployment usually move up (and down) together;
Over the past half year, however, unemployment has remained near record lows while saving increased sharply—and the economy has flatlined;
If saving falls back in line with unemployment, then the economy has more momentum than previously expected—with implications for policy.
The Bank of England’s Chief Economist Huw Pill spoke at length in an MNI webinar last week, an interview well worth careful study—being a seminar conducted in a free form format that allowed for candid discussion.
Reflecting on past forecast failings, Pill gave the sense of being in the middle of a soul-searching exercise inside the Bank to understand where things had gone wrong. He mentioned they are conducting “a robustness exercise and exploring the implications of different assumptions and see where they lead us.”
In terms of their forecast errors, Pill suggested that there were three conditioning assumptions that subsequently turned out wrong.
First, last summer there was “a hiatus on the fiscal side” when there was no Prime Minister, which delayed the announcement of fiscal support for households—and since their forecasts are based on announced policies, they could not allow for the cap on energy prices at the time.
Second, market pricing of Bank Rate last autumn had been “contaminated” by the impact of the mini-budget, showing more policy tightening than they were comfortable with at the time.
Third, more recently, there has been a significant fall in gas prices—despite shifting to wholesale gas futures for forecast purposes, the outturn for energy has been more favourable still.
These three conditioning assumptions rendered their forecasts for real GDP at various vintages in the past year too pessimistic. That said, Pill noted, these assumptions explain only some of the likely forecast error.
Further has been the ability of households and firms to adapt to the energy shock, blunting impact of the terms of trade on activity.
Finally, and perhaps most interesting, Pill noted that typical inflation-targeting models are linearized for small deviations from some steady-state—which is perhaps sensible when shocks are slight. But we have been “pulled into areas” where non-linearities might come to dominate, making the outputs of such models questionable.
In summary, the Bank is now forced to confront the real world after a particularly poor set of forecasts.
An unemployment-consumption puzzle
We got a hint when Pill also signalled a change in thinking about the prospects for unemployment rate, although this was already emerging in the February Monetary Policy Report (MPR).