Forecast uncertainty and the Bank of England’s interest rate decisions

Abstract

To assess the Bank of England’s Monetary Policy Committee decisions on the official bank rate under forecast uncertainty, I estimate simple forecast-based interest rate rules augmented by the exact forecast standard deviations recovered directly from the Inflation Report fan charts. I find that forecast inflation uncertainty strongly intensifies the reaction of the interest rate decisions to a forecast deviation of inflation from target. Conversely, forecast output growth uncertainty attenuates the reaction of the interest rate decisions to a forecast deviation of output growth from its long-run mean. Asymmetries in forecast uncertainty are highly relevant for inflation. Forecast upward risks to inflation contribute strongly to the intensifying effect of forecast inflation uncertainty, while forecast downward risks have hardly any significant impact. Moreover, I find that forecast risks to inflation have a direct effect on the interest rate decisions, in particular when inflation is forecast close to target. Uncertainty forecasts obtained from the Survey of External Forecasters, though, contain no explanatory power.