Buttonwood: Thinking outside the Bank THE world expects a lot of its central bankers. Politicians demand that they control inflation, keep the economy growing and the financial sector stable. At times, central banks seem to do all the work: it was Mario Draghi of the European Central Bank, not the leaders of Germany and France, who stopped the sell-off in euro-zone bond markets in 2012, for example. Sometimes politicians seem to be sabotaging the central bankers, tightening fiscal policy when the banks are easing to help the economy. But can we rely on central bankers to get things right? They are subject to the same behavioural biases as the rest of us. That is the theme of a recent, thoughtful speech* from Andrew Haldane, the Bank of England's chief economist. There are various mechanisms to ensure the bank acts in a considered and rigorous manner. It is accountable for its actions. Its goals are set by Parliament and if it misses its inflation target, the governor has to write a letter to the chancellor of the exchequer, Britain's finance minister, explaining why. Decisions on interest rates are made by a committee, which includes academics and economists from outside the institution - a way of avoiding groupthink. At least one member of the committee has dissented at around half of all meetings. But there have still been failings, as Mr Haldane freely admits. It is obvious in retrospect that problems were building in the banking sector in 2005-06. Leverage had risen and the regulations of the time served to obscure the nature of the risks the banks were taking. Mr Haldane has emphasised how important banks were in fuelling the crisis in an earlier speech.** Yet in the decade preceding the financial crisis of 2007-08, the minutes of the monetary-policy committee's meetings suggest that it spent just 2% of its time discussing banks. The central bank moved centre-stage in the aftermath of the crisis, providing liquidity to struggling banks, pushing interest rates to their lowest level in its 300-year history and buying £375 billion ($590 billion) of British government bonds. Given the scale of its interventions, it was imperative for the bank to get its economic forecasts right. But as Mr Haldane admits, it did not. Since the crisis, the bank's forecast errors for output and inflation, like those of external forecasters, have tended to be one-sided and serially correlated. Mr Haldane describes this as a hubris bias. Before 2007, during the period known as the Great Moderation, the bank's forecasts were highly accurate. This may have led to overconfidence in its predictive powers. Its inflation report shows fan charts showing the likely outcomes for economic variables; since the crisis, half of all outcomes have occurred in the outer 20% of its forecasts. Most notably, inflation exceeded the 2% target for four consecutive years, even though the bank consistently forecast that it would return to target in 18-24 months. The central bank took no action to bring inflation back down during that time, on the understandable grounds that tightening policy would cause considerable economic damage. Still, it is hard to describe something as a "target" in such circumstances. Were a husband to tell his wife that he had a target of being faithful, had failed to meet it over the previous four years, but hoped to do so over the following two, the marriage would be pretty short-lived. To his credit, Mr Haldane is trying to address the problem, attempting a "cultural revolution." Instead of using research to support the bank's view, it will in future "put into the public domain research and analysis which as often challenges as supports the prevailing policy orthodoxy." This new approach "will act as another bulwark against hubris, overconfidence and groupthink." But this is a tricky path to tread. On the one hand, the bank's every statement is pored over by the markets for signs of future policy changes, so the publication of out-of-the-box thinking might only lead to confusion in investors" minds. On the other hand, the central bank may well need fresh thinking to get its forecasts right. The big new hope for monetary policy is "forward guidance" - a steer from the bank on the outlook for interest rates two years, rather than just one month, ahead. Forward guidance is useless if the bank has no better vision of the future than a funfair psychic.