Sunday, December 03, 2006
Shadow MPC votes 7-2 to hold Bank rate
Posted by David Smith at 10:59 AM
Category: Independently-submitted research

The results of the latest 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 concerning the official Bank rate paid on commercial bank reserves to be announced on Thursday 7 December.

On this occasion, seven SMPC members voted to hold Bank rate at the 5% rate announced on 9 November, two voted for a further ¼% increase, and nobody voted for a cut. Looking further ahead, four of the holds believed that, while a rise was needed, it made sense for the MPC to wait until either next month or February 2007, when a new set of Inflation Report forecasts would be available.

However, two of the SMPC members who voted for a hold in December believed that the next move in the official Bank rate should be downwards, with the remainder having a neutral bias.

Comment by Roger Bootle
(Economic Adviser, Deloitte)
Vote: Raise by ¼%

I think that it will be necessary to raise interest rates again to bring inflation down to the target. A sharp economic slowdown in the US should also bring a slowdown in the UK next year but this cannot be presumed to bring much of a reduction in inflation without further policy tightening. The experience of the 1990s was that economies could reflate, with falling unemployment, and yet experience scarcely any increase in inflation. But the converse may also be true. (This is the idea of the flat Phillips Curve.) With asset markets rampant and monetary growth strong there is an asymmetry in the risks facing policy-makers. It is vitally important that inflationary expectations be contained. I would vote for an immediate ¼% increase in interest rates - although I expect the MPC to wait until the next Inflation Report in February.

Comment by John Greenwood
(Chief Economist, AMVESCAP)
Vote: Hold

After the disappointing 1.8% real GDP growth rate recorded in 2005, the economy has shown steadily improving performance during 2006. Real GDP has climbed to and remained constant at 0.7% quarter-on-quarter for the past four quarters, reaching 2.7% year-on-year in 2006 Q3. A revival in business investment spending and stronger consumer spending both contributed to the resumption of faster growth. The renewed upswing in the housing market has boosted household spending plans, and the simultaneous upswing in the stock market has added another element to the general level of consumer and business confidence. These trends are consistent with the double-digit growth of money and bank credit over the past two years – probably due to interest rates being below the levels appropriate for stable growth with sustained low inflation.

Inflation in the UK is subject to somewhat more uncertainty than usual due to the 14.0% growth of M4 money supply over the year to October, the strong upturn in equities, and the 8% rise in house prices, together with stronger economic activity in Europe on the one side, counterbalanced by restrained wage increases, higher unemployment, and an appreciation in the pound on the other. In its November inflation report, the Bank of England again indicated that the CPI was likely to exceed their 2% target over the near term before falling back to the 2% target over the two-year forecast period. I expect inflation to remain above the Bank’s forecast levels in 2007. To keep inflationary pressures contained it is likely that the Bank will need to raise rates again during the next six months, and my current bias would be to raise rates by ¼% in February 2007.

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

The real numbers continue to show that the economy is continuing to progress firmly. GDP grew at about its trend of 0.7% in the third quarter of 2006. Household expenditure growth was a modest 0.4% in the quarter and the balance on goods and services acted as a negative factor, but general government consumption was 1.0% higher and gross fixed capital formation grew by 2.3%. This evidence, along with continued resilience in the housing market and strong credit growth, suggest that GDP growth is likely to be at least 2½% for the year as a whole.

Large scale immigration – not least of all 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, as the Governor of the Bank has commented, the data on net immigration leave much to be desired. And it is, therefore, currently more than usually difficult to estimate the size of the output gap (a slippery concept at the best of times) and hence the correct response on interest rates.

But, with prices inflation continuing to run ahead of the Bank’s 2% central target (CPI inflation is currently running at around 2½%) and increased public expectations of higher inflation, there is an increased risk of higher pay demands and a pick-up in earnings inflation. This is despite the pick up in unemployment. The forthcoming round of pay settlements is crucial to inflationary developments.

On balance the economic data support the view that the next move in interest rates should be up. But there is no urgency for another rise in the wake of November’s increase to 5.0%. Rates should be unchanged in December.

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

Broad money is still growing at some 14% and inflation is above target at 2.4% and projected to rise further, staying above target until mid-2007. On the other hand, there is limited evidence that real economy factors are likely to be substantially negative. The main downside risks appear to be further falls in oil prices and the risk of a significant slowdown in the US. But with inflation comfortably above target at the moment there should be ample scope to cut rates later if these scenarios arise.

My vote is to raise rates to 5.25%, then hold there for a time to see the effect on money growth. If money growth slows, as it might, 5.25% may be high enough.

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

‘The lags are long and variable’ is a saying attributed to the late Milton Friedman. Professor Friedman was a strong advocate of the role of broad money in determining economic activity but he never believed that the link was mechanistic, one-way, or consistent. With central banks all over the world targeting inflation, monitoring the money supply has become pretty much a sideshow. However Friedman would counsel us (as he did in his regular Wall Street Journal column published a day after his death) that to ignore the money supply would be a serious mistake. Even in a world where central banks use the rate of interest to influence inflation expectations, the money supply has information content and the money supply continue to grow in double-digit figures. But the lags are long and variable. Having bared its teeth with last month’s rise in the rate of interest, the MPC should pause to allow the economy time to respond.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold

As widely expected the Bank raised the interest rate at its last meeting to 5%. I have argued in the past that the Bank needs to maintain its credibility since it is this that is the mechanism by which inflation is kept low. To some extent the Bank therefore has to respond to a wide perception that inflation might increase. However, as the Bank's latest Inflation Report itself agrees, the prospect is that inflation will remain under control, according to a wide range of indicators. This is manifestly the case, as I have argued in my occasional past contributions to this SMPC poll - whether one looks at implied inflation premia in asset prices, or wage forecasts, or just plain commercial inflation forecasts.

While it may have suited the Bank to refer to the money supply growth rate (M4) on this occasion, it seems to have been a piece of opportunism. M4 velocity wanders around for a variety of reasons to do with liquidity choices by Other Financial Intermediaries (including hedge funds and pension funds). Under inflation targeting as effective as the UK's has been now for over a decade, one has the final luxury of observing velocity pure and simply by looking at money supply growth. The information it this velocity about future inflation is demonstrably nil.

Thus my recommendation now would be that the Bank starts preparing the markets for the next move being downwards in due course. Rates of around
4.5-5% look like a sustainable equilibrium range. Thus I propose a modest bias towards easing with no immediate change.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold.

Last month I voted for a ½ rather than the ¼ percentage point rise that occurred. I did so because it was warranted by the persistent very buoyant monetary growth. The MPC is running the risk of having done too little too late. If it carries on like this rates will continue to rise. It would be better to do enough in time and be able to look forward to rates stabilising. When the time comes for the MPC to decide on another rise, I fear that I will again be voting that it should be ½ rather than a ¼ percentage point. Finally, it should be noted that persistent rises in rates do much more damage than short-lived upward fluctuations even if the latter appear to be erratic.

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

The Chancellor of the Exchequer will be delivering his Pre-Budget Report at 12:30 pm on Wednesday 6 December, the day before the MPC’s decision is announced. Previous practice has been for the MPC to receive an early HM Treasury briefing on the main macroeconomic contents of the Pre-Budget Report and it is unlikely that the contents of the Pre-Budget Report will lead to a different rate outcome than would have occurred otherwise, even if the Chancellor is likely to raise his growth forecasts for 2006 upwards to 2¼-2¾%, from the 2-2½% set out in the Budget. The corollary is that the structural Budget deficit is almost certainly worse than was previously expected. The policy inconsistency between a loose fiscal stance and an appropriately tight monetary one could lead to a serious crowding out of private sector activity, especially in the tradable goods sectors, such as manufacturing. The fact that the cumulated £22.9bn PSNB recorded in April to October 2006 was running well above the £20.6bn recorded in the corresponding period a year earlier, despite stronger than expected growth and buoyant North Sea tax receipts, further suggests that the credibility of fiscal policy is not what it should be. There is a risk that this will cross-infect the credibility of monetary policy, given that it requires a remarkably sophisticated set of private sector economic agents to distinguish between the credibility of the fiscal and the monetary authorities.

The high tax content of UK energy costs means that Britain’s various cost of living indices are less vulnerable in both directions to the vagaries of the oil price than those of many other countries. Even so, it is worrying that between June and October, headline CPI inflation in the Euro-zone dropped from 2.5% to 1.6%, in the US from 4.3% to 1.3%, and in Canada from 2.5% to 0.9%, while the annual increase in the UK CPI only eased from 2.5% to 2.4%, and the old RPIX target measure accelerated from 3.1% to 3.2%, and the all-items RPI accelerated from 3.3% to 3.7%. The stability of UK CPI inflation might be regarded as a tribute to the effectiveness of the MPC in broadly achieving its targets, but it could also be indicating that inflationary pressures are more entrenched in Britain than elsewhere. The UK’s persistent trade deficits may be another sign that the country has a structural excess of home demand over domestically produced supply. Further evidence that the economy may be overheating is provided by the 3.3% year-on-year rise in non-oil market sector gross value added (including rental income from housing) in the year to
2006 Q3, compared with the increases of 2.8% and 3.2% recorded in the first and second quarters, respectively, and 2.4% rise recorded in 2005 as a whole. Non-oil market-sector GVA is a better guide to the behaviour of that part of the economy that can be influenced by monetary policy than total GDP, which rose by 2.7% in the year to the third quarter (2.9% excluding oil and gas).

The present 5% official bank rate may not be too far from a neutral real rate of 2½% or so if current CPI inflation is used as the inflation measure, but could be well below neutral if inflationary expectations are formed differently. For example, if 10% of the population formed their inflation expectations from the ‘excess’ growth of broad money, 40% used the headline RPI, and 50% the CPI, then perceived weighted average inflation would be 3¾% and the present real bank rate only 1¼%. The balance of risks suggests that a further rate rise is necessary, and that the main issue is one of timing. Following November’s ¼% increase it probably makes sense to leave the next rise until the new year, although it may also be appropriate to go in January 2007 rather than wait until the next set of Inflation Report forecasts are available in February. There is a widespread view that the UK bank rate will peak at around 5¼% next year. However, the cash target rate in Australia, where inflation was 3.9% in 2006 Q3 and broad money growth 11.2% in September (compared with 14% in Britain in October) was raised to 6¼% on 8 November, and this may indicate where UK rates are heading, if not in 2007 possibly in 2008.

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

The portrayal of the UK economy in official statistics is disintegrating. It is incoherent: it no longer holds together. As a consequence, the body of statistical evidence, let alone survey evidence, can be held to support diametrically opposite views of the UK economic outlook next year. In these circumstances, the firm growth consensus is extremely vulnerable and the Bank of England’s GDP assumptions are a hostage to fortune.

There are four underlying paradoxes. First, how can the economy be growing at or above its long-term trend when so many households are in financial distress? Second, how can visible exports grow so rapidly when the output of goods is virtually stagnant? Third, how can the balance of payments deficit be so small when the deterioration in the net international investment position is so great? Fourth, why are the public finances in such a poor state if the economy is recording trend growth?

At the heart of many of these incongruities is the emergence of a few hot sectors or activities that confer disproportionate gains on a small percentage of the workforce. The concentration of income growth among those with high marginal tax rates is helpful to the gathering of tax revenue. This enables the public sector to fund an expansion of its activities and to provide additional employment. Slackness of lending standards and greater risk-taking behaviour by the financial sector has bridged the gap between inadequate after-tax incomes and rising consumption. Thus, the explosion of insolvency is likely to be sustained over many years.

The UK economy is extremely vulnerable to a financial sector setback that combines with tighter credit conditions. Not only would the growth contribution from the hot sectors fail, but tax revenues would be severely disrupted. A failure to appreciate the incoherence of economic progress exposes investors to the risk of significant earnings disappointments in 2007 and beyond. The MPC’s enthusiasm for raising interest rates is likely to give way to an urgent reconsideration over the next 6-12 months

* The SMPC 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 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 more profound 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).