Sunday, May 06, 2007
Bank gradually takes away the punch bowl
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


The oldest cliche about monetary policy, thanks to William McChesney Martin, is that the central bank’s role is to “take away the punch bowl just when the party starts getting interesting”.

Martin, longest-serving chairman of America’s Federal Reserve Board (1951-70) – a few months longer than Alan Greenspan – meant that when the economy is too exuberant the central bank should curb that enthusiasm by raising interest rates.

The Bank of England takes its punch-bowl role seriously, though latterly it has also been something of a punch bag. Today marks the 10th anniversary of the announcement of Bank independence by Gordon Brown.

It is unfortunate for the Bank that the anniversary has coincided, not only with the highest inflation rate for a decade and a half (inflation on the consumer prices index measure has not been above 3% since August 1992) but also the first “Dear Gordon” letter from the governor to the chancellor during the independence era.

This, in turn, has brought a flood of mainly unjustified criticism down on the Bank. Insiders see a large part of this as a political stick with which to beat Brown and they are probably right.

In a speech last week to the Society of Business Economists, Mervyn King, the Bank governor, recalled being summoned from the tennis court by Eddie (now Lord) George, his predecessor, to be told of Labour’s decision to make the Bank operationally independent.

The Bank was ready for change; it was in the process of beefing up a committee that would advise the chancellor on interest-rate changes. It had not, however, been prepared for independence.

Those early days threw up some interesting facts for anybody contemplating a Mastermind on Bank independence. Which member of the monetary policy committee (MPC) had a 100% record in voting for a rate hike at every meeting he attended? Answer: Sir Howard Davies, now director of the London School of Economics, who attended just two meetings as deputy Bank governor in the summer of 1997 before being spirited away to run the Financial Services Authority.

The first three meetings of the MPC were attended by six, six and five voting members, respectively. I had forgotten it took until June 1998, and the passing of the Bank of England Act, for the committee to get to its full complement of nine. Since then there have been a few occasions, usually due to Brown’s tardiness over appointments, when the committee has been under strength.

The most “active” MPC member who served for a decent stretch was Willem Buiter, who voted on 27 occasions to change rates (17 up, 10 down) in 36 meetings, a 75% “activity” rate.

King’s speech provided a useful reminder, amid some of the current criticism, about how successful the MPC has been. Economic growth has averaged 2.8% and the average deviation of inflation from target has been minus 0.08 points (a small undershoot).

Between 1950 and 1996, he pointed out, Britain’s record on growth and inflation was the worst in the G7 (America, Japan, Germany, Britain, France, Italy and Canada). Growth tended to be slower and inflation higher than in these other countries. Since Bank independence, Britain’s combined performance on these measures has been the best in the G7.

Could this have been achieved if, as some argue, the Bank had paid greater attention to house prices? I think not. Interest rates would have been higher and much more volatile and the economy far less stable. Asset price inflation may be the price we have had to pay for more general stability, but it has been a price worth paying.

Those who say that the Bank has simply benefited from a benign global environment have to explain why Britain’s relative performance has improved so much. King did not claim everything for the Bank, but he is right to indulge in a bit of self-congratulation.

As he put it: “The behaviour of the UK economy has improved over the past decade, both in terms of its performance and its stability, and that improvement has been more marked in the UK than in the rest of the G7.

“Although structural reforms over several decades have made the economy better able to respond to economic shocks, the new monetary framework has also played a key role. Inflation expectations have been successfully anchored to the target.”

That, of course, brings us right up to date. As the MPC approaches its 121st meeting this week (another fact for Mastermind: there were 13 meetings in 2001 or else this would be the 120th), does it still have inflation expectations anchored? The answer, despite the recent rise in inflation and plenty of scary headlines about it being out of control, appears to be yes. The latest Citigroup-YouGov survey of inflation expectations shows them to be 2.5%, only slightly above the 2% target.

There is plenty of demand in the economy, according to the CBI’s reading of the strength of retail sales last month, the best for nearly three years. Do not, however, discount the effect of the fine April weather on spending. The housing market, meanwhile, is showing tentative signs of cooling. Consumer credit has weakened.

Should the Bank begin its second decade of independence by shocking us with a half-point rate rise? Apart from the fact that it does not look warranted by the data, it would be a strange way of demonstrating that the Bank is anxious to improve its communications; 61 out of 61 City economists surveyed expect a quarter-point hike to 5.5%.

Some members of the “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, are rather more aggressive, but its verdict also chimes with the consensus.

Four shadow MPC members – Tim Congdon, Gordon Pepper, Andrew Lilico and Anne Sibert – favour an immediate half-point rate hike. Three others – Kent Matthews, David B Smith and John Greenwood – opted for a quarter-point increase to 5.5%. Two – Patrick Minford and Peter Warburton – do not think a rate rise is needed at all.

That implies a 7-2 vote in favour of a quarter-point hike (assuming the half-pointers would support it, having failed in their bid to get a bigger increase).

It also implies that, on the shadow MPC at least, there is a “bias” to raise rates beyond 5.5%. Two of the quarter-pointers, Smith and Greenwood, have a bias to increase interest rates further. Two of the half-pointers, Congdon and Lilico, think Bank rate will need to rise beyond 5.75%.

They, like Mr Micawber in reverse, are waiting for something to turn down; that being mainly growth in the “broad” M4 measure of the money supply, discussed here briefly last week and described by King in his speech. As always the full shadow MPC minutes will be on my website – – today.

PS: Attending a conference the other day, I was struck that when Lord Levene, chairman of Lloyd’s, strode up to the podium the loudspeakers rang out with the cacophony that is We Built This City (on rock and roll). Levene is an estimable fellow and a fine representative of the City of London, but I’ve never seen him as one of life’s rock’n’rollers. Not only that but the track, by Jefferson Starship, was once voted the worst rock song ever.

When I occasionally take to the lectern, I imagine bounding up, David Brent-style, to Simply the Best. More often it is a silent shuffle accompanied, if the audience is lucky, by a trip or two. I once started off a talk by dropping all my notes. I was still able to deliver the speech, though not necessarily in the right order.

Anyway, the Levene experience has given me an idea for an Economic Outlook competition. There’s been a run on my new book, The Dragon and the Elephant, similar to that for Kate Moss’s new Top Shop range. But I’ve managed to keep a signed copy back, maybe more depending on the response, for the winner.

The competition is quite straightforward. What piece of music would you play to bring Gordon Brown up on to a stage. And, if it is not immediately obvious: Why?

From The Sunday Times, May 6 2007


Son of A Preacher Man; it's both apposite and ironic;

"And the only one who could ever reach me
Was the son of a preacher man
The only boy who could ever teach me
Was the son of a preacher man
Yes he was, he was, oh, yes he was
He was the sweet-talking son of a preacher man
I guessed he was the son of a preacher man
Sweet-lovin son of a preacher man
Ahh, move me..."

I suppose you could rewrite it a little; "boiled sweet lovin' son of a preacher man..." After all Gordon has pinched Willy Wonka's everlasting gobstopper hasn't he?

Posted by: Jonathan at May 6, 2007 01:04 PM

"Asset price inflation may be the price we have had to pay for more general stability, but it has been a price worth paying. "

Is this the same as saying the boom we have had is going to be worth the inevitable bust?

Posted by: A Smith at May 6, 2007 01:56 PM

Dear David,
An interesting point raised by the Governor’s speech seems to have largely been ignored. I refer to the unwillingness of the Bank of England to start publishing a fan chart for the future path of the base rate. The BoE staff are afraid that most commentators will misinterpret the fan chart and I do not blame them in light of the hysterical media response to the April inflation rate. This is a pity, really. Such a fan chart (in addition to the existing fan charts for output and inflation) would have allowed research to pin down more accurately the complex relationship between interest rates, inflation and output in the UK.

Posted by: Costas Milas at May 6, 2007 08:01 PM

"Asset price inflation may be the price we have had to pay for more general stability, but it has been a price worth paying."

What stability? For the under-35's, you might as well be living in Weimar Germany as you see your entire lifetime of income undermined by the the housing market, a mass transfer of wealth to baby boomer home owners (for whom the price was definitely worth paying). House price inflation is still inflation -- economists can bury their heads in the sand all they want. Excluding housing from CPI (and a good portion of housing from RPI) is completely arbitrary. Automobiles are a big ticket asset, they're usually financed so interest rates affect their price, all of the same arguments as to why they should be exluded from CPI apply, and yet they still make up a large percent of the figure. Might have something to do with technological change generally driving down the price of autos in real terms over time, maybe? Recent economic growth in the UK has been built to a large degree on consumer spending, which would not have happened without the housing price boom and impoverishment of first time buyers.

Posted by: RichB at May 7, 2007 04:30 AM

Just plain wrong I'm afraid. The UK economy, until recently, was driven by consumer spending but that was due to an extremely favourable set of circumstances for consumers - lower interest rates, a strong pound, a huge net increase in private sector employment, strong real income growth, and so on. The housing boom was a by-product of these same influences but not the driver of them.

You may or may not know that there was considerable resistance some years ago on the RPI advisory committee to including any house price component in the RPI on the same grounds as you don't include share prices. You consume cars - their value declines as you own them - that is not the case for housing, an asset. This is a pretty basic distinction.

As for under-35s, you make your choice. Why the obsession with ownership? I know plenty of young people who rent, have a great lifestyle, and do not spend their spare time obsessing about whether the housing market will crash or not.

Posted by: David Smith at May 7, 2007 09:29 AM

money supply inflation is occurring at over 10% per year. Those that enjoy the benefit of this inflation are the property-owning classes. They don't do anything to earn their increased wealth. Those that are made poorer by not owning assets have done nothing to deserve being made poorer.

Posted by: the_austrian at May 7, 2007 04:49 PM

Can't allow that one to pass - the correlation between M4 growth and house-price inflation is no better than its correlation with general inflation.

Posted by: David Smith at May 7, 2007 05:40 PM

i don't deny that it's complicated, but take a look at this chart of house prices ( and look at the top left-hand chart on page 2 of this ( document. The blue line shows M4 from '66 to '06. Look at the very sharp drop-off in 1990. It matches very well with the fall-off in house prices of the same year...

Posted by: sideshowbob at May 7, 2007 06:20 PM

You seem to have changed your name between posts, but no matter. You can't compare a monetary variable, M4, with real house prices. But, accepting that both M4 growth and nominal house prices fell in that period, so did pretty well everything else. The fit between M4 and inflation, or nominal GDP, or house prices, has been poor since then. It was poor before then, in the 1980s, when it was a target variable.

Posted by: David Smith at May 7, 2007 06:33 PM

I think this graph shows there was quite a good correlation in the '80s But if you don't think M4 shows up in the housing market or the FTSE, where exactly does all that money go... It must show up somewhere, or am I missing something?

Posted by: the_austrian at May 7, 2007 07:01 PM

The problem is with thinking of M4 as money. It is one measure of what we loosely call the money supply, but only one, and it is subject to very many distortions. Even without this, national money supply measures are of limited use in explaining global asset price changes. I don't say there's no information content in M4. I do say that those who make a fetish of it will lead us up a policy blind alley.

Posted by: David Smith at May 7, 2007 08:28 PM

The song for Brown has to be: Oasis - Don't Look Back in Anger

Posted by: Chris Crowther at May 8, 2007 09:03 AM

"You consume cars - their value declines as you own them - that is not the case for housing, an asset. This is a pretty basic distinction." If you don't consume housing, then why is their a housing depreciation element to the RPI? Depreciation measures decreasing value caused by usage over time.

Your reaction to my comment speaks volumes about how out of touch "mainstream" economists are on this issue. People under 35 do have a choice: a lifetime of debt slavery or no chance at a reasonable family life. Take your pick. Renting often involves frequently moving house, and given the limited stock of family-sized rental units, you often have to move quite far to find a suitable house. That's fine if you're young and mobile, but it just isn't practical for a family with children to rent long term in the private market. Almost 90% of the private housing stock in this country consists of owner occupied residences. If you have to live somewhere, you generally have to buy (even if, as at the moment, it makes a whole lot more sense, in theory, to rent).

As an illustration of this, my partner and I were thinking about adopting a child. We rent a house in London. Adoptions are administered by local councils for the most part and the process lasts several years. You cannot move away from your local council in the middle of the process and have the adoption continue. The fact that we rent wouldn't matter if we lived in a council flat with tenancy rights, but because we rent a private house and our landlord (like most landlords) will not offer a lease lasting more than 12 months, we can't start the adoption process (our living arrangements are viewed as insufficiently stable). In practical terms, the UK is not set up to support families in long term private rentals. You can say that people have a choice between renting and buying, but it's just theory, not reality.

Posted by: RichB at May 8, 2007 09:31 AM

Song for Brown. Taxman. The Beatles.

Posted by: Peter Osler at May 8, 2007 10:04 AM

Thanks for the many song suggestions.

In terms of housing, as I said, there was a strong body of opinion that the depreciation element should never have been included in the RPI for the reasons I set out, though there has always been some kind of imputed rent measure in the index.

I sympathise with your personal plight RichB, though as you must acknowledge it is quite unusual and has more to do with the red tape surrounding adoption as the state of the economy.

Posted by: David Smith at May 8, 2007 10:12 AM

How about "Gold" by Spandau Ballet - in celebration of Mr Brown's skills as a gold trader

Posted by: Andy Moffat at May 8, 2007 02:34 PM