Sunday, January 07, 2007
Shadow MPC votes 5-4 for rate hike
Posted by David Smith at 10:59 AM
Category: Thoughts and responses


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 11 January.

On this occasion, four SMPC members voted to raise Bank rate by ¼% on 11 January, one wanted a ½% increase, there were three holds, and one person voted for a cut. The result was an overall 5 to 4 four vote in favour of raising rates immediately in January, while one of the holds had a bias to raise in February, when a new set of Inflation Report forecasts would be available to the MPC, if a rise had not already occurred by then.

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.

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

The evidence is gathering that the inflationary danger is greater than it has been for some time. The real risk is not that it will rise a great deal further but rather with inflation having been above the target persistently this will start to affect inflationary expectations and wage claims. The latest inflation figures showing CPI at 2.7% issued a clear warning. Accordingly I would raise rates immediately – although I recognise that the MPC is much more likely to leave matters until the Inflation Report in February.

Comment by Tim Congdon
(Visiting Fellow, London School of Economics)
Vote: Raise by ¼% in January
Bias: To raise further

Money (on the broadly-defined M4 measure) rose by 0.5% in November, to take the annual growth rate to 13.1%. As usual, financial sector money is proving more volatile than aggregate money and has climbed by almost 30% in the last year. This surge in money balances is the most persuasive explanation for the buoyancy of asset prices in 2006. (Quoted equities have had a good year, but the excesses in this cycle appear to be more marked in private equity and commercial property.) Admittedly, domestic demand has not been as strong as might have been expected, on past relationships between asset prices and demand, and that qualifies the case for alarmism about money supply trends. (But the forecasts of a 2006 slowdown – which were a commonplace a year ago – look unwise in retrospect.)

My view is that the UK economy is now characterised by a serious overhang of excess money balances, and that persistent asset price buoyancy and above-trend demand growth are to be expected in 2007 at current interest rates. The labour market appears to be steady and consistent with an approximately zero output gap. (Unemployment has barely changed in recent months, while pay growth is stable at about 4%.) But changes to redundancy laws and increases in the minimum wage have probably increased the natural rate of unemployment over the last year. So output may be ½% above trend, while demand is likely to grow at an above-trend rate in the next few quarters. With CPI inflation already above target, the case for another rise in base rates is clear-cut. A quick move to 5½% might have the necessary effect of jolting expectations in key asset markets, notably those in residential housing and commercial property. My expectation is that the Bank will adjust rates upwards in ¼% steps and an eventual peak in the 5½% - 6% area is possible.

Comment by John Greenwood
(Chief Economist, AMVESCAP)
Vote: Hold
Bias: Raise rates by 0.25% in February.

Real GDP has been recovering since 2005 Q2, maintaining a steady quarter-to-quarter growth rate of 0.7% for the four quarters 2005 Q4 to 2006 Q3. Following recent revisions in the data, the year-on-year growth rate for 2006 Q3 has been revised up to 2.9%. Also, over the past year nominal GDP growth has accelerated from 3.6% to 6.0%. The upswing in both nominal and real growth has been led by a revival in business investment spending and stronger household expenditure, both encouraged by double-digit increases in equity and property prices. Over the calendar year the FTSE 100 Index increased just over 11% and the FTSE 250 by 27%; commercial properties are up 13.7% (IPD, capital only index), while house prices (according to Nationwide) have risen by 10.5%. The combination of strong asset price increases and moderate levels of interest rates have together generated 12.1% credit growth and 13.1% growth of M4 in the year to November. For an economy already at a mature stage of the business cycle expansion, these growth rates are uncomfortably high. Fortunately most of the growth in lending and most of the addition to money holdings remains in the hands of non-bank financial institutions and industrial and commercial companies, rather than with the household sector. However, inflation risks could rise sharply if these money balances migrate to the household sector (e.g. via wage increases).

Against this background I am forecasting a real GDP growth rate of 2.5% for 2007 as a whole, and CPI inflation at 2.3%, above the mid-point of the Bank of England’s target (2.0%). It has to be acknowledged that restrained wage increases, higher unemployment, and an appreciation in the pound are factors tending to hold down inflation in the short term. However, to keep inflationary pressures contained in the longer term 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: Raise by ¼%
Bias: Then wait and see

The real numbers continue to show that the economy is continuing to progress firmly. GDP growth is likely to have exceeded 2½% in 2006, with the economy ending the year on a firm note. The ONS’s experimental series for the index of services, for example, for the three months to October was 0.9% higher than the previous quarter. The housing market appears in buoyant mood with most forecasters looking for substantial price gains in 2007.

There is now no doubt that large scale immigration – not least of all from Eastern Europe since the last enlargement in May 2004 – has added to the growth of productive potential in recent quarters and has contributed favourably to the control of earnings inflation. Given the latest EU enlargement of Romania and Bulgaria (and despite the Government “restrictions” on immigration from these two countries which are likely to be quite ineffectual) it is likely that sizeable net immigration will continue. But with the acknowledged deficiencies in immigration data, it is impossible to be specific about the size of the overall impact of immigration on the economy.

November’s inflation report was disappointing with the year-on-year CPI increase, at 2.7%, well above the Bank’s 2% central target. RPI inflation, a more relevant measure when considering the knock-on effects of prices inflation on wage settlements, was nearly 4%. With January to April normally the biggest months for pay settlements, it is more than understandable that the Bank has said that it will be keeping a close eye on pay deals over the next few months.

On balance the economic data support the view that the next move in interest rates should be up. Given the pick up in prices inflation, the risk of higher pay settlements and the buoyant asset prices there is now little reason to delay the increase. Rates should be increased to 5.25% in January.

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

I would vote strongly to hold. The rise in rates will have influenced expectations by aiding the restoration of the credibility of the Bank's anti-inflation policy. However, the effect of expectations on the monetary aggregates through the demand for bank and building society credit will take longer to be observed. The simple matter is that the monetary aggregates reflect decisions that
have already been made and are in the pipeline. Therefore we should not be too alarmed with the numbers for the growth of broad money at this stage. Similarly, a too early a cut in rates will send out entirely the wrong signal that the Bank is not serious in controlling long-term inflation.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: Towards further reductions

There is now a hue and cry to raise rates. However, rates are already high in real terms - well above long term index-linked gilts for example, even US ones (assuming, as I would, that UK ones have been driven down by absurd UK regulation of pension funds' stock composition). There is a lot of talk about 'wages holding the line'; however there is no evidence that wages are accelerating. Wage growth has been impressively static around 4% for years on end which fits very well with the idea that expected inflation has been consistently about 2% while expected productivity growth has been about the same.

Since 1992 I have enjoyed several episodes like this, where the worry brigade have foreseen a 'wage explosion'- sometimes backing it up with numbers for money growth, sometimes with 'bubbles', sometimes with concern about the GDP gap. On all occasions, looking back now, I see that they missed the key point about regime change. Inflation targeting works a bit like the gold standard (had the gold standard been related to inflation rather than the price level of gold); whatever happens to the velocity of money the rate of inflation is pinned down. This in turn gets embedded into expectations. Now is the time to move rates down again. Enough has been done to head off any concerns about credibility that might reasonably have existed. I suggest a quarter point cut.

For forecasts, my view is that we again face prospects of growth and inflation both of around 2%; with interest rates having now peaked; the current account will continue in deficit at around 3% of GDP, with a similar public sector borrowing requirement.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Raise by ½%in January
Bias: Then ‘wait and see’

The Governor of the Bank of England, Mervyn King, is an enthusiastic follower of football and has described what he calls ‘The Maradona theory of interest rates’. Maradona was the great Argentine footballer who scored two goals in the match against England in the 1986 World Cup. In the second he beat five English players by running in a straight line when they expected him to swerve either to the right or to the left. The Governor argued:

‘Monetary policy works in a similar way. Market interest rates react to what the central bank is expected to do. In recent years the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official rates. They headed in a straight line for their goals. How was that possible? Because financial markets did not expect interest rates to remain constant. They expected that rates would move either up or down. Those expectations were sufficient – at times – to stabilise private spending while official rates in fact moved very little’.

The Governor went on to argue that managing expectations was fundamental to monetary policy. Here is another football analogy. Managing expectations is similar to managing football fans. A football manager has no trouble at all in managing the fans if his club keeps on winning. If the side starts to lose managing the fans becomes far more difficult. The message to the Governor is to make sure that he keeps on winning. He must get a step ahead of the game and not trail behind. This is the case for a ½% rise in interest rates.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise by ¼%
Bias: Further tightening likely to be required

The New Year is traditionally a time for looking ahead and it seems sensible to briefly review the latest projections for 2007 and 2008 generated by the Beacon Economic Forecasting (BEF) macroeconomic model. These employ the raft of official statistics for 2006 Q3 published just before Christmas and the 2006 Q4 outcomes for financial-market prices. The result is that UK GDP is expected to follow 2006's annual average increase of 2.7%, with rises of 2.5% in 2007,and 2.3% in 2008. This is slower than the projected growth rate for the OECD area as a whole of 3.2% in both 2006 and 2007, and 3.0% in 2008, reflecting the tax and regulatory induced sclerosis of the supply side of the British economy.

Inflation prospects clearly depend on the price of oil in the short term (a figure of US$62.5 per barrel of Brent Crude in 2007, rising to US$63 in 2008, has been assumed, compared with US$66.0 in 2006). UK CPI inflation is expected to average 2.4% in 2007, and 1.8% in 2008. Equivalent figures for RPIX would be 3.1% in 2007, and 2.5% in 2008. The smaller basket of goods in the CPI means that it is more sensitive to energy costs, and this explains why it may give a misleadingly optimistic indication of progress against core inflation. OECD inflation is expected to average 2.1% in 2007 and 2.0% in 2008, compared with 2.5% last year.

One factor making for lower British inflation is that that the growth of UK M4 is expected to slow from an annual average of 13.4% in 2006, to 11.7% in 2007, and 7.2% in 2008. The UK is now a global outlier where monetary growth is concerned. OECD broad money went up by a modest 5.9% last year, and is expected to rise by 5.1% this year, and 4.8% in 2008, Rapid monetary growth in Britain has buoyed asset prices, stimulated private home demand, and boosted tax receipts, but poses a long-term threat to sterling, which may be an accident waiting to happen if overseas central banks stop intervening to hold down their currencies. Apart from sterling, the other main monetary danger is that the re-entry from the UK's money and credit boom will be abrupt, and accompanied by rising bad and doubtful debts, credit rationing by the lending institutions, a private sector recession and a ballooning fiscal deficit.

This suggests that the MPC will be batting on a sticky wicket over the next few years. Base rates are expected to end 2007 at 5¾%, and rise to 6-6¼% at their peak in mid 2008, but ease thereafter. Australia, which has had similar monetary growth to the UK, introduced a cash target rate of 6.25% on
8 November, broadly in line with the predicted UK peak. The main reason why the MPC will raise rate is likely to be a weakening of sterling, particularly if foreign central banks stop buying it for their reserves. House prices have enough monetary push behind them to go up by 5.1% 'through' 2007 (DCLG index, Q4 to Q4) and 1.9% through 2008 but are expected to decline in 2009.

One problem facing the monetary authorities is that fiscal policy is damaging the supply side, showing unwarranted deficits at the sweet spot of the business cycle, and rapidly losing plausibility. The latter could cross infect the MPC’s credibility, if people are not prepared to make fine three-way distinctions between the credibility of politicians, the fiscal authorities, and the Bank. The PSNCR is expected to be £41.1bn in 2006-07, £40.3bn in 2007-08, and £47.8bn in 2008-09, despite fiscal drag raising the tax/GDP ratio. Britain’s other twin deficit, that on the balance of payments is expected to rise from £34.3bn in 2006, to £40.2bn in 2007, and £59.9bn in 2008, before easing in 2009. This could give rise to credibility issues in the FOREX markets, if private agents rather than central banks become the main support for sterling.

The uncertainty attached to all forecasts explains why central banks rightly feel their way through the fog of data rather than going nap on one particular view. However, after such a long period of rapid monetary growth, the upside and downside risks are not symmetrical. The enhanced psychological impact on wage bargainers of raising rates in January, rather than waiting until February, seems worth going for, following the poor November inflation data.

Comment by Peter J Warburton
(Director, Economic Perspectives Ltd)
Vote: Hold
Bias: To ease in the second half of 2007

National accounts for the third quarter of 2006 confirmed that the household sector is struggling. The latest labour market release shows virtually no gain in total hours worked in the economy on an annual comparison and this is reflected in a weak showing for wage and salary incomes, up by 4.6% in the year to Q3. Households’ gross disposable income growth slowed from 5.1% in 2005 to 3.7% on the latest comparison, with real disposable income growth at 1.3%, but only 0.4% higher in 2006 Q3 than 2005 Q4. The saving ratio fell from 6.2% in the final quarter of 2005 to 5.1% in 2006 Q3.

It is easy to be carried away by the GDP growth figure of 2.9% and to assume that this represents an economy that is close to overheating. The truth is that business and financial activity surrounding transactions in assets, aided and abetted by residential property investment, is responsible for roughly half of the growth in the whole economy, leaving a rump of underperformance elsewhere. Not surprisingly, there is no comparable boost to employment or regular employment incomes and the likelihood of an inflationary outburst remains slim.

The wealth effects from asset revaluation have sustained household consumption at a high level in the recent past, but these effects are waning. Corporate dividend payments, received mainly by the household sector, are running about 10% lower than in 2005. The equity revaluation effect on pension funds contributed almost 80% of households’ meagre gross saving in 2006, suggesting that discretionary saving is almost non-existent on a net basis. Even the residential property revaluation effect is waning in significance as the pattern of house price inflation is increasingly focussed on a few hotspots.

The Pre-Budget Report has warned consumers that they face higher taxation on motor fuels and on air travel, while predictions of council tax increase in April are well ahead of inflation. Despite the obvious embarrassment of the rapid growth of M4 lending and M4 money supply, the spill over effects into the consumer economy are remarkably mild. In predicting just 1.2% real consumer spending growth this year, I expect businesses to find themselves over-stocked and over-invested and to make their own downward adjustments to spending plans. Another increase in short-term interest rates would be inappropriate.

Note to Editors
What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership
The Secretary of the SMPC is Professor Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is Professor David B Smith (University of Derby and Beacon Economic Forecasting). 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 IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.


Yet we know the BoE will be gutless in raising rates this month and will adopt another "wait and see" stance, despite rising inflation and higher than expected wage increases.

Posted by: Kev M at January 8, 2007 12:38 PM

I eat my words.

Posted by: Kev M at January 16, 2007 02:59 PM

One more rate hike will begin to dampen the property market, especially when property investors begin to feel the pinch on property rental returns.

Posted by: stop repossession at May 22, 2007 06:42 PM

Ok the latest bank of England figure on inflation is 2.5% which is down from 2.85 % since the last rate rise. Although people are expecting another rate rise, would the rates will not decrease again on the long run with inflation dampening?

Posted by: sell my house fast at June 15, 2007 08:56 PM
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