Tuesday, October 04, 2005
Shadow MPC says no case for change in rates
Posted by David Smith at 02:23 PM
Category: Independently-submitted research

As usual, the results of the meeting of "shadow" monetary policy committee are set out below, in advance of the actual meeting of the Bank of England MPC this week.

Members of the Institute for Economic Affairs’ (IEA’s) SMPC speak in a personal
capacity and their contributions are arranged in alphabetical order.

The rate recommendations are with respect to the Monetary Policy
Committee (MPC) rate decision to be announced on Thursday
6 October. On this occasion, six SMPC members voted to hold rates
in October, while two voted for a further ¼% rate reduction, and
one member voted for a ¼% increase.

Roger Bootle, whose submission was not used on this occasion because nine votes had already been cast, would have voted for no change in October, but a
¼% cut in November. There is a general view that November will be
the more important rate-setting month because it will coincide with
the publication of the next Bank of England Inflation Report.

The wider economic background is discussed in more detail in the
quarterly SMPC minutes. The next quarterly SMPC meeting will be
held at the IEA on Tuesday 25 October, and the minutes from this
physical meeting will be released ahead of the 10 November
rate decision.

Comment by Professor Tim Congdon
(Lombard Street Research)
Vote: Raise Rates by ¼%

Consumer price inflation will rise sharply over the next three
months, as recent oil, gas and energy price increases come through.
The annual rate of increase in the consumer price index could exceed
3% and require the Governor of the Bank of England to write an
Open Letter of explanation to the Chancellor. As monetary policy
must look ahead at least two years, that does not necessarily mean
that interest rates should rise. More fundamental points are that -
despite a diversion of spending power equivalent to about 5% of
world output towards oil and gas producers since 2002, because of
the price rises - the world economy is still doing rather well, and in
the UK is enjoying roughly trend growth. (Unemployment has risen
only slightly this year.) With money supply growth continuing to
run at about 10%, the upward risks to inflation over the medium
term exceed the downward risks. Base rates should rise by ¼%.

Comment by John Greenwood
(Chief Economist, AMVESCAP)
Vote: No Change

Since the MPC cut rates by ¼% to 4½% on 4 August, the published
data suggest that the UK economy has continued at or near trend
growth. Although the retail sector continues to exhibit some
weakness, the broader CIPS service sector (or PMI) indicator for
August held quite steady. The residential property market continues
to suggest a plateau, rather than the start of any downward trend,
particularly as the number of loans approved for house purchase
(97,000 in July) has now been moving upwards for eight months.
Data for manufacturing, industrial production and business
investment have held their levels in recent months. Data for the
labour market and earnings have shown no further weakening.
In the monetary area, sterling M4 has continued to grow at
double-digit rates (10.2% year-on-year in August), with M4 lending
growing only fractionally more slowly (9.7% year-on-year in July).
Business lending has been picking up, offsetting slower lending
growth to the personal sector.

CPI inflation data for August showed a month-on-month increase of
0.4%, and the year-on-year figure jumped to 2.4%. Following the oil
price hikes of recent weeks, a greater CPI increase can be expected in
September. Although this should not trigger a letter from the Bank’s
Governor to the Chancellor, the strong growth in bank balance
sheets should nevertheless be viewed as a signal of inflation risks
ahead. Industrial input prices have risen strongly (+12.9% year-onyear
in August), while output prices (+3.0% in August) have been
contained by competition and margin compression.
In summary, with the economy still growing close to trend rates,
demand pressures mixed and cost pressures strong, there is no
margin for further easing. Rapid money growth rates imply a risk
that demand could strengthen again, reigniting inflation. This
leads to the conclusion that rates should not be cut, but held at the
current level.

Comment by Dr Andrew Lilico
(Europe Economics)
Vote: No Change

With inflation well above target and still rising (CPI in August at
2.4% being the highest level since the official series began in 1997),
with broad money growth still in double digits in August
(provisional estimates of 10.2% for M4), and with oil prices
consistently well above US$60 a barrel, there can be no question of
interest rate cuts at this stage. The more relevant question is whether
the MPC should reverse its misguided August cut, and if so, how
quickly.

Pay growth is steady at 3.9% and factory gate inflation has fallen
slightly to 3.0%, suggesting that (perhaps oil aside) pressures in the
pipeline are not, at this stage, mounting too rapidly. Retail sales have
staged a modest recovery over the last quarter, up 0.8% in June to
August compared with the previous three months, but the annual
picture is still one of a considerable slowdown in growth.
Manufacturing is essentially flat, with just 0.1% growth in June and
July. Overall growth at 0.5% in Q2 was not disastrous, and M0 (a
potential contemporaneous indicator, at least of turning points) grew
at around 6% through August and September, up from the 4-5%
levels of May to July. House price growth was modest, but there is
little sign of substantial falls yet.

Thus, the real economy picture is patchy, but offers little basis to
justify interest rate cuts in the face of above-target and rising
inflation. The flawed August decision may have to be reversed over
the next few months, unless there is a significant further downturn
in the real economy, but for now I am inclined to hold.

Comment by Professor Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: No Change

While nobody seriously believes that inflation is caused by inflation
expectations, the view that the Bank reacting to signs of inflation
rising above or below target somehow creates low inflation by
anchoring inflation expectations, has gained credence, allowing the
MPC to ignore what is happening to the money supply. If the money
supply continues to grow in double digits, the MPC will quickly
learn to regret its decision to lower the REPO rate to 4½%. However,
signs that the weakening of the real economy has fed back into the
money supply (the causation between the real economy and the
money supply is two-way) have finally emerged. The provisional
rate of growth of broad money in August was down to 10.2%,
compared with a revised figure of 11.3% in July. The slowdown in
the real economy is not as sharp as many had feared and is of the
right proportions to bring GDP back into line with capacity. While
the economy shows signs of going in the right direction, it would be
a mistake to change interest rates. The cut in rates was an error but
to reverse the decision so soon would compound the error with a
loss of credibility.

Comment by Professor Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut Rates by ¼%

For nearly thirteen years there has been steady growth in the UK
with very little inflation. The two facts are connected: the lack of
inflation has given monetary policy freedom to act against incipient
slowdowns by cutting interest rates fairly promptly, and to as low a
rate as necessary. There have been some years where growth has
dipped a bit below 2% and others where it has risen towards 4%; in
all these, interest rates have moved pragmatically in response,
respectively to stimulate and restrain. That is the classical role of
interest rates. Sometimes people talk about such behaviour as
interest rate ’activism’, to be contrasted with ‘old-time monetarist
religion’; however this is the opposite of the truth. Were the central
bank to follow a classical money supply growth target, interest rates
would move around vigorously to clear the money market. Thus
‘interest rate activism’ equals ’money supply stability’.

Comment by Professor Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: No Change

Last month I argued that the ¼% reduction in interest rates was a
mistake because monetary growth continued to be excessive. The
position has not changed significantly. Interest rates should be raised
at the first sign of buoyancy in real economy data, if not sooner.
Some people are arguing that the rise in the price of oil, which has
continued during the last few months, is a reason justifying the
reduction in rates. Whereas they are correct that the rise in oil’s price
is demand deflationary in the short run, because consumers of oil cut
back on expenditure on other goods more quickly than producers of
oil increase their expenditure, experience in the 1970s suggests that it
is unwise to reduce rates for this reason.

When the price of oil rose in the 1970s, some countries, including the
UK, tried to avoid the deflationary impact by relaxing policy.
Trouble arose because an increase in oil’s price is also inflationary.
The result was that, instead of there being a once-and-for-all increase
in the level of retail prices, prices continued to rise, for example,
because of a wage-price spiral. Eventually action had to be taken to
stop inflation from accelerating, the result being recession. Other
countries, which did not act to offset the initial deflationary impact
of oil’s price on demand, had lower inflation and avoided the worst
of the recessions suffered by the first group of countries. Currently,
there is no danger that inflation will rise to the extent that it did in
the 1970s but there is a danger that it will exceed the 3% level at
which the Governor of the Bank of England has to write to the
Chancellor.

Comment by Professor Anne Sibert
(Birkbeck College)
Vote: No Change

The International Monetary Fund has revised downward its forecast
of UK real GDP growth to 1.9% for 2005 and 2.2% for 2006. The
resulting widening of the expected output gap should put
downward pressure on inflation.

Offsetting this are developments in the oil markets. Oil prices have
fallen below their August peak: the short-term disruption caused by
Hurricane Katrina has been offset by releases from strategic reserves,
Saudi Arabian offers to increase crude production, and beliefs that
damage from Hurricane Rita may be less than expected.
Nevertheless, the growth in world demand raises concerns for the
long term, and futures prices continue to remain high.
UK inflation is now slightly higher than European Union average
inflation: August inflation was 2.4%, the highest increase since the
1997 inception of the MPC. On balance, the lower projected demand
is not sufficient to outweigh inflation fears and no further reduction
in the interest rate is warranted.

Comment by David B Smith
(Chief Economist, Williams de Broë plc)
Vote: No Change

With the benefit of another month’s data, the ¼% reduction in the
official REPO rate to 4½%, announced on 4 August, still looks like a
mistake, which should be reversed at an appropriate moment, but
the effects of a minor change in the official rate of interest should not
be exaggerated. Simulations on our own forecasting model indicate
that the a ¼% REPO rate change makes a maximum difference of just
0.1 or 0.2 percentage points to the levels of most economic variables,
even after six or eight quarters have elapsed. This is trivial in terms
of the revisions to official data, or the speed and power with which
international events can influence Britain’s open and
trade-dependent economy. The new Bank of England Quarterly
Economic Model also seems to have a relatively weak pass-through
from interest rates to the wider economy, and it remains a mystery
why people get so worked up about relatively small rate changes.
This does not mean that moving base rates over the entire ½% to
17% range observed since World War II would not have an impact,
however.

The British economy now appears to be suffering from two distinct
‘stagflationary’ shocks. The first is the increased price of energy,
which is not something the UK can do much about, apart from
easing the tax regime on North Sea oil producers. The second has
been the increase in the government spending, tax and regulatory
burdens, which has hit the supply side and means that fiscal policy
is pulling in the opposite direction to the MPC’s remit to control
inflation. Some people have advocated giving higher priority to the
need to boost demand growth and, by implication, less to the
achievement of the inflation target. The danger with this approach is
that it risks discrediting the MPC’s reputation for impartiality, if
people come to suspect that the committee is more concerned with
boosting home demand - in order to stimulate tax receipts and float
the Chancellor off the fiscal rocks on which he has impaled the
public finances - than it is with fighting inflation.

The political impasse in Germany has weakened the euro, and
permitted a stronger pound than Britain’s combined fiscal and
monetary stance probably justifies, and the danger of a run on
sterling remains a sword of Damocles overhanging the British
economy and current monetary arrangements. With the short-term
inflation outlook likely to remain disappointing, as the September
inflation figures from Continental Europe are already starting to
indicate, there seems to be no case for cutting rates in October. In
practice, November, which sees the publication of a new Bank of
England Inflation Report is more likely to see a rate change than
October. However, the MPC could damage its reputation for
political independence - and being committed to ‘sound money’
above all else - if it does cut in November without an extremely clear
justification from the data released in the interim.

Comment by Dr Peter J Warburton
(Director, Economic Perspectives Ltd)
Vote: Cut Rates by ¼%

There has been much talk of a stabilisation of the residential
property market over the summer, but Rightmove’s compilation of
asking prices has fallen for the past three months, and national
house prices are on course to record annual declines before the end
of the year. Interestingly, there was a surge in property transactions
non-liable for stamp duty in the June quarter, but a 45% decline in
liable transactions as compared to the equivalent period of 2004. This
suggests that actual, rather than mix-adjusted, average and median
transaction values are falling already.

Although the domestic private sector inflation rate (excluding items
affected by specific duties and interest rates) has edged up in recent
months, the annual pace, at about 1.4%, is hardly worrying and
should not be considered an obstacle to another REPO rate cut in
2005. Publication of the July trade data confirmed the bizarre nature
of the surge in June exports and the inherent unreliability of the
second quarter GDP data.

Meanwhile, the public finances show increasing signs of strain. But
for the windfalls in oil taxation resulting from higher market prices,
Mr Brown would be in much deeper trouble with the IMF and
European Commission. With VAT receipts decelerating, public
sector pay inflation at 5.5% and interest payments running 16%
higher than in 2004, there is no scope for fiscal policy to take the
strain of a weakening economy. While a further economic slowdown
may be unavoidable, there is scope to edge interest rates a little
lower.

Comments

Interesting comment by Peter Warburton concerning the increase in transactions non-liable for stamp duty in the 2nd quarter.

I was wondering if this observation takes into account the change in the stamp duty threshold?

Thanks.

Posted by: Michael at October 5, 2005 01:17 PM

David
I am looking to invest in the USA in the near future.
Please could you give me your opinion on the dollar rate against the pound and their interest rates in the short and long term.
Keen reader of yours in the sunday times.

Regards

Andy goode

Posted by: A Goode at November 2, 2005 10:18 PM