Sunday, June 04, 2006
Shadow MPC votes 7-2 to hold rates
Posted by David Smith at 10:59 AM
Category: Independently-submitted research

The results of the latest Shadow Monetary Policy Committee (SMPC) e-mail poll for the Sunday Times are set out below. Members of the Institute for Economic Affairs’ (IEA) SMPC speak in a personal capacity and their contributions are arranged in alphabetical order. The SMPC poll was completed on Tuesday 2 June, although some contributions were received earlier, and the UK rate recommendations are with respect to the Monetary Policy Committee (MPC) rate decision to be announced on Thursday 8 June.

On this occasion, seven SMPC members voted to hold rates in June, while two SMPC members voted to raise rates by ¼%. Looking further ahead, four SMPC members expressed a bias to raise the official REPO rate, while one thought the next move should be downwards. The wider economic background is discussed in more detail in the quarterly SMPC minutes. The last quarterly meeting was held on Thursday 20 April and was written up in last month’s extended SMPC release, while the next will be held at the IEA on Tuesday 18 July
at 6:00pm, and will be released on the Sunday ahead of the 3 August MPC announcement.

Readers might like to know that a number of SMPC members have recently contributed to a new book on monetary policy and the financial markets, Issues in Monetary Policy: The Relationship Between Money and Financial Markets, edited by Kent Matthews and Philip Booth (John Wiley & Sons Ltd, in association with the IEA), which examines UK monetary policy issues at a deeper level than is possible in these monthly minutes.

Comment by Roger Bootle (Economic Adviser, Deloitte)
Vote: No change

The case for an immediate cut in interest rates has all but evaporated. A cut may still be necessary in due course, but it would take a slowdown in the world economy, most probably driven from America, to bring this about.

In the short term, the issue is more about whether to increase interest rates. With inflation exactly on target, and no signs of immediate pressure, I would favour waiting at least until the August Inflation Report. By that time, it should be clear whether the Bank’s still relatively optimistic growth forecasts are likely to be fulfilled.

Comment by Professor Tim Congdon
(Visiting Fellow, London School of Economics)
Vote: Raise REPO rate by ¼%

High money supply growth is still being recorded. Despite the recent stock market setbacks, asset markets have enjoyed a good 2006 and business surveys have become more positive. I’m puzzled by the rise in unemployment, but would not rule out the possibility that the natural rate of unemployment (ie the rate at which inflation is stable) has increased and is still increasing.
At current interest rates, roughly double-digit growth in bank credit and money will persist. I favour a 25 basis point rise in base rates.

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

Monetary conditions warrant a rate hike, but weak equities suggest a hold for the time being
Domestic demand has been showing signs of recovery, led by strong asset price increases (in both the stock market - until the recent setback - and the property market). Sterling lending to the private sector has been accelerating sharply in recent months (to 12.6% year-on-year in April), ensuring that £M4 growth (13.1% year-on-year in April) will remain in double digits. I view the rise in unemployment as a lagged response to last year’s economic slowdown, and therefore not to be interpreted as a sign of current economic weakness.

Although inflation is presently in line with the 2% target, the three-year period of acceleration in £M4 must be expected to pose significant risks to price stability if it is allowed to persist. Were it not for the current downturn in asset markets, I would vote for an immediate 25 basis point rate increase. Until the current equity market shake-out stabilises, I vote to keep rates at 4.5%.

Comment by Ruth Lea (Director, Centre for Policy Studies, and Non-Executive Director of Arbuthnot Banking Group)
Vote: No change

Trend growth in 2006?
GDP growth rose, on the ONS’s latest estimates by 0.6%, in the first quarter, despite the apparent sharp slowdown in household spending. The ‘shortfall’ was made up by a recovery in fixed investment and a build-up of inventories. But it can be argued that the “weakness” in consumer spending in the first quarter was partly a correction to the very strong fourth-quarter figure (quarterly data are erratic). This, along with stronger survey evidence on business activity and a resilient housing market, gives good reason to believe that the economy should grow at around trend for the rest of the year.

Unemployment higher, but modest
Even though unemployment has been rising, the unemployment rate is still relatively modest. Moreover, some slackness in the labour markets is judicious at a time when the Bank of England is concerned about price inflation transmitting into earnings inflation.

Equity market turbulence does not justify higher rates
There is, therefore, no reason to ease policy in order to stimulate the economy. Some may argue that an easing of policy is justified by the recent turbulence in the equity markets. But the recent behaviour is more likely to be one of correction than collapse (it really is too soon to talk of apocalyptic crashes) and the outlook for equities remains reasonably sanguine. If correction does turn into collapse, then the Bank can always cut rates.

Bias to raise
The next move in interest rates should be up - but not yet. There is no urgency. And, given the turbulence in the equity markets, this is all the more reason to provide a stable policy background at the present time. I vote for no change.

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

Rapid monetary growth could undermine MPC credibility
Signs of a recovery in domestic demand will have confounded the Jeremiahs that have been calling for a cut in interest rates over the past twelve months. To those who argue that a credible Bank of England interest rate policy anchors inflation expectations at the target of 2%, money supply figures provide little information content. However, what makes the Bank of England interest rate policy credible is precisely the attention that is paid to monetary aggregates. In that respect, double-digit broad money growth shows no sign of easing, and this is now being joined with rising M0 growth (7.5% in April). When both monetary aggregates move in the same direction, there is little room for doubt as to what the final outcome will be in the absence of a reversal of the trend. However, domestic demand needs to show further signs of strength before interest rates are raised. Furthermore, fragility in the world financial markets suggests caution in a precipitous rise in interest rates. Interest rates should remain on hold for the time being.

Comment by Professor Anne Sibert (Birkbeck College)
Vote: Raise REPO rate by ¼%

Global economy is strong
The real global economy continues to perform strongly and the OECD has increased its global growth forecast from 2.9% to 3.1% for this year, noting that growth in the US and Japan should be above trend over the coming months. Some deceleration can be expected in 2007, and there is some downside risk, especially if the necessary further decline in the real exchange rate of the US dollar, and the associated reduction in the US external current account deficit, were to become disorderly.

Financial market shake-out corrects anomalies
The global financial turmoil of the past weeks is likely to be the beginning of a longer-term and overdue correction of two anomalies: exceptionally low risk-free long-term real interest rates and unrealistically low credit risk spreads. Such restoration of financial market normalcy need not impede continued global economic growth; the obvious downside risks to real economic activity from asset market swings can be addressed by monetary policy, if and when they materialise.

Inflation and unemployment
The UK CPI inflation is on target and, at unchanged interest rates, the MPC projects it to rise above target in the short run and to remain slightly above target through 2007. First-quarter real GDP was up 2.2% on a year ago, and 2.6% on the fourth quarter of 2005. Growth for 2006 and 2007 is forecast at or above 2.5%. The outlook for energy prices is highly uncertain, and there is a substantial upside risk. The unemployment rate has risen to 5.2% in 2006 Q1 from 4.7% a year ago, but this may reflect a rise in the natural rate of unemployment due to the increase in the minimum wage and a rise in the tax burden.

Inflation risks justify ¼% rise
There clearly is no current case for a rate cut. A reasonable case can be made for no change or a 25 basis point increase. However, I believe that the risk of inflation exceeding its target is sufficient to merit a 25 basis point increase.

Comment by Professor Peter Spencer (University of York)
Vote: No change

Monetary growth and financial markets
The effect of the expansionary monetary policy is evidently working through the asset markets into the real economy at the moment. M4 money growth has moved up to 13% pa in recent months, supported by private sector borrowing. The housing market is moving ahead strongly, after pausing briefly last year. Mortgage borrowing has bounced back strongly, although unsecured borrowing remains subdued. The stock market has fallen from its recent peak, but this looks like a healthy correction, rather than the beginning of a collapse. Transactions in all of these markets are running at near-record rates, supporting incomes and employment, most obviously in the business and financial services sector. In the meantime, manufacturing has picked up on the back of domestic demand and exports to Europe.

Consumers under pressure
Low and stable interest rates, and rising employment and earnings, should underpin the housing market and the High Street this year, assuaging any residual fears of rising interest rates and unemployment, and falling house prices. However, with transport and energy bills still rising and fiscal drag continuing to bite, the growth in consumer spending is unlikely to regain the heady pace of recent years. Consumers appear to be particularly responsive to changes in monetary policy at the moment. Last year’s slowdown was in response to an increase in interest rates of just 1¼%. The recovery in the run-up to Christmas can be attributed to the cut in August - of just ¼%. This sensitivity clearly reflects the high level of household debt. But it also seems that people now regard nominal changes in interest rates as relative price signals to which they need to respond, rather than as indicators of rising inflation.

Reasons to hold
This makes me reluctant to argue for a rate rise in the present circumstances. Consumer confidence looks fragile and an early rate rise, likely to be seen as the first of several, could easily upset this again. That is not the only reason for caution. The fall in the stock market may have similar reverberations if it continues. The labour market has weakened significantly over the last 18 months. Sterling has appreciated strongly against the dollar in recent weeks and the recovery in our European markets cannot be taken for granted.

Comment by David B Smith
(Chief Economist, Williams de Broë plc and University of Derby)
Vote: No change

Higher interest rates overseas, and poor domestic monetary discipline, may induce a UK rate rise
There are growing signs that the UK economic recovery is widening and deepening, while the likelihood of higher interest rates overseas, which might pull the rug out from under sterling if they were not matched by corresponding increases in Britain, also suggests that there is now a reasonably strong case for raising Britain’s official REPO rate. The rapid, and possibly accelerating, annual growth in the broad money and credit aggregates also suggests that Britain’s monetary discipline needs to be tightened, especially as the rate of monetary expansion in Britain is far faster than that in the OECD area as a whole. Annual CPI inflation was bang on target in April, at 2%, but it is not clear how relevant this is to a forward-looking inflation-targeting regime.

But weak stock markets and a strong pound, imply a hold
The main reasons for wanting to postpone a hike in UK interest rates are the recent shake-out in world equity markets, and the fact that the sterling index is reasonably strong, although this may reflect the expectation of a UK REPO rate increase, and the foreign exchange markets are capable of turning on a sixpence if this expectation is not met. On balance, we suspect that the MPC will want to wait until 3 August, when it has a new set of Inflation Report forecasts available to it, before raising rates. There would seem to be no great harm in such a delay. However, the odds could shift in favour of a ¼% UK rate hike on 8 June if the European Central Bank (ECB) were thought likely to raise its REPO rate by ½%, rather than the generally anticipated ¼%, forty-five minutes after the UK announcement. It must be presumed that the Bank of England would have a strong feel for, if not actual foreknowledge of, the ECB decision. The appropriate verdict for June, alone, appears to be ‘hold’, but with an increasingly strong bias to raise by ¼% as soon as global stock markets have stabilised.

Comment by Peter J Warburton
(Director, Economic Perspectives Ltd)
Vote: No change

Serious problems in interpreting UK GDP data
Without question, the UK interest rate structure has been pulled upwards by global influences in the past three months, but this remains an unwelcome and inappropriate development as far as domestic economic conditions are concerned. First-quarter national accounts data show a slightly faster annual pace of nominal GDP growth, 4.4%, evenly split between real GDP growth and price inflation, but hardly a pace that cries out for correction. Indeed, the outlook for real GDP is riddled with uncertainty, due to the bizarre and distorted data for external trade. It seems that inventories have been boosted to square the output and expenditure accounts, and that the true quarterly growth figure could lie anywhere between 0.2% and the reported 0.6%.

New service sector output data
Interestingly, the experimental data set for output of the services industries shows a deceleration from a three-monthly growth rate of 1% in December, to 0.6% in March. While the manufacturing sector has benefited from improving world trade volumes of late, it is the momentum of the service industries, with an output weight of 73%, which will set this year’s trend. The output of the business services and financial intermediation sectors peaked in the three months to October and the public sector services contribution began to ebb away at around the same time. Rising unemployment and soft earnings inflation bear out the thesis of an underlying loss of economic momentum.

Excess risk appetite on the part of lenders
The policy situation is complicated by the acceleration in bank and building society lending since last November. While the pace of net lending to the household sector has slowed appreciably, to around 5% annually, bank lending to commercial property development, hedge funds, sub-prime housing finance corporations, special purpose vehicles, private equity firms and unidentified others, is rampant. This composition of lending does not pose an obvious and direct threat to consumer price inflation, but it warns of an excessive risk appetite in many housing and financial market contexts. Ironically, the unwinding of the associated asset price movements could soon translate into a negative demand shock for the UK economy.

Next move should be a cut
In conclusion, the outlook for the domestic economy is fragile and highly dependent on the evolution of the US economy, US financial markets and on the path of global real bond yields. While UK credit and monetary developments are unnerving, the banks will ultimately be disciplined by their own bad debt experiences. The case for a small cut in the REPO rate later in the year can still be made, but there seems no urgent need for it.


What a difference a few months make! The tide appears to be turning.

I suspect cool hand Mervyn will probably avoid casting a rate hike vote at present. A rate increase later in the year is looking increasingly likely.

The sun has finally appeared and will hopefully get those shop tills ringing (or beeping as they do nowadays).

Posted by: Werewolves at June 4, 2006 03:25 PM

The markets expect a rise, the ECB is expected to raise, inflation is the "scourge of the economy", the housing market is heating up, but will the MPC be fiddling while Rome burns?

Posted by: Dave at June 5, 2006 12:19 PM

Ah another "decision" from the MPC to keep eveything as it is. Lets hope the inflation juggernaut in the road ahead doesn't wake the driver from their sweet slumber ...

Posted by: Barry at June 8, 2006 08:25 AM
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