Sunday, October 01, 2006
Shadow MPC votes for October rate hike
Posted by David Smith at 10:59 AM
Category: Independently-submitted research

The results of the most recent Shadow Monetary Policy Committee (SMPC) monthly E-Mail Poll (carried out in conjunction with the Sunday Times) are set out below. The rate recommendations are made with respect to the Bank of England’s decision with respect to the official Bank Rate paid on commercial bank reserves to be announced on Thursday 5 October.

On this occasion, six SMPC members voted to raise Bank rate by ¼%, while three voted for a hold, and nobody voted for a reduction. Looking further ahead, one of the holds believed that, while a rise was needed, it made sense for the MPC to wait until November, when a new set of Inflation Report forecasts would be available. However, there was also a view that the MPC might have to reverse its avowed tightening policy early next year.

The SMPC itself is a group of independent economists drawn from academia, the financial sector and elsewhere, who assemble 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. That it is the first such body in the UK (having been inspired originally by the US Shadow FOMC, which was founded in the early 1970s) and that it meets regularly to discuss the deeper intellectual issues involved, help distinguish the IEA’s SMPC from the similar exercises now carried out by a number of publications. A deeper examination of the monetary policy issues than is possible in these monthly documents can be found in the book Issues in Monetary Policy: The Relationship Between Money and Financial Markets, edited by Kent Matthews and Philip Booth (John Wiley and Sons Ltd., in association with the IEA).

The material that follows appears with the permission of the original authors and has not been amended by Lombard Street Research, which has been disseminating the SMPC’s deliberations since August. The next IEA gathering is scheduled for Tuesday 17 October. The minutes of that meeting will be published on Sunday 5 November, while the final SMPC E-mail poll for calendar 2006 will be released on Sunday 3 December.

Comment by John Greenwood
(Chief Economist, AMVESCAP)
Vote: Raise by ¼%

The UK economy has continued on a buoyant course through the summer. Manufacturing orders have been on an upward trend since August last year, and service sector activity is showing no signs of slackening. Retail sales volumes have fully recovered from their temporary bout of weakness in 2004-05, increasing 4.3% year-on-year in August, up from 0.6% in September 2005. On a 3-month moving average basis all-economy nominal wage growth was 4.4% in July. Although these growth rates are well within normal bounds, and may therefore imply no reason for concern, developments in the asset markets and in the monetary sector are much less reassuring.

Over the past year equity prices are up about 12-13%, and house prices are showing a renewed upward spurt. The Halifax house price index increased 8.1% over the year to August (up from 2.3% in July 2005), while the Rightmove index of asking prices for homes rose 9.8% in the year to September. Underlying these strong upward moves in asset prices are sustained rapid growth rates in the broad measures of money and credit. For example, M4 has accelerated to 13.7% in the year to August (up from 6.3% in August 2003), with wholesale deposits up 24.5% in the year to July. Bank and building society lending has also accelerated from 9.9% in January this year to 14.7% in August. Finally, in August alone BBA mortgage lending to individuals increased by £6.2bn, a new monthly record.

While personal sector measures such as retail deposits (up 7.4% in July) have lagged the broader measures, M0 has nearly doubled its growth rate over the past year, accelerating from 3.8% in June 2005 to 7.5% in August 2006.

The Bank of England’s MPC has correctly shown concern about CPI prices rising above targeted levels, particularly in their forecasts of sustained rises in the CPI. In contrast to the situation just a year or two ago, today both goods and service prices are accelerating. For example, using the formerly targeted RPIX measure of inflation, goods price inflation has increased from zero in early 2005 to 1.8% in August, and service price inflation has risen from 2.9% in January 2004 to 5.1% in August 2005. There is a growing risk that the rises in money and credit growth and hence asset prices will in time percolate though to the CPI. Rising inflation cannot be solely attributed to energy prices.

Comment by Dr Ruth Lea
(Director, Centre for Policy Studies, and Non-Executive Director of Arbuthnot Banking Group)
Vote: Raise by ¼%

The real numbers suggest that the economy is continuing to progress firmly. GDP grew by an above trend 0.8% in the second quarter of 2006. Growth was driven by a robust 1% increase in household consumption, arguably boosted by World Cup related expenditure. Investment also picked up strongly in the quarter. This evidence, along with continued resilience on the housing market and strong credit growth, suggest that GDP growth could exceed the Chancellor’s Budget forecast of 2% to 2½% for the year as a whole – as indeed the Bank of England now expects.

Large scale immigration – not least from Eastern Europe since the last enlargement in May 2004 – has undoubtedly added to growth in both 2005 and 2006 and contributed favourably to the control of earnings inflation. But, withprices inflation continuing to run ahead of the Bank’s 2% central target (CPI inflation is currently running at around 2½%, reflecting higher fuel and utility bills) and increased public expectations of higher inflation (including those reported by recent BoE surveys), there is now an increased risk of higher pay demands and a pick-up in earnings inflation. This is despite the rise in unemployment.

On balance the economic data support the view that the next move in interest rates should be up. The widespread market expectation is for an increase in November at the time of the Bank’s next Quarterly Inflation Report. But there is little economic justification to hold the move back. Rates should be increased by ¼% in October.

Comment by Dr Andrew Lilico
(Europe Economics)
Vote: Raise by ¼%

Consumer price inflation was back to 2.5% in August, the third month in a row at which it has been markedly above target. Annual M4 growth was up to 13.7% in August, whilst after experiencing an unsurprising slight dip in the latter part of August, narrow money growth has picked up in September. In short, monetary growth is still very rapid, and monetary policy is still very accommodative in a period in which inflation is significantly above target and may threaten the upper threshold later in the year. This suggests that a rise will at some point become necessary.

On the other side, although unemployment has increased by 0.8% over the past year, it has done so from an extremely low base in a period of considerable worker immigration - this should not be a concern at this stage. Average earnings rose 4.4% in July, and again are not a significant worry at this stage. House price inflation rose 0.2% in the three months to August on the Halifax measure, and prices do not appear under imminent threat. August output price inflation for manufactured products was at 2.6%, with input price inflation falling and expected to fall further - driven by the main negative factor for prices: oil prices falling to under $60/barrel. The falling oil price and the risk of deterioration in the US driven by fears over the housing market there appear to be the main factors speaking against raising interest rates now - apart from the MPC's habit of changing interest rates mainly at the time of quarterly inflation reports (which does not really seem a legitimate consideration under the UK inflation targeting regime).

Overall, then the conclusion is this: unless matters are overtaken by events that are at this stage speculative at best (such as considerable further falls in oil prices or a collapse in the US housing market) interest rates must rise; there is little economic case for waiting - the case for waiting depending on a habit of the MPC's that falls outside the monetary policymaking framework. Rates should rise now, giving us additional scope to cut rates if some of the negative scenarios actually transpire.

Comment by Professor Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold

Those who argue that the recent interest rate hike by the Bank of England must be followed by another one in quick succession to calm asset markets are implicitly assuming that market expectations are backward looking. Arguments that the markets are already expecting a further rise in rates and therefore must be validated are not convincing. The markets are anticipating the reaction of the MPC in the next few months, which is not the same as market expectations of inflation in the medium term. The reaction of the MPC in August was correct and has confirmed that the Bank will act to restore credibility when it needs to. Admittedly, broad money growth remains uncomfortably high and we should expect to see some moderation in the growth in money and credit as the economy responds to the Bank interest rate signal. However, long-term indicators do not suggest that expectations of inflation have picked up and neither do wage settlements. Let the economy get used to the August rise.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Raise by ¼%

Buoyant monetary has continued and such growth almost invariably leads in due course to higher inflation. The recent fall in the price of oil is a reduction in the price of just one good. Inflation is an increase in prices in general. Rises in the prices of other goods are likely to more than offset. Interest rates are too low and should be raised.

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

The UK economy continues to operate at about full capacity. The favourable supply shock represented by the immigration of about half a million mostly skilled workers from central and Eastern Europe is unlikely to be repeated. The increase in the overall tax burden resulting from a six-percentage point increase in public spending as a share of GDP since 2000 is likely to have increasingly negative effects. CPI inflation is 2.5%. Earnings, including bonuses, are growing at over 5%. Despite the recent weakening of oil prices CPI inflation is likely to remain over 2% for the foreseeable future. Interest rates should be increased by 25 basis points.

Comment by Peter Spencer
(University of York)
Vote: Raise by ¼%

Monetary policy remains lax. Although the base rate was increased to 4¾% in August, it is surely below the natural rate. My latest estimate of the trend in productive potential, which takes into account the growth of the labour force through increased participation and immigration, suggest that this could be as high as 3%. Adding in the 2¾% rate of GDP price inflation that is consistent with the 2% CPI target suggests that interest rates could be as much as a percentage point below the natural rate. I am not suggesting that interest rates need to be raised by as much as this, especially with households so laden with debt, but this sort of calculation provides an indication of the direction in which they need to go.

This expansionary monetary policy is clearly working through the asset markets into the real economy. The growth in M4 has accelerated to 13.7% pa in recent months, supported by private sector borrowing. The housing market is remarkably buoyant and this is clearly reflected in the pick-up in retail activity. Although unsecured borrowing remains subdued, mortgage borrowing has bounced back strongly. Equity markets are moving ahead again. Even the manufacturing sector has picked up. Business surveys have moved off their highs in response to the higher exchange rate, and perhaps worries about the US market, but remain positive.

Inflation has also picked up again, but this appears to reflect the impact of higher energy and commodity prices rather than domestic influences. So far, wage inflation has remained surprisingly subdued, reflecting confidence in the MPC’s ability to hold the line as well as the effect of inward migration. There is a good chance that falling oil and gas prices could produce better CPI figures this winter. Nevertheless, interest rates must be raised to bring the monetary aggregates and asset markets to heel, before the expansion threatens public confidence in the inflation target.

There seems little reason to delay the next increase until November. The increase in August apparently reduced consumer confidence but seems to have had little effect in the housing market and the high street. The markets are prepared for another rise, so the effect on the pound should be minimal. I would increase base rate by another quarter point in October.

Comment by David B Smith
(University of Derby)
Vote: Hold

There appear to be two intellectual frameworks that can be applied to the setting of the official REPO rate in a large closed economy such as the US or the Euro-zone. Firstly, there is the Conventional Theoretical Macroeconomic Model (CTMM) which concentrates on the real REPO rate, defined as the nominal REPO rate less anticipated inflation, as the ultimate determinant of inflation, operating via the pressure of demand as represented by the output gap. The second approach emphasises the need for the growth in the stock of broad money to be in equilibrium with the increase in the demand for money at the officially desired rate of change of the price level. Both theories need to be modified in the context of a small open economy, such as Britain’s, and it was suggested in last month’s SMPC contribution that there was a trade off between higher official interest rates overseas and increased rates at home. This is because a more aggressive monetary stance in, say, the US would reduce inflationary pressures in Britain, because of its impact on global inflation trends that then rapidly feed back into the UK because it is such an open economy.

One problem with the CTMM and its emphasis on the natural real rate of interest is that the observed real rate of interest has been all over the place in practice, and even taking decade-long averages, for example, does not eliminate this volatility. Thus, if one takes the UK three-month inter-bank rate less the annual increase in the ‘double-core’ retail price index excluding mortgage interest rates and house price depreciation over the period 1956 Q1 to 2006 Q2, the mean real rate is 2.33% but the maximum is 9.03%, the minimum is minus 16.56%, and the standard deviation is 3.94%. Unfortunately, it is not possible to perform such a long analysis using the CPI, but CPI inflation over the period 1977 Q1 to 2006 Q2 was 0.52 percentage points less than ‘double-core’ RPI inflation, which also excludes house price effects. This suggests that the mean CPI defined three-month interest rate over the past half-century has been around 2.85%, with a range of minus 16% to 9.55%. With CPI inflation at 2.5% in the year to August, and ‘double-core’ RPI inflation 3.2%, such calculations suggest that an official Bank rate of close to 5½% is needed to achieve a neutral real rate of interest if present inflation rates were to be sustained indefinitely. However, this number is subject to the large volatility associated with the real rate in the past.

The sustained rapid growth of the UK broad money and credit aggregates has been a subject of concern for some time, and the British economy is certainly not showing signs of inadequate demand anywhere other than in the unemployment figures. However, rising unemployment could well reflect the impact of increased labour market regulation and the increased minimum wage in pricing out from employment the less productive workers in the cheaper parts of the country, rather than an inadequate level of effective demand. Overall, there now seems to be a strong case for a further ¼% hike in the official Bank rate paid on commercial bank reserves, and the main uncertainty is whether this should happen on 5 October or 9 November, when the MPC will have a new set of Inflation Report forecasts available to it. On the basis that a better-informed decision is likely to prove superior to a less well informed one, and that there are long lags between base rates and CPI inflation, there seems to be a reasonable case for holding in October but raising in November, unless subsequent developments strongly argue otherwise.

Comment by Dr Peter J Warburton
(Director, Economic Perspectives Ltd)
Vote: Hold

The rise in the REPO rate to 4.75% in August was more a reflection of the inadequacy of the existing policy framework, than a reasoned response to a genuine inflationary threat. The MPC lacks an effective instrument of control over the wild expansion of bank lending to OFCs (other financial companies). With annual growth rates in financial company borrowings reaching almost 30% in the summer months, all manner of special purpose vehicles and private equity firms have received support. Property assets have been bid up to extraordinary heights, providing collateral for other business purchases.

This activity stands a world apart from the economic mainstream, where producer pricing remains tight and order books indifferent. The task of setting interest rates appropriate to the mainstream private sector economy – where current interest rates equate to a real rate of over 3% - and to the devil-may-care financial sector presents an insoluble problem. While the MPC has the comfort of official GDP estimates showing a 0.8% quarterly gain, the financial and property sectors are significantly over-represented in this performance.

The MPC’s chosen strategy is to increase the pressure on the mainstream economy, and particularly on embattled consumers. While this can be expected to reduce pricing pressures in some contexts, it fails to address the parallel risk of an abrupt reversal in the fortunes of the financial and property sectors. In conjunction with the deepening threat posed by US economic deceleration, the MPC faces the prospect of having to reverse its avowed tightening early next year. The credibility of further interest rate increases must be called into question.

With oil and gas prices looking to be subdued in the remaining months of this year, the probability of the CPI breaking its 3% threshold is diminished. Not that the 3% level carries any great economic significance. My vote is to hold interest rates in October.


I think Professor Kent Matthews is spot on with his analysis. I am not at the moment persuaded that a further interest rate rise in November is imminent. Whilst I acknowledge that inflation is uncomfortably high and the growth of broad money is a worry, in my opinion this is due to the tail-end of an inflationary bulge that occurred with the energy price hikes of late last year.

It has also been very noticeable that oil prices have fallen sharply in recent weeks, and Gordon Pepper is wrong to dismiss the significance of this. And, as many commentators have said, wage inflation remains surprisingly subdued. Finally, the effect of the August interest rate rise has yet to be felt so, in the absence of any significant inflationary threats, it's my belief that the BoE will wish to keep interest rates on hold for the foreseeable future.

Posted by: Chris Ashley at October 1, 2006 04:52 PM

Base rate is sensitive to Real GDP growing more or less than 0.625% for each quarter.
I would like to read the reports from your own shadow MPC.
Foreign central banks are holding huge quantities of US$s.US M0,M1 and M2,broad money has been growing very fast since before 2000.So,its best if all currencies free float,especially the USD.I especially like what Gordon Pepper and Tim Congdon have to say.

Posted by: Derek Wildman at December 15, 2006 02:28 PM