Sunday, March 04, 2007
Volatile markets change shadow MPC's mind
Posted by David Smith at 10:59 AM
Category: Independently-submitted research

The outcome of the latest Shadow Monetary Policy Committee (SMPC) monthly E-Mail poll (carried out in conjunction with the Sunday Times) is 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 8 March. On this occasion, two SMPC members voted to raise Bank rate by ¼% on 8 March, one wanted the shock therapy of a ½% increase, and there were six holds.

However, two of the holds changed their minds from being in favour of a ¼% increase at the last moment because of the international stock-market shakeout on 27 February, which occurred at a very late stage in the production of the poll (most submissions were completed earlier). Several SMPC members maintained a bias to rise, so the debate was about the timing of the next rate increase as much as the need for it.

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

All the signs are that the economy is in rude health, even though recent
consumer figures have been soft. Money supply growth continues to be strong
and asset prices are extremely high. The housing market is still very strong.
Interest rates are simply too low. In real terms, using the CPI, they are only
2½% and against RPIX they are only 1¾%. Even though inflation should fall
back sharply in the second half of the year this effect will be largely technical.
Meanwhile, underlying inflationary forces could be strengthening. The MPC
needs to act decisively to regain control. It should raise rates again to 5½% and
then pause. It may be necessary eventually to raise rates to 6%.

Comment by Tim Congdon
(Visiting Fellow, London School of Economics)
Vote: Raise by ½%
Bias: Then neutral

Money growth continues to run at rates incompatible with on-target inflation in
the medium term. In the year to January M4 increased by 13.0%, whereas the
annual M4 growth rate that would comfortably keep inflation at 2% must be in
single digits. As is usual at this stage of the cycle, the excess supply of money is
most obvious in the financial sector. (As is also usual at this stage of the cycle,
the Bank of England is showing in its published work that it doesn’t understand
what is going on.)

The financial sector’s money balances soared by almost a quarter in 2006, after climbing by over 27½% in 2005. Here is the most obvious explanation for the buoyancy of UK asset prices in the last couple of years.

Above-trend growth of demand is likely over at least the next six months and
probably for longer. My guess is that UK output is currently about ½% above
trend (i.e., the output gap is positive by ½%), but that it will be 1-1½% above
trend by the end of the year. Recent news on wages suggests that inflation
expectations are already rising. They will rise further, leading to a serious
problem in restoring on-target inflation in 2008.

Of course, the drop in energy prices will help the CPI in the next three to six
months. But excessive monetary growth – not movements in the relative price
of energy and non-energy prices – is the ultimate cause of rises in the absolute
price level. I have been expecting strong business surveys, but – even so – most macro developments in recent weeks have surprised on the upside. The Bank of England has consistently been ‘behind the curve’ in the last eighteen months. It should now raise rates by ½%.

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

The economy continues to grow strongly. Fourth quarter GDP rose 0.8% in the
quarter and growth for the year 2006 was a creditable 2.7%. Services output
was some 1% higher in 2006 Q4 than in Q3. Even though January’s retail sales
numbers looked weak, they should be treated with caution. January’s figure
followed a strong December figure and data around the December/January
period are especially erratic because of the problems with seasonal adjustment.

Even though the CPI headline rate of inflation, as anticipated, fell in January
compared with December and, furthermore, is expected to be around the 2%
mark in the second half of the year, this does not indicate that there is no need to worry about inflationary pressures.

One concern remains the risk of a wage-price spiral and, even though this appears to be low on the Bank’s radar screen, it cannot in my view be wholly dismissed. Incomes Data Services reported that the median level of pay settlements jumped to 3.5% in the three months to January. This was the biggest rise since the end of 1998 and compares with a revised figure of 3.05% during the three months to December. In addition, monetary aggregates are still rising very strongly.

I would recommend holding rates in March but my bias remains towards further
tightening. Tightening would be all the more appropriate if sterling, which is
currently firm against the euro and even more so against the dollar, shows signs
of weakening. Given the large trade deficit this is a risk that cannot be

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

Taking the December inflation figure as including a blip component (and the
MPC as having narrowly escaped from violating its target for the moment), we
nonetheless still face inflation that has been consistently well above target for a
sustained period. M4 growth is still some 13%, and although the three-month
M4 figure has fallen to 10%, the three-month M4 lending figure has risen back
towards the annual figure – thus it would be premature to conclude that broad
money growth is already easing in response to earlier interest rate rises.

Having too much money in an economy is a little like too much carbon dioxide
in an atmosphere - we cannot say that any particular month's inflation rise is due to the presence of too much money, and there may always seem to be some special factors that give a more convincing explanation for the specific event (be they tuition fees, air duties, oil prices, or whatever). But if there is too much money about then what we can say with confidence is that the inflationary temperature will be tending to rise.

Of course, it is likely that inflation will temporarily fall in coming months as past oil price rises start to drop out of the statistics. But, unless other factors intervene to curtail monetary growth (such as a downturn and a loss of confidence - of which there is no immediate sign), inflation will pick up again in due course. Interest rates should rise by ¼%. If, after a month or two, we see that M4 growth really has fallen to 10%, then perhaps ¼% will be enough for now. But that remains to be demonstrated.

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

There is a good argument for not rushing into a further rise in interest rates.
Inflation has come off the boil while sterling remains strong. The evidence from
the real sector is benign and following on from the last rise in rates some time
needs to be allowed to see how the economy pans out. The only sticking point is
the growth in broad money, which shows no sign of easing. So another rise in
rates is called for at some time soon but not quite yet. The policy implication is
to hold but with a bias to raise.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Neutral, pending developments in stock markets.

Last month I argued that interest rates should be raised until the FTSE index
falls below 6000. In the event the market has fallen, because of developments
overseas, without rates being raised.

Currently, domestic monetary forces in the UK remain bullish for asset prices
but those in the US are bearish. The fall in share prices in China was the trigger
for the fall in the US but domestic monetary forces in the US explain why the
US market has reacted as it has. A substantial fall in share prices in the US
inevitably affects share prices in the UK.

Rates should now be left on hold pending developments in stock markets.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: To raise

With demand looking buoyant and the economy enjoying the benefits of a
favourable supply side shock, the outlook is for strong non-inflationary growth.
Output should grow by 3% in 2007 as inflation falls back below the 2% target
later in the year. What happens then depends upon the interplay between the
strong demand and supply forces currently at work in the economy.

Demand is being driven by buoyant monetary and credit market conditions.
This monetary expansion has been clearly reflected in asset prices and
transactions, explaining why managers in business and financial services are so
confident about prospects at the moment. Nevertheless, the base rate was raised again in January and there is a good argument for waiting to see what effect this has before raising again. In the meantime, the strong performance of the supply side should help ensure that any extra demand is reflected in higher output rather than higher prices. This performance is largely due to increased labour force participation and immigration, but productivity has been surprisingly
strong against this background. This helps to explain why the inflationary
effects of the energy and commodity price increases have passed through the
pipeline with only minor second round effects. So far, fuel and energy price
increases and fiscal drag have simply squeezed consumer spending power. We
need to wait and see how this situation pans out before raising interest rates

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

One reason why the MPC was right to raise base rate in January, rather than
wait until February, was that the timing magnified the psychological impact of
the move, and fired a warning shot across the bows of private sector wage
negotiators, without making any great difference to the long-run impact of the
rate of interest on the real economy. The decision to hold in February was also
appropriate because the sterling index was around 106 (January 2005=100) at
the time, and there was a risk of seriously damaging Britain’s debilitated
tradables and manufacturing sectors. The subsequent easing of sterling to 104.4on 27 February, continued rapid monetary growth, and signs of renewed
speculative excess in the property and financial markets, suggest that monetary
policy remains too loose, even if overseas and domestic inflation are likely to
ease significantly during 2007 Q2 and Q3, as the US$70.5 oil prices recorded in
the middle quarters of 2006 become part of the base for the calculation of
annual inflation. However, the US$61.4 paid for a barrel of Brent Crude on 27
February was actually above the 2006 Q4 average of US$60.2, so the oil price
effect may be less favourable towards the year-end.

Britain’s £55.8bn deficit on its trade in goods and services last year, which
compares with deficits of £44.6bn in 2005 and £35.0bn in 2004, also suggests
that the UK economy is suffering from the symptoms of a suppressed inflation,
in which an excessive growth of broad money balances is leaking overseas
because of the country’s high marginal propensity to import. This is entirely
consistent with the theory of international monetarism and helps explain why
the link between money and inflation has been historically weaker in Britain
than in large closed Continental economies. Britain has been able to fund its
twin fiscal and balance of payments remarkably painlessly in recent years
because overseas central banks have been sitting on their currencies and the
subsequent build up in their foreign exchange reserves has been partly invested
in sterling assets, including government bonds, and also encouraged private
investment through stimulating the carry trade. It is an interesting question
whether it is prudent for the UK to take advantage of the unnaturally cheap
credit made available as a result of other nation’s currency manipulations. It
may be economically rational but it leaves the country highly vulnerable to a
change of policy overseas. If the Chinese currency was suddenly allowed to
float, for example, sterling could plummet and gilt yields go through the roof.

In every monetary tightening cycle there comes a point when there is a risk of
overkill, even if the currency often weakens and eases the strain on the tradables sector once rates are perceived as having peaked, demonstrating the market principle of ‘buy on the rumour, sell on the news’. If the Bank wanted to be ‘clever’ it could raise rates by ½%, and then indicate that this was the cyclical
peak. However, such a policy could backfire if it produced an avalanche of
sterling selling, rather than a modest downwards adjustment. The very recent
shakeout in world stock markets also suggests that the MPC should tread lightly
for the time being. On balance, it seems appropriate to hold the official base rate
at 5¼% on 8 March, even if the 21 March Budget slightly complicates matters.
Looking further ahead, and as a broad-money monetarist, one can easily discern
the need for further tightening once global stock markets have stabilised.
However, the predictive power of the monetarist approach would also have to
be reconsidered if sterling remained robust at a time when UK broad monetary
growth is twice the 6½% 2006 Q4 OECD average.

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

Recent UK data developments have cast doubt on the sustainability of the
robust behaviour of personal consumption in the final quarter of last year.
January’s retail sales detracted markedly from the previous monthly gains and
the national accounts reveal that employment incomes rose by a mere 4.2% in
the year to Q4. Business expenditures are buoyant, particularly for fixed capital
formation, but a slowing of inventory accumulation betrays a lack of confidence in the strength of consumer demand. Facing known tax increases (air passenger duty and council tax) in addition to any tightening that may be announced in the March Budget, consumers are registering downbeat responses in attitude surveys. Many have not actually borne a higher mortgage payment since variable rates began to increase last summer.

On the monetary scene, the M2 money stock has slowed from a 10% annual rate last April to an annualised 6-monthly pace of around 7%. Wholesale money
growth continues to be excessive, at 24% in December, down from a peak of
30% in the late summer. Judging from the very keen pricing of loans to, and
deposits from, hedge funds, private equity houses and securities dealers, it is
clear that banks have been targeting this business with a view to gathering
advisory fees on transactions. Whether this is rational behaviour has yet to be
seen, but these distortions to the monetary aggregates plainly have little to do
with demand pressure in the goods and services economy.

M4 lending growth has also moderated, from a 14.6% growth rate in August
2006 to an annualised 6-monthly growth rate of 10% in December. The
financial sector bonanza shows signs of increasing exhaustion and the spring
housing market is unlikely to repeat the plucky performance of last year. On
virtually all counts, the inflationary excesses of the deal-driven sectors are
abating. As far as consumer prices are concerned, the outlook is for a return to
2% inflation within 6 months. Although nominal GDP increased by 5.5% in the
year to 2006 Q4, the case for a further increase in the base rate appears weak.

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).

The next SMPC e-mail poll will be released on Sunday 1 April while the next SMPC gathering at the IEA is scheduled for Tuesday 17 April. The minutes of that meeting will be published on Sunday 6 May.

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