Sunday, July 30, 2006
Shadow MPC votes 5-4 for rate hike
Posted by David Smith at 10:59 AM
Category: Independently-submitted research

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 3 August.

On this occasion, five SMPC members voted to raise rates by ¼%, while four voted for a hold, and nobody voted for a reduction. The SMPC itself is a group of independent economists drawn from academia, the City and elsewhere, which gathers once a quarter at the Institute of Economic Affairs (IEA) in Westminster, to monitor UK monetary policy. The inaugural SMPC meeting was held in July 1997, two months after the Bank of England was granted operational independence, and the Committee has met almost every quarter since.

The Secretary of the SMPC is Professor Kent Matthews of Cardiff Business School, Cardiff University, and Chairman is Professor David B Smith (University of Derby). Other current members of the Committee include: Professor Patrick Minford (Cardiff Business School, Cardiff University), Professor Tim Congdon (Visiting Fellow, London School of Economics), Professor Gordon Pepper (Lombard Street Research and Cass Business School), Professor Anne Sibert (Birkbeck College), Dr Peter Warburton (Economic Perspectives Ltd), Professor Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (AMVESCAP), Professor Peter Spencer (University of York), Dr Andrew Lilico (Europe Economics) and Dr Ruth Lea (Director, Centre for Policy Studies and Non-Executive Director, Arbuthnot Banking Group). Professor Philip Booth (Cass Business School and the IEA), who also regularly attends physical SMPC meetings, is technically a non-voting IEA observer. However, he is awarded a vote on occasion to ensure that exactly nine votes are cast.

The next SMPC meeting is scheduled for Tuesday 17 October 2006. The SMPC’s regular monthly e-mail polls, carried out in conjunction with the Sunday Times, will continue to appear in the interim and will next be published on 3 September and 1 October.

Shadow Monetary Policy Committee Votes to Raise Interest Rates
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 to raise interest rates by five votes to four.

More hawkish tone
There was a significant change of mood from previous meetings. Two members who wished to raise rates expressed a bias to raise rates further in the future. Two members who voted to hold rates had a bias to raise rates at some point in the near future. Prof. Patrick Minford, of Cardiff University Business School, who had previously voted regularly to cut rates, was now sufficiently nervous about the situation to decide against cutting rates.

Money worries
Many members were worried about sustained increases in the measures of monetary growth. Tim Congdon said, “M4 money growth has been in double digits for nearly two years…I expect above trend growth of demand followed by inflation.”

International pressures for higher rates
David B Smith, Chairman of the SMPC, expressed concern about the rise in inflation that had been announced earlier in the month and also did not believe that the UK could keep such low levels of interest rates when they were being raised in the USA and Europe. He argued that we could not be completely insulated from the international position.

Case for holding rates
The minority view on the committee felt that there was insufficient evidence of inflation becoming established and there were concerns about the strength of economic activity. On balance, four members felt that we should wait for further developments both in inflation and in the real economy, before taking moving interest rates.

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

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 18 July 2006

Professor Philip Booth (IEA Observer), Professor Tim Congdon, John Greenwood, Dr Andrew Lilico, Professor Kent Matthews (Secretary), Professor Patrick Minford, Professor Ann Sibert, David Brian Smith (Chair), David Henry Smith (Sunday Times Observer).
Prof. Roger Bootle, Ruth Lea, Prof. Peter Spencer, Dr Peter Warburton, Prof. Gordon Pepper

Chairman’s comments
New distribution arrangements
David B Smith explained that his departure from Williams de Broe, following the firm’s takeover by Evolution Group, means that new arrangements will have to be made for the physical dissemination of the SMPC Minutes to a City audience. The physical production of the Minutes was not a problem, as David had all the necessary facilities to hand. Having discussed various options with both his Sunday Times namesake and the IEA, David B Smith proposed that Lombard Street Research should distribute the minutes as part of their in-house publications. One advantage of using Lombard Street Research was that they were prepared to publish the minutes as they received them. This would not be possible in the case of many large security houses, for example, because of the legal constraints under which they operated. It was also hoped that using Lombard Street Research would enable a seamless transition, with no gap in the dissemination process.

The proposal was accepted unanimously

David B Smith then asked Tim Congdon to introduce the monetary situation.

The economic situation
Broad money growth must fall for inflation to remain at target
Demand and Supply of money must be in equilibrium
Tim Congdon referred to the PowerPoint notes circulated prior to the meeting. In accordance with standard theory, the demand to hold money must equal the supply in macroeconomic equilibrium. If the actual stock of money balances does not equal what agents want to hold, they will buy and sell goods, services and assets, causing national income/expenditure and asset prices to change until all money balances are again willingly held.

Equilibrium unemployment may have risen
M4 growth has been in double digits for nearly two years. In line with experience in other cycles, corporate and financial sector money holdings have been more volatile than the quantity of money as a whole. Late 2005 and 2006 have seen marked asset price inflation, with excess money undoubtedly one of the key influences at work. Tim Congdon said that he expects above trend growth of demand followed by inflation. The evidence is that output is still at trend. Unemployment has risen, but the CBI survey of skilled labour shortage has a better correlation with the output gap. It is possible that the natural rate of unemployment has risen because of supply-side factors. It cannot be deduced that output is below trend just because unemployment has risen. Bank lending has grown rapidly partly to finance merger and acquisition activity. In the medium run interest rates must rise to bring M4 growth down to figures consistent with the inflation target. Tim Congdon suggested that M4 growth of 6-8% a year would be consistent with the official inflation target in the medium and long runs, much less than the 13.7% increase seen in the year to June.

World interest rates too low
Monetary policy is too stimulatory, globally
In the USA interest rates are too low to restrain the growth rates of bank credit and money to levels consistent with inflation of about 2%. The Fed has stopped targeting M3. Growth in money holding has been particularly in large time deposits, which are probably held mostly in the non-bank financial sector. But the US is not the only country with too low interest rates. In the wider world, current rates of interest will not slow the growth of the world economy.

Discussion and policy response
Monetarist relationships hold for the OECD in aggregate, but there is weaker evidence for the UK
David B Smith said the there was quite strong evidence that the OECD area as a whole acted rather like a traditional monetarist closed-economy model and that the OECD price level co-integrated with the ratio of OECD broad money to GDP, just as the quantity theory would predict. However, the same does not seem to apply to the UK considered in isolation, where there was no evidence that retail prices co-integrated with output-corrected M4 broad money. He said that the statistical evidence suggested that UK price level reflects overseas prices as converted by the sterling exchange rate in the long run. This is consistent with the international monetary approach, as should perhaps be expected given the openness of the British economy, but it did suggest that Britain’s improved inflation performance in recent years probably had more to do with the benign world inflation background than it had to do with the successful operations of the MPC.

False parallels with the 1970s
Patrick Minford said that he disagreed with the analysis and said that the issue today is if inflation is seriously picking up or not. The situation today is not like the 70s where there was loss of control of the monetary environment. Fluctuations in inflation today are not symptomatic of rising inflation.

Clarification on inflation
Anne Sibert asked for clarification how it can be inferred that the recent rise in inflation is not a signal of a permanent rise. Patrick Minford said that the rise in inflation can be explained by real factors. There has been no movement in the underlying rate of inflation in any major economy.

Role of money
Tim Congdon asked for clarification as to what is the role of money in Patrick Minford’s economic model?
Money supply is endogenous and passive
Patrick Minford said that under an inflation-targeting rule, the money supply is endogenous. This is different from a money supply targeting rule. The anchoring of inflation is based on the credibility of the inflation target rule. This is an expectations-equilibrium. He called it the ‘club-in-the closet’ model. The markets know that the central bank would not hesitate to use the interest rate ‘club’ if there was any sign of an upturn in inflation and therefore any rise in inflation above the target is interpreted as a temporary blip. The credibility of the central bank is evidenced on the wage figures. Philip Booth and Andrew Lilico objected that the central bank must act so as to validate the expectations of private sector agents. Andrew Lilico argued that the club-in-the-closet approach would lead to an undesirable two-state equilibrium, in which expectations only moved (and hence the central bank only acted) when the central bank was impotent to achieve its target.

Validation of central bank credibility
Anne Sibert asked how these market beliefs can be validated. Kent Matthews said that these beliefs can only be validated and credibility be maintained if the central bank shows that it will make a small rise in interest rates for the slightest rise in inflation above the target. Andrew Lilico said that the central bank may find that it is prudent to make a small rise in rates early as opposed to a stronger rise later. He said that an inflation target rule does not mean that money has no information content.

Has the demand for money risen?
Kent Matthews asked Tim Congdon whether the increase in financial institutions money holdings could not be voluntary. Tim Congdon explained that – like all agents - non-bank financial institutions have an equilibrium level of money holdings, given certain values of asset and goods prices. Fund managers cannot anticipate large takeover announcements. The effect of a burst of takeover activity is to inject unexpected, involuntary money holdings into their portfolios. Each individual manager may then try to get rid of the excess money, but – taking all funds and fund managers together – they cannot do so, as they are buying and selling amongst themselves. Equilibrium is restored by share prices rising. But a further round of effects then follows, because a jump in share prices puts them out of line with other asset prices. For wealthy people London housing equity is an important alternative to UK and foreign stocks. So a rise in share prices is followed – very often – by inflation in London house prices. But there are also equilibrium relationships between London and regional house prices, and eventually all asset prices are affected by the rise in money balances that began with bank finance for M & A activity. In the final analysis there are – of course – also equilibrium relationships between asset prices on the one hand and incomes and goods prices on the other.

Individual votes
Disappointing June inflation data
David B Smith first drew attention to the disappointing June inflation figured that had been published on the morning of the SMPC meeting and then asked the members of the committee to vote on a rate recommendation.

Comment by Professor Philip Booth
(Cass Business School and Institute for Economic Affairs)
Vote: Raise by ¼%
Raise rates to maintain credibility
Philip Booth said that an independent central bank has worked in keeping inflation low. But the central bank has to act to keep its credibility. He voted to raise interest rates by ¼% with a bias to a further rise.

Comment by Professor Tim Congdon
(Visiting Fellow, London School of Economics)
Vote: Raise by ¼%
Raise with bias to raise again
Tim Congdon said that the high rate of broad money growth is associated with asset price inflation. Current RPI inflation is 2.9% and CPI inflation is at 2.5%. A lot of the numbers are about oil prices but the continued growth in broad money warrants a ¼% rise in rates now with a bias to a further rise.

Comment by John Greenwood (Chief Economist, AMVESCAP)
Vote: No change
Uncertainties justify a hold for time being
John Greenwood said that the economy was on the borderline of requiring a rate hike, but there was enough doubt about the strength of economic activity (e.g. corporate investment and household spending had strengthened but wage increases were subdued) and inflation (e.g. headline prices were above target but core inflation was still well below target) that he did not see the need to raise interest rates immediately. He expressed a bias favouring a rate hike by ¼% at some point in the not-too-distant future.

Comment by Dr Andrew Lilico (Europe Economics)
Vote: Hold
Hold with bias to raise
Andrew Lilico said that there were grounds for caution and he voted to keep interest rates on hold with a bias to a rise. He added that he thought that, although raising rates in response to the 2.5% CPI inflation just out would constitute an over-reaction to one month's figures, statistical developments should be monitored very closely, and that he might contemplate a rise as soon as next month.

Comment by Professor Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise by ¼%
Games theory approach is not inconsistent with higher rates
Kent Matthews said that on Patrick Minford’s reasoning there should be a rise in interest rates. Patrick Minford has explained his reasoning as a cooperative equilibrium but a dynamic game is more appropriate where the central bank asserts its position as the ‘leader’ in the game by raising rates a little before a change in expectations forces their hand. He also agreed with Andrew Lilico that there was information content in the money supply figures. If Patrick Minford is right a small rise in rates will secure another longish period of inflation stability. He voted to raise interest rates by ¼% with no bias to further rises.

Comment by Professor Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Wage inflation subdued
Patrick Minford said that there was no flicker in the key indicators such as wage growth. Relative price effects will raise inflation above target. However the Bank for International Settlements and others have signalled nervousness about pass through issues. He said there was sufficient nervousness around to keep things as they are and he voted to keep rates on hold.

Comment by Professor Anne Sibert (Birkbeck College)
Vote: Raise by ¼%
Anne Sibert favoured a rate increase. CPI inflation was 2.5% in June, well above target and as high as it has been since 1997. Significant wage growth may have been inhibited by migration and increased participation. Oil prices reached a record $78.40 a barrel on 14 July. The Middle East conflict, the stalemate over the Iranian nuclear power and fears of bad US hurricane season suggest the possibility of future oil price rises.

Comment by David B Smith
(University of Derby)
Vote: Raise by ¼%
Higher overseas rates could oblige MPC to follow, or risk a run on sterling
David B Smith that it looks like the ECB is going to raise rates in early August and there is the issue of how far the MPC can resist the world environment of rising interest rates before it endangered a run on sterling. Referring to Patrick Minford’s earlier comments, he said that in the 1950s and 1960s inflation expectations were also weak, in part because many people still remembered the falling prices of the inter-war period. This gave the authorities a highly favourable inflation/output trade off initially, but this deteriorated as people came to realise that the fiscal and monetary policies actually being pursued were objectively inconsistent with stable inflation. The story today is similar, people have not yet cottoned on to the full laxity of fiscal and monetary policy because of the brilliant public relations campaigns waged by central banks but there is an increasing risk that they will do so. The other concern is that rising unemployment may be the result of increased labour-market regulation. The minimum wage in particular has probably now reached the point where it is a serious threat to the employability of less productive workers in the cheaper part of the country. In the light of the recent monetary and inflation data, he voted for a ¼% rise immediately. However, he was sufficiently concerned by rising joblessness - and the possible effects of the deteriorating geo-political situation on financial and business confidence - to have a bias to hold for a period thereafter.

Votes in Absentia
Written submission
The SMPC sometimes allows a small number of votes to be cast in absentia and adds their written submissions to the record of the meeting, particularly where it avoids the possibility of a tied vote. On this occasion only one vote was cast in absentia since eight people were present at the physical meeting.

Comment by Peter J Warburton (Director, Economic Perspectives Ltd)
Vote: Hold at 4½%
Weak service output suggests slower growth in 2006 Q2
On 21 July, official statistics were released for the UK services sector showing a slippage in the 3-monthly growth rate from 1.1% in January to 0.7% in May. Separately, industrial production slowed from a 0.8% quarterly pace in Q1 to just 0.2% in April and May. On this basis, the growth rate for Q2 seems to be heading for around 0.6% rather than the 0.8% estimated for Q1 in the provisional GDP release. The popular portrayal of the UK economy as regaining momentum seems to be curiously at odds with the data, given the known distortions of the World Cup.

More on services
Considering the new, and partially experimental, services data in more detail, 14 of the 21 sub-sectors accounting for 58% of services output, are growing less vigorously than in January. Of the seven sub-sectors that are growing faster than in January, four (education, human health and social work, air transport and private households with employees) show only a trivial improvement. Real estate services are the clear winner in the growth stakes, although transaction volumes have cooled more recently. Other business activities have prospered, as has financial intermediation, yet both are likely to have suffered from the setbacks in equity markets during May and early June.

Industry and trade
After the mini-revival in UK production of consumer durables and capital goods ahead of the World Cup, there is a clear bias to anti-climax in the industrial production data. This can be observed also in the trends of exports and imports with non-EU countries (where the missing trader VAT fraud is presumably negligible). Export volume growth to non-EU countries has ground to a halt in the past six months, while imports have remained buoyant. The bilateral surplus in visible goods with the US – the only one of any size – has declined from £800m per month to £500m per month in the past year.

US developments will have a major impact on Britain
In conclusion, the outlook for the domestic economy remains fragile and highly dependent on the evolution of the US economy, US financial markets and on the path of global real bond yields. A US economic deceleration appears to be unfolding and its likely impact will be deflationary for the UK. Further increases in unemployment and subdued increases in average earnings support the case for holding UK REPO rate at 4.5% for the time being. Conditional on this reading of external events, the pendulum will swing towards the need for a small cut in the rate later in the year or early in 2007.

Policy Response
1. On a vote of 5 to 4, the physical meeting of the SMPC agreed that interest rates should rise immediately by ¼%.
2. Two of the members who voted for a ¼% rise did so with a bias to further rises.
3. Two members who voted to hold had a bias to raise rates in the future.
4. Two of the members who had voted to raise rates immediately by ¼% had a bias to hold subsequently.


The obviously hadn't read your article below 'Time for steady nerves on rates'.

Posted by: Werewolves at July 30, 2006 11:26 AM
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