MPC's new dove ruffles a few feathers over sterling

A forecast based on the random walk model would be pretty good until it turned out to be catastrophically wrong

SUSHIL WADWHANI, the newest member of the Monetary Policy Committee, caused a stir last week with a speech arguing that the pound could stay high for longer than many people were anticipating, and inflation would, therefore, be lower than forecast. And among these other people he included his fellow MPC members.

His was an argument of two halves. The first was an attack on the conventional assumption used in preparing the Bank's inflation forecast, which has sterling declining gently during the next two years. The second was his preferred exchange-rate forecast.

The Bank's current convention uses the catchily titled concept of "uncovered interest parity" (UIP), which is based on the instinct that if there were a consistent opportunity for profit, traders would arbitrage it away. Suppose you can earn 6 per cent putting your money in the UK for a year and 4 per cent on a similar investment in Germany. If the exchange rate is expected to remain unchanged, the choice is a no-brainer. Investors would borrow in euros to deposit in sterling. Enough of them would do it, in theory, to send UK market interest rates lower and euro rates higher until they were equal.

So an observed 2 per cent interest differential ought to imply an expected 2 per cent depreciation in sterling over the year. And this is how the Bank calculates the exchange rate forecast it uses in making its predictions for inflation. In August's Inflation Report, prepared when the sterling index stood at 103.1, this method implied a gentle decline in the index to 96.6 by mid-2001.

As the chart suggests, the exchange rate actually rarely behaves in this way. Not surprisingly, detailed econometric research confirms the eyeball impression. The UIP theory provides only a poor forecast of actual exchange rate movements. Dr Wadhwani went on to show that a simple alternative - the random walk assumption that the exchange rate today is equal to the exchange rate yesterday plus a random shock - performs better in terms of forecasting actual moves in the pound.

Again, simply looking at the chart suggests intuitively that this should quite often be true. For the level of sterling does move in fairly stable if narrow ranges for long periods, and not only during the ERM episode. It has done precisely this since early 1997, bobbing around between 100 and 110 on its index.

Does that mean it would be right to agree with the MPC's newest and biggest dove that the Bank's inflation forecast should be based instead on the conventional assumption that the exchange rate will stay constant? For if so, that has a dramatic implication for interest rates. It would bring the inflation forecast down by 0.4 percentage points, which would allow a far lower level of rates.

Well, not necessarily. For a forecast based on the random walk model would be pretty good until it turned out to be catastrophically wrong. A session on economic forecasting at last week's conference of the British Association for the Advancement of Science (yes, economics is a science and has been officially since 1897) shed some light on predicting exchange rates.

David Hendry of Nuffield College, Oxford, noted that simple forecasting rules can be very successful but nevertheless not very interesting. Take two friends who play a game of predicting every 30 seconds whether somebody standing at a bus stop will stay or not. One decides to predict this person will stay, until he leaves, and then she will switch her forecast to predicting that he will not be at the bus stop. She will be right every time except the single one when she has predicted he will stay but he goes. It will look like a pretty good forecasting record.

The other friend figures people wait at bus stops for the bus, so she predicts the person will stay until the bus comes and then leave on the bus. But the bus arrives, the person stays and a minute later is picked up by a car. This forecast was right for a bit and then went badly ashtray. Like the UIP, not such a good record.

However, it would not do for the Bank of England to be right about forecasting the exchange rate in the simple way, and predicting a constant exchange rate is exactly this kind of forecast. It would be right until the pound fell, and a different constant forecast might well be right after the pound fell. But all of the significance for the economy would be packed into the bit in between, the single episode of incorrect forecasting.

As Ray Barrell of the National Institute for Economic and Social Research pointed out in another paper at the conference, the behaviour of the pound is characterised by sudden, sharp shifts from one band to another. Sterling will stay strong, and a constant forecast will be perfectly reasonable, until it falls sharply. Interest rate decisions somehow need to take account of the likelihood of a sharp depreciation as these are exactly the episodes that have in the past lit the blue touch paper on inflation.

Dr Wadhwani's paper goes on in its second half to set out a theory that explains why the pound has been strong, and could therefore be used to predict when and why it might fall. He argues that the fundamental level for sterling depends on trade deficits, unemployment rates and equity returns; and empirically the current account turns out not to matter much. The rise in sterling can be explained by the increase in German unemployment relative to UK unemployment. The most likely event to send the pound falling sharply would be a drop in US and therefore UK share prices.

A good forecast for the exchange rate now would put perhaps a 60 per cent chance on its staying around its current level and a 40 per cent chance it will fall 20 per cent. Quibble about the probabilities, but the two most likely outcomes are far apart from each other. The Bank's middling UIP forecast, in between the two, is the least likely thing to happen. It might be unsatisfactory, but without a consensus on which of the alternatives to plump for, it must still be the least controversial.

As Lord Burns, the former permanent secretary to the Treasury, remarked at the British Association: "The exchange rate has been one of the biggest complications for policy makers in the last 25 years." That certainly hasn't changed. And ironically, the currency markets sent sterling higher in reaction to Dr Wadhwani's speech even though, if he were to win the argument on the MPC, interest rates would be lower. After all, if one of the Bank's eggheads is saying the pound will stay strong, it must be true - mustn't it?

Suggested Topics
Start your day with The Independent, sign up for daily news emails
ebooksAn introduction to the ground rules of British democracy
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £45K: SThree: SThree were established in 1986....

Recruitment Genius: Compliance Manager

£40000 - £60000 per annum: Recruitment Genius: A Compliance Manager is require...

SThree: Talent Acquisition Consultant

£22500 - £27000 per annum + OTE £45K: SThree: Since our inception in 1986, STh...

Recruitment Genius: Experienced Financial Advisers and Paraplanners

Negotiable: Recruitment Genius: This extremely successful and well-established...

Day In a Page

Seifeddine Rezgui: What motivated a shy student to kill 38 holidaymakers in Tunisia?

Making of a killer

What motivated a shy student to kill 38 holidaymakers in Tunisia?
UK Heatwave: Temperatures on the tube are going to exceed the legal limit for transporting cattle

Just when you thought your commute couldn't get any worse...

Heatwave will see temperatures on the Tube exceed legal limit for transporting cattle
Exclusive - The Real Stories of Migrant Britain: Swapping Bucharest for London

The Real Stories of Migrant Britain

Meet the man who swapped Romania for the UK in a bid to provide for his family, only to discover that the home he left behind wasn't quite what it seemed
Cheaper energy on the way, but it's not all sunshine and rainbows

Cheaper energy on the way, but it's not all sunshine and rainbows

Solar power will help bring down electricity prices over the next five years, according to a new report. But it’s cheap imports of ‘dirty power’ that will lower them the most
Katy Perry prevented from buying California convent for $14.5m after nuns sell to local businesswoman instead

No grace of God for Katy Perry as sisters act to stop her buying convent

Archdiocese sues nuns who turned down star’s $14.5m because they don’t approve of her
Ajmer: The ancient Indian metropolis chosen to be a 'smart city' where residents would just be happy to have power and running water

Residents just want water and power in a city chosen to be a ‘smart’ metropolis

The Indian Government has launched an ambitious plan to transform 100 of its crumbling cities
Michael Fassbender in 'Macbeth': The Scottish play on film, from Welles to Cheggers

Something wicked?

Films of Macbeth don’t always end well - just ask Orson Welles... and Keith Chegwin
10 best sun creams for body

10 best sun creams for body

Make sure you’re protected from head to toe in the heatwave
Wimbledon 2015: Nick Bollettieri - Milos Raonic has ability to get to the top but he must learn to handle pressure in big games

Nick Bollettieri's Wimbledon files

Milos Raonic has ability to get to the top but he must learn to handle pressure in big games
Women's World Cup 2015: How England's semi-final success could do wonders for both sexes

There is more than a shiny trophy to be won by England’s World Cup women

The success of the decidedly non-famous females wearing the Three Lions could do wonders for a ‘man’s game’ riddled with cynicism and greed
How to stop an asteroid hitting Earth: Would people co-operate to face down a global peril?

How to stop an asteroid hitting Earth

Would people cooperate to face a global peril?
Just one day to find €1.6bn: Greece edges nearer euro exit

One day to find €1.6bn

Greece is edging inexorably towards an exit from the euro
New 'Iron Man' augmented reality technology could help surgeons and firefighters, say scientists

'Iron Man' augmented reality technology could become reality

Holographic projections would provide extra information on objects in a person's visual field in real time
Sugary drinks 'are killing 184,000 adults around the world every year'

Sugary drinks are killing 184,000 adults around the world every year

The drinks that should be eliminated from people's diets
Pride of Place: Historians map out untold LGBT histories of locations throughout UK

Historians map out untold LGBT histories

Public are being asked to help improve the map