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The Old Lady of Threadneedle Street is no Mystic Meg.

Interest rates in Britain may have been set too high because of poor forecasting by the Bank of England, according to a group of academics including Mr Sushil Wadhwani, a member of the Bank's Monetary Policy Committee.

A preliminary version of the paper, to be published in June by the Centre for Economic Policy Research and the International Centre for Monetary and Banking Studies, says the BoE's forecasts for the pound have been flawed because the exchange rate was assumed to move in line with existing interest rate differentials.

As a result of this assumption, also used by other central banks, the BoE has continued to predict a depreciation of sterling over the past four years, while the pound has gone from strength to strength.

'A corollary of this exchange rate forecasting error is that, other things being equal, the BoE's inflation forecast has been persistently higher than it might have been under perfect foresight of the exchange rates and, therefore, there is a risk that interest rates have been set too high,' the report said.

Last November, the MPC responded to its lack of success in forecasting the exchange rate by making changes to its methodology.

The CEPR paper also argues that central banks should respond to asset price bubbles - for example, exaggerated movements in share prices or exchange rates - when setting interest rates instead of single-mindedly targeting inflation. This would help reduce overall inflation and output volatility.

For example, if a currency is significantly overvalued, interest rates should be cut even if that means inflation moves slightly above target in the short term, the report said. 'Using interest rates to insulate the economy from 'exchange rate shocks' over and above the effect of such a shock on the central bank's inflation forecast appears to be welfare-improving,' it said. The paper said its proposal were wholly consistent with the Chancellor's remit to the Bank, known as the Old Lady of Threadneedle Street after its London location.

But the academics stressed that the proposal did not amount to having an exchange rate target.

Business View/Page 19
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Publication:The Birmingham Post (England)
Date:May 13, 2000
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