The former Fed boss could potentially reshape the Bank of England with his review.

• Last summer, a review was initiated to evaluate the Bank's ability to accurately predict the significant global inflation surge resulting from Russia's full-scale invasion of Ukraine.
• Economists predict that Bernanke will prioritize the Bank's communication of uncertainty regarding its central forecasts during external shocks, as well as its conditioning path for interest rates.

The Bank of England will release a highly anticipated review by former Federal Reserve Chair Ben Bernanke on Friday, which may result in substantial alterations to its monetary policy approach.

Last summer, a review was initiated to evaluate the Bank's difficulties in predicting the significant global inflation surge resulting from Russia's invasion of Ukraine. As a consequence, the BOE was slow to increase interest rates, ultimately leading to raising its main bank rate to a 15-year high of 5.25%.

The MPC had anticipated that inflation would fall at a slower rate, but now it is falling faster. Some economists argue that the Bank is making the same mistake in reverse by not cutting rates quickly enough, even as the economy is slowing down.

In a research note published on Tuesday, it was suggested that Bernanke's recommendations would focus on two main areas. The first of these areas concerns how the Bank of England communicates uncertainty around its central forecasts.

Jari Stehn and James Moberly, Goldman economists, anticipate that Bernanke will suggest that the fan chart should be less prominent or retired, and that the Bank should use alternative scenarios more frequently.

"Scenario analysis could more clearly communicate the conditionality of the forecast, convey uncertainty, and better represent the range of views on the Committee."

The Bank's inflation forecasts are based on a probability distribution, which is presented using a "fan chart."

Some of the information in the scenarios is already reflected in the MPC's assessment of risk skew and in the communications of MPC members, Stehn stated.

Last week, Senior Economist Sanjay Raja proposed a scenario-based approach during exogenous shocks as a focal point of Bernanke's assessment.

The Bank of England and other major central banks worldwide faced a significant challenge in the aftermath of the Covid-19 pandemic: estimating the potential inflation risks arising from global supply chain disruptions, which could stem from lockdowns and demand constraints or from the ongoing conflict in Ukraine.

The MPC's failure to monitor inflationary pressures was largely attributed to fan charts, and Raja predicts that they will likely be eliminated in the future.

The Bernanke review suggests that the MPC should use scenario-based analyses when exogenous shocks increase uncertainty about the Bank's central projections.

"Allowing for differing views on the committee to be reflected more formally through the use of alternative scenarios, such as hawkish vs dovish risks, would be reflected in the current make-up of the MPC."

A change to the interest rate conditioning path

Goldman suggests that the second area of focus will likely be the path for interest rate conditioning. The Bank currently provides two forecasts for GDP, unemployment rate, and inflation - one based on the market-implied trajectory for interest rates and another assuming constant interest rates.

Unlike the European Central Bank and the Fed, the Bank of England does not provide a single forecast based on the market-implied path for interest rates, nor does it present a "dot plot" for each member to chart their policy stance, inflation, real GDP, and employment.

Stehn stated that while it is possible that Bernanke could suggest that the MPC adopt a "dot plot" or publish a Committee forecast for the policy rate, it is less likely. The downside of providing a policy rate forecast is that it could be misunderstood as a commitment to a specific rate trajectory.

"If the MPC were to shift from basing its policy on the market-implied rate path to a forecast policy path, this would be a more substantial alteration in the policy framework than utilizing scenarios."

Raja from Deutsche Bank proposed that Bernanke should recommend adhering to a single set of conditioning assumptions and issue a joint forecast for GDP, unemployment rate, and inflation.

Raja stated that this could involve adopting an internal perspective on interest rate projections, replacing the market yield curve with a preferred interest rate profile.

"The primary benefit lies in preventing significant changes in Bank of England (BoE) projections due to market misinterpretation of policy expectations or global events affecting market pricing before a forecasting round. By relying on an internal interest rate conditioning path, there is less volatility and a lower likelihood of a "tail wagging the dog" scenario."

Streamlining communication

Deutsche Bank suggests that the Bank of England could concentrate on simplifying its communication to reduce the amount of documents, statements, and projections that need to be digested at each meeting, as well as enhancing the MPC's core message from meeting to meeting.

Raja suggested that the policy statement could be improved by making minor adjustments, adopting a more concise and consistent approach similar to that of the Fed and ECB, which would facilitate market interpretation and help distinguish "new news."

The use of scenario-based analysis or an endogenous interest rate path could enhance the transparency of the Bank of England's policy outlook, but Raja believed it would not significantly impact markets or the near-term trajectory of monetary policy.

When Clare Lombardelli becomes the BOE Deputy Governor in July, she will be responsible for implementing Bernanke's recommendations.

Raja stated that the MPC remains independent, and all votes and decisions made by its members will remain independent.

"The Bernanke Review will reset the way the Bank forecasts and communicates its projections to the public."