The results of the latest Shadow Monetary Policy Committee (SMPC) quarterly meeting (in conjunction with the Sunday Times) are set out below. The rate recommendations are made with respect to the Bank of England’s REPO rate decision to be announced on Thursday 4 May. On this occasion, seven SMPC members voted to hold rates, while two voted for a ¼% reduction.

At its latest meeting, the IEA’s Shadow Monetary Policy Committee, a group of leading monetary economists that monitors developments in UK monetary policy, voted against changing interest rates by seven votes to two when Britain’s REPO rate is next set, on 4 May.

Most members of the SMPC felt that the arguments for and against a change in interest rates were finely balanced. There has been a significant rise in energy prices, but overall inflation was still subdued. Against this, there is evidence that economic activity is recovering again, while the continued high level of UK money supply growth concerned a number of members. There were few risks arising from the international economic background unless energy prices continued to rise.

Although the majority of members voted for no change in interest rates, and no members voted for an immediate increase, several members felt that interest rates would have to rise in the future, as a result of the medium-term impact of rapid broad money growth.

Tim Congdon said “The choice is between a modest rise in rates now or a more drastic one later”, but he believed that rates should be left where they were this month. David Smith, Chief Economist at Williams de Broë, suggested that he would not be surprised if rates had to rise before the year end.

John Greenwood, Chief Economist at AMVESCAP, said “There is no case for a rate cut, but rates should be held at the current level for the current time.” However, two members, Andrew Lilico of Europe Economics and Peter Warburton of Economic Perspectives, wanted an immediate rate reduction of ¼%.

Members of the SMPC were concerned that policymakers and commentators are focusing on ‘core inflation’ and therefore omitting from consideration key parts of price indices that relate to the underlying cost of living. This is particularly problematic when energy prices are rising rapidly for reasons that are not cyclical; in such circumstances, core inflation may understate underlying inflation and the policy stance will be too loose.

The minutes of the meeting are attached below. Minutes of all recent Shadow Monetary Policy Committee meetings are available from the Articles Section of the IEA website at www.iea.org.uk.

The Shadow Monetary Policy Committee, which has shadowed the MPC since its creation, meets quarterly but also conducts a regular e-mail monthly survey of members’ views on monetary policy. It normally publishes this, together with a poll on the Committee’s view on interest rates, on the Sunday before the meeting of the Bank of England’s Monetary Policy Committee.

Minutes of the Meeting of 20 April 2006
Attendance: Professor Philip Booth (IEA Observer), Professor Tim Congdon, John Greenwood, Dr Ruth Lea, Dr Andrew Lilico, Professor Kent Matthews (Secretary), Professor Anne Sibert, David B Smith (Chair), Dr Peter Warburton.
Apologies: Professor Gordon Pepper, Professor Roger Bootle, Professor Patrick Minford, Professor Peter Spencer.

Chairman’s comments
David Smith asked John Greenwood to present his analysis of the world and UK economies.

The economic situation
World Economy: Low inflation and growth at potential
Monetary policy has been normalised
John Greenwood referred to the circulated notes and charts (Appendix I). The overview of the international economy is that monetary policy in some major countries has now been normalised, particularly the Anglo-Saxon economies, resulting in flat or slightly inverted yield curves. The European Central Bank (ECB) has started to raise rates and the Bank of Japan (BoJ) has indicated an end to quantitative easing. Monetary growth in the US is not excessive. The likely result is growth at or near potential, and low inflation.

Inflation expectations remain low
Market measures of inflation expectations from indexed-linked bond yields suggest that long-term inflation expectations remain low in the US. Allowing for the distortion caused by recent institutional demand for index-linked gilts in the UK, inflation expectations remain anchored at low levels.

Consensus forecasts indicate benign outlook
Even in emerging markets, inflation remains under control, except for oil-producing economies, where there is evidence of overheating. The consensus forecasts for the world economy are remarkably benign, with the Euro-zone economies and Japan at last joining the rest of the developed world, and growing at a satisfactory rate.

US: Healthy corporate profits
Anglo-Saxon housing markets have been boosted by low real rates
of interest
In the US, the major concern is with the housing market. However, in the UK and Australia, house prices have plateaued rather than crashed. The common factor in all three house price booms was the decline in the real rate of interest caused by the excess of global savings over investment. The continuation of low real rates implies that we are likely to see a flattening of house prices in the US also. In the UK, equity withdrawal has not boosted consumption, but resulted in balance sheet adjustment through the acquisition of financial assets. In the US, only 20-30% of mortgage withdrawals have gone to fund consumption. Thus the flattening of house prices will not result in a major downturn in consumer spending, and there is unlikely to be any obvious slowdown in the economy.

US monetary policy
Healthy internal funds in the US corporate sector have resulted in share buy-backs and muted corporate borrowing, but business investment is expected to rise. There is little pressure for rates to rise from corporate borrowing. However, the expectation is that the Fed will raise rates further on 10 May. Money growth (M2) in the 5-7% range is not excessive. Bank credit is growing at a steady rate, mostly driven by real estate loans. The basic picture is benign, with core inflation at around 1.9%, provided the yield curve is flat and interest rates roughly match nominal GDP growth.

Euro-zone interest rates
Confidence indicators show a pick-up in the Euro-zone. Rapid money supply growth remains a concern for the ECB, and therefore rates could rise to 3-3½% over the next year, ending with a flat yield curve but at a lower level than in the UK or the US.

Japan
Japan shows some improvement in economic activity. The Bank of Japan is using open market operations to soak up excess reserves, which will push up rates. The economy will recover, but if there is any danger of faltering, the Bank of Japan will hold off from raising rates.

UK Economy: Recovering slowly
British growth is returning to trend, obviating need for rate cuts
Narrow money growth has remained steady at 5-6% but sterling M4 broad money has shown strong growth of over 12%, driven largely by the growth in wholesale deposits. M4 and nominal income growth have been moving in different directions. The economy has been recovering slowly. Retail sales and consumer spending have shown signs of revival. Exports have improved, due to increased Euro-zone economic activity. Inflation has fallen back below the target - the March CPI figure was 1.8% year-on-year - and is likely to remain marginally below it for the rest of the year. As growth gets back towards trend, there is no compelling case for a cut in rates. The official REPO rate will remain at 4.5% for most of 2006.

Discussion and policy response
Eastern European immigrants
Anne Sibert asked about the likely effect of immigration into the UK from Eastern Europe. She said that the effects on demand are faster than the effects on supply. John Greenwood replied that he expected immigration to affect only long-term growth, not the cyclical pattern of growth, while Peter Warburton said that the low-skilled jobs taken up by immigrants help to explain falling productivity.

World growth driven by developing, not mature, economies
Tim Congdon said that John Greenwood’s commentary did not mention developing economies. The buoyant growth in the world economy is not being driven by the mature economies but the developing economies. Inflation is coming through oil, other energy and commodity price inflation. Focusing on core inflation underestimates actual inflation.

Energy costs
Kent Matthews asked for clarification on what he saw as a one-off relative price effect caused by real factors, rather than an inflation effect. Tim Congdon explained that continuously rising energy and commodity prices must feed into inflation. Anne Sibert said that there was no disagreement that continuously rising oil prices does have an overall inflation effect.

Monetary growth has accommodated increased energy costs
David Smith said that monetary accommodation was needed to convert energy price rises into a permanent inflation effect, but that this had been happening, to some extent, with OECD broad money growth having accelerated to 6¾% over the past year.

Rate debate
Andrew Lilico said that it was not clear that the oil prices would continue to rise, but that he would prefer to use a broad measure of inflation. He added that it was not clear why the present situation did not warrant a rate cut. GDP is below trend and inflation is low. In response, John Greenwood said that the improving external environment was pushing the UK back towards trend output.

Bearish bonds
Peter Warburton said that the global bond market was in a serious bear phase. There are technical reasons why the long-term rate of interest is low. The government was able to borrow at low rates because of the overseas take-up. He expected government borrowing to continue for sometime.

Individual votes
David Smith asked the committee to make its recommendation.

Comment by Professor Philip Booth (Cass Business School and Institute for Economic Affairs)
Vote: No change
Misleading opinion polls on inflation
Philip Booth said that the Bank of England should not take notice of opinion polls on the views of members of the public on inflation expectations: market-based measures are more reliable. He said that there was no reason for a rate cut. He was concerned about the monetary aggregates, but a rate rise now would be fine-tuning for the sake of it. He voted to hold.

Comment by Professor Tim Congdon
(Visiting Fellow, London School of Economics)
Vote: No change
Money has gone into asset prices
Tim Congdon said that the high rate of broad money growth is associated with asset price inflation. The puzzle is that domestic demand remains weak. The choice is a modest rise in rates now or a more drastic one later. He said that rates should be left where they are at this time.

Comment by John Greenwood (Chief Economist, AMVESCAP)
Vote: No change
Bias to raise
John Greenwood said that there was no case for a rate cut, but that the rate should be held at its current level with a bias to raise.

Comment by Dr Ruth Lea (Director, Centre for Policy Studies and Non-Executive Director, Arbuthnot Banking Group)
Vote: No change
Economy returning to trend growth
Ruth Lea said that the economy is returning to trend growth. Also, the trend growth rate is likely to be lower because of negative supply effects. She said that she was unhappy that the Bank of England was using a National Opinion Poll (NOP) survey of inflation expectations. She voted for no change.

Comment by Dr Andrew Lilico (Europe Economics)
Vote: Cut REPO rate by ¼%
Cut now, but be prepared to raise REPO rate later
Andrew Lilico said that rates would have to be raised higher than the present, and indeed higher than the market expects, at some time in the fairly near future - perhaps starting later this year. Such rises would tend to limit growth’s returning to trend within the forecast horizon. Inflation is below target, so there is scope for a small cut now and then to raise rates later. He voted to cut rates by ¼%.

Comment by Professor Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: No change
Rapid monetary growth implies rates will have to rise in future
Kent Matthews said that although market-based expectations signal low inflation, he was not convinced by the argument that the credibility of the Monetary Policy Committee anchors inflation expectations. Both narrow and broad measures of money are too high but, in particular, double-digit broad money growth warrants interest rates be raised in the future. He voted to hold with a bias to raise.

Comment by Professor Anne Sibert (Birkbeck College)
Vote: No change
GDP is at trend
Anne Sibert said that there was no new news that had persuaded her to change her views. GDP is returning to trend. Although the oil price effect is matter of concern inflation has fallen. She voted for no change.

Comment by David B Smith
(Chief Economist, Williams de Broë and University of Derby)
Vote: No change
New research finds money is a predictor of long-run inflation
David Smith said that new research from the Bank for International Settlements and the Bank of England confirmed the view that output gaps affected short-run inflation, but that long-term inflation was governed by money supply growth. At some point in the future interest rates will have to rise. The question is, should this be pre-empted by raising rates now or later? Joblessness is rising, and the economy faces further negative supply-side problems with a loss of competitiveness due to higher taxes. He said that he would not be surprised if rates had to rise before the year end, in part because of higher rates overseas. He voted to hold.

Comment by Peter J Warburton
(Director, Economic Perspectives Ltd)
Vote: Cut REPO rate by ¼%
Cut and hold
Peter Warburton questioned whether there had been a meaningful upturn in the UK economy since the last SMPC meeting in January, particularly in light of negative developments in external trade. While some housing indicators had strengthened, there was no evidence of a national improvement in market conditions. Rightmove’s index of asking prices for April remains just 4% higher than a year ago. Given that the global real bond yield environment has become more restrictive since the start of the year, and with nominal GDP growth still sub-4%, he thought it prudent to reduce the REPO rate by 25 basis points, but this reduction should not been seen as the first of a series.