The “MPC-ometer", discussed in numerous posts between 2007 and early 2009, is designed to predict monthly Monetary Policy Committee decisions based on incoming economic and financial data. The model suggests that policy tightening will soon be necessary, barring new “shocks”. This contrasts with the message of the February Inflation Report but news may force the MPC to execute a swift U-turn. An attempt to maintain inappropriately loose policy settings could accelerate sterling’s slide, further undermining the credibility of the Report's forecast of lower inflation.

The MPC-ometer is designed to predict the weighted-average interest rate vote of the Committee’s members. For example, if five want to raise official rates by 25 basis points (bp) while four prefer no change, the weighted-average vote is +14 bp (five-ninths of 25). If it is assumed that votes are either for no change or a move of 25 bp – reasonable under “normal” economic and financial conditions – then the model forecasts an actual rate change when the weighted-average prediction is greater than +12.5 or less than -12.5 bp. Introduced in September 2006, the MPC-ometer performed well over the subsequent two and a half years, correctly signalling the month and direction of 12 out of 13 rate movements – two more than the mean economists’ forecast from the monthly Reuters poll.

The MPC-ometer’s 12 inputs were selected on the basis of statistical analysis and can be grouped into indicators of economic activity, inflation and financial market conditions. The inflation sub-set is largest, comprising the latest headline annual increases in consumer prices and average earnings as well as several measures of expectations. Activity indicators include GDP growth and business / consumer confidence while credit spreads and movements in share prices and the exchange rate are used to gauge financial conditions.

A review of its forecasts during the period of unchanged rates since last March indicates that the MPC-ometer has continued to provide guidance about policy decisions. Specifically, it predicted further easing moves in May and August, months in which the MPC announced a £50 billion expansion of asset-buying plans. The model suggests that the MPC regards £50 billion of additional purchases as equivalent to a reduction in Bank rate of about 17 bp. On this basis, the £200 billion programme has substituted for a further rate cut of about 70 bp.

The weighted-average interest rate vote forecast by the model was negative between April and November last year, consistent with a residual easing bias. It rose, however, to +3 bp in December and +10 bp in January before falling back to +2 bp in February in response to preliminary figures showing GDP growth of only 0.1% in the fourth quarter. The forecast has rebounded to +12 bp in March, reflecting higher inflation, further gains in business and consumer confidence – both now well above long-run average levels – and upwardly-revised GDP expansion of 0.3% last quarter.

The MPC-ometer suggests, therefore, that as many as four members will vote to tighten policy this week. The February Inflation Report and more recent MPC communications indicate that such an outcome is highly unlikely. The current divergence between the model's forecast and MPC behaviour raises three possibilities.

First, the model may be signalling an imminent shift in the Committee's thinking. It has sometimes been "early" historically. Economic news and market developments since the Report was prepared have weakened the case for retaining an easing bias and may have emboldened members concerned about excessive policy laxity.

Secondly, the model may simply have broken down. Estimated on data since the MPC's inception in 1997, it may be failing to capture the full range of influences on monetary policy in the wake of a deep recession. This argument, however, is weakened by the similarity of the model's prediction and the latest vote of the Sunday Times Shadow MPC, which also has a good forecasting record. Three Shadow MPC members voted to raise Bank rate by half a percentage point this month – see David Smith's blog for the minutes.

This leads on to the third possibility, which is that the MPC's historical reaction function, rather than the MPC-ometer, has broken down. The Committee has, in effect, shifted to "inflation targeting lite", downplaying the requirement of its remit to achieve the 2% inflation target, defined by the consumer price index without exclusions, "at all times" in favour of supporting an economic recovery and promoting fiscal tightening by promising a monetary-policy "pay-off". Market suspicions of such a shift may be contributing to current sterling weakness.