All through life our brains like to use “general rules of thumb” when dealing with problems. These rules may come through personal experience or maybe they are more prescriptive and laid down by doctrine.
When dealing with problems I have sometimes found it useful to use a “factor of three”. For example, if I plan to do a DIY job in the house, bitter experience tells me it will take three times as long as I might expect. Similarly, in my distant past, my military training followed the doctrine that when attacking a defended position, your force would need to be at least three times the size of similarly equipped defenders; events on the ground have shown that Russia overestimated its forces and underestimate those of Ukraine (and its Western support) thereby putting itself on the wrong side of this golden rule. Such a guide can help avoid the shock of a gross under-estimation of outcome.
The Bank of England (BoE) publishes its expectations for inflation 12 months hence. Looking back at the Bank of England’s Monetary Policy Report of August 2021, the Monetary Policy Committee’s own 12 month forecast for the Consumer Price Index (CPI) inflation we are experiencing today was only around 2.2% (with little difference between including or excluding energy and VAT); indeed, external (to the Bank of England) forecasters were also only expecting 2.2% in Q3 of 2022. Fast forwarding 6 months to February 2022, (the report was written prior to Russia’s invasion of Ukraine, but with other post COVID-19 inflation forces already on the loose) the Bank of England had increased its Q1 2023 inflation expectation to circa 5.3%, whereas the average of external forecasters was somewhat behind at 3.1%.
Even in May this year, with much more relevant information available to all parties, the Bank of England in that report was projecting CPI to be (only) 6.5% in Q2 2023, more surprisingly there were no external forecasters predicting it to be over 6% and their average forecast was for just 3.7%.
Last month, Citi, the investment bank, issued a headline-capturing warning of UK CPI likely to exceed 15% in the first quarter of 2023 (around three times what the BoE was predicting for Q1 2023 back in February 2022); even the Bank of England’s report of that month was predicting Q3 2023 inflation to be almost 10%. Clearly, the forecasts as recently as February were in “gross error” territory.
What does this tell us apart from the folly of attempting to predict macro-economic data? Answers on a postcard; however, I would contend that it is a perfect example of the danger of anchoring. After many years of official and (optically at least) succeeding in achieving inflation of around 2%, there was a classic case of group think and anchoring at play in the minds of economic forecasters. Personally, it reinforces the fact that in circumstances that are not particularly unusual (war, pestilence, and famine) there is a high risk of underestimating things by a factor of three, even when the forces at play are known.
With such uncertainty and variability of outcome being an almost inevitable result of numerous known and unknown factors, it often baffles me how the forecasting industry garners so much attention and apparent credibility from observers. Perhaps it is the inevitable result of a lucrative machine who’s vested interest is to convince people that they need their services.
The folly of blind faith in forecasts was illustrated even more starkly last week as a result of the fiscal event or “mini budget” (indeed the government did not even publish any forecasts to accompany the policy announcements). Gilts have been regarded as the benchmark “risk free” security, providing little volatility and a measured reflection of future interest rate “normalisation”. Therefore, how shocking it was to see the quiet backwater of the 30 year UK Treasury Index Linked Gilt fall from around 118p in early September to around 53p on Wednesday 28th September (it has since recovered to 101p).
Humans like to have a number to hold onto as it feels tangible and brings confidence. Gross Domestic Product (GDP), inflation, and employment figures are only as good as the data fed into them; they are the measurements of the immeasurable. The reality of course is that the economy is far more ethereal than that. Furthermore, who is to say that doubling GDP is a good thing, if it comes at the woefully underestimated cost of climate change and catastrophe?
That desire to measure and have a number to point to is understandable, however it can be misleading, especially when used to compare things that are not actually directly comparable. My colleague Gary Moglione wrote about the subject of fees back in August (read Gary’s thoughts here) and how the new rules on the disclosure of total look through costs, while laudable in principle, can run the risk of false comparisons in practice. As these rules are now having to be applied across the funds industry, it is essential that investors take time to appreciate what is actually being disclosed, what services are being provided by whom, and how they're being charged. We would welcome any questions from investors on this matter to explain the recent changes.