Sunday, June 03, 2007
Shadow MPC narrowly rejects back-to-back rate hike
Posted by David Smith at 09:01 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 Monetary Policy Committee’s (MPC’s) Bank Rate decision to be announced on Thursday 7 June.

On this occasion, three SMPC members voted to raise Bank Rate by ¼% on 7 June, and one wanted the shock therapy of a ½% increase, but five members voted for leaving rates unchanged, meaning that the ‘holds’ won the day. There was an overall bias to raise rates in the near future, however, with two of the holds and, indeed, some of those who wanted to hike in June wanting higher rates in subsequent months.

Comment by Roger Bootle
(Economic Adviser, Deloitte)
Vote: Raise by ½%
Bias: Raise Further

The inflationary prospects facing the MPC are deteriorating and the danger that inflation could get out of control is increasing. No one should be fooled by the fall in inflation that will happen over the next few months; the issue is what will happen to inflation next year and beyond. The MPC needs to raise rates to a level that will have a real impact on borrowers and lenders. I suspect that the impact will be greater if they deliver a shock in the form of a 0.5% increase in one go. But if they choose to avoid this, then they should follow the next 0.25% increase with another very shortly. The stakes are too high to be pussy footing. It is time to take bold action.

Comment by Tim Congdon
(Visiting Fellow, London School of Economics)
Vote: Raise by ¼%
Bias: Tightening

The Bank of England has been too dilatory, largely – in my opinion – because it has not been paying sufficient attention to the growth of money. In my Powerpoint-style presentation at the last SMPC meeting (Editorial Note: this is available from timcongdon@btinternet.com or xxxbeaconxxx@btinternet.com), I argued that the growth rate of bank and building society credit needs to halve from its levels in 2006 and early 2007 in order that the growth rate of bank deposits (i.e., money) be brought down to about 5% - 7% at an annual rate.

It is clear that – at current interest rates – bank credit is not going to slow enough. The growth rate of all lending to individuals has responded to the rise in interest rates. Roughly speaking, it has slowed from over 13% at an annual rate in 2004 to 10% - 11% at present. However, corporate borrowing has revived, with the Merger and Acquisition (M & A) boom motivating some extremely large deals. Many of these deals – which will create new deposits – are far from fruition, but have been announced and will proceed. Reports are appearing of less mortgage demand. But mortgage approvals in March were £31.2bn, compared with £28.6bn a year earlier. Suggestions of a halving of credit growth – which is what is needed – are wide of the mark.

On the real side data, business surveys indicate that the so-called “tightening” since 2004 has failed so far. (Of course – if we think of monetary policy in terms of the quantity of money instead of the interest rate – policy hasn’t tightened at all.) Price increases in the latest IPM manufacturing survey were the highest in the survey’s (admittedly quite short) history. Claimant count unemployment has fallen significantly (i.e., by 10,000 – 15,000 a month) in recent months.

I am in favour of a rate rise of ¼%, and expect further rises to be needed. I am shifting my view of the peak to 6½% from 6%, because of the Bank’s slowness to react to a situation of obvious deterioration in the inflation prospect. A period of weak asset prices will be essential to check the current mini-boom/boom. It is surprising – perhaps even a little alarming – that the stock market continues to advance, despite the rises in rates. The Bank’s analysis of the relationship between money and asset prices – and particularly between financial sector money and asset prices – has been useless. As I have pointed out before, this is a recurrent feature of the UK money and credit cycles.

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

The Bank's passivity, though not unexpected, is nonetheless disappointing for all that. The Bank has simply been much too slow in raising rates. It began too late, and once it started it did not raise aggressively enough. The straightforward and predictable consequence has been that, in the short-term, inflation has risen above the Bank's corridor of discretion and inflation now seems unlikely to come back to the 2% target over the longer term without higher rates than would have been necessary had the Bank been more decisive.

The Bank does not appear to believe that its credibility has been damaged by recent events. I disagree. The MPC minutes suggest that those members who might have been tempted by a half point rise in May were not totally convinced that a rise above 5½% would be necessary to bring inflation back to target. Until very recently I had expressed sympathy to this thought, but now I disagree.

The mystique the Bank bore from never missing its inflation target in fifteen years of operation has now been lost, and it is a matter of increasing urgency that it address the underlying excessive monetary growth. This will not be achieved at current rates. The market does not believe so; and the Bank's own model does not predict so. Rates must rise. I suspect now that they will reach at least 6% - perhaps as much as 75 basis points higher than would have been necessary had the MPC been more decisive. Eventually this must have implications for GDP growth, but for now the priority should be to recover monetary control.

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

The Bank is paid to be unpopular but over-reacting can be as damaging as under-reacting and there is no evidence that the Bank's credibility has been permanently damaged by the breach in the inflation corridor. Wage inflation remains subdued, the inflation risk premium on long dated bonds has barely moved and the foreign exchange market shows no sign of panic. The Bank can afford to take measured action. Accepted that the broad money supply growth is a cause for worry but equally problematic is why the markets have not taken fright at this sign of monetary laxity, which has been with us for some time now. It could be that a single measure of money (or any single indicator) is not enough on its own to cause panic, without the support of other indicators. Indeed the market is expecting a further rise in either next month or in July but the accumulated effects of the recent rises in rates must be allowed to take effect. There are signs that the mortgage market is responding.

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

There has been a lot of nervousness recently about whether inflation is getting stronger; 'pricing power' is 'returning' according to some and this aspect is mentioned by the Bank in its minutes. If this phrase has any meaning it would be that margins were being raised. At the aggregate level the profit share is currently high and so this process has already happened; by implication real wages have tended to grow by less than productivity. This can be interpreted as the result of pressures on labour from international competition and technology. However these factors are real, to do with relative prices rather than with the general level of prices. Looking at forces on expectations these continue to keep inflation around 2% (or a bit more in RPIX terms). The only argument for raising interest rates would be that somehow the real interest rate required by savings-investment equilibrium was higher than the current nearly 4%; this seems unlikely given experience of real rates over recent decades. My view would be to hold therefore

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

The money supply continues to grow at 13% or more, driven by lax lending criteria. It seems that banks and building societies have relaxed loan multiples and other lending criteria because the benign macroeconomic environment has lulled them into false sense of security. There seems little doubt that interest rates will need to be raised again to moderate this expansion. However, it is not clear just how high rates need to go - consumers are carrying a large burden of debt and there are already tentative signs of a reaction in the housing market and the high street. Rates should be raised at a measured pace to minimise the risk of overkill. Base Rate went up in May and I would be inclined to keep it at 5.5% in June.

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

The MPC’s remit is to aim for the inflation target mandated by the Chancellor of the Exchequer using a very short-term nominal interest rate as its sole instrument to pursue this target. This remit has the legal advantage of unambiguity. But it also begs the question in positive economics of whether the implied model of the economy involved is a reliable and robust representation of the complexities of reality. Likewise, one is obliged to accept as a given the current role and structures of the Bank of England when contributing to SMPC polls, where the question is what should happen to the official Base Rate at the next MPC meeting.

In practice, there appear to be serious flaws in the current institutional set up – these were discussed in my recent Economic Research Council monograph Cracks in the Foundations? A Review of the Role and Functions of the Bank of England After Ten Years of Operational Independence (www.ercouncil.org) – while changes in the official REPO rate seem to be a weaker and less reliable policy implement than is usually assumed. In particular, Britain’s economic openness means that both UK inflation and output growth are heavily and rapidly influenced by international developments. It seems to require surprisingly coarse rate adjustments, and a lot of patience, to drag domestic economic variables away from these global trends. In addition, it is hard to see how one can control the supply of a broad interest bearing money definition, such as M4, by raising the short term rate of interest paid on bank deposits, rather than operating on an ‘opportunity cost’ variable such as the official bond yield.

The wider economic evidence suggests that the short-term movements in inflation on which the financial markets tend to fixate are largely random ‘noise’, medium-term movements reflect the output gap – but if, and only if, inflationary expectations remain tethered – while long-term movements reflect the growth of the monetary aggregates, at least at the level of the OECD area as a whole. Britain’s money and credit growth are clearly excessive, although the wall of official and private Asian and Middle-Eastern money looking for a home means that this has not driven down sterling as it would have done normally, even if one may have reservations about how long cheap international credit will be available to plug the UK’s twin deficits. It should also be remembered that the demand for broad money goes up as the real return on liquid deposits rises, and that a demand induced increase in M4 can have a contractionary impact on the economy. Mr King’s 2 May speech to the Society of Business Economists clearly explains the issues involved.

If one does not believe that base rate changes are a quick acting or a powerful lever over the real economy, it is possible to make a case for voting tactically and going for a hold in June. One reason is that the sterling index was 103.9 (January 2005=100) on 29 May, and that this is high enough to maintain downward pressure on UK inflation, over and above the effects of falling household energy costs in the next few months. However, the strength of real non-oil market-sector gross value added, which rose by 3.6% in the year to 2007 Q1, the 3% increase in non-oil real GDP (and 3.2% rise in the GDP deflator) over the same period, and the fact that rampant asset markets suggest that monetary policy remains too loose, all suggest that further tightening is required. The question is whether this can be done by modest increases in Bank Rate, or whether a more radical re-consideration of Britain’s monetary arrangements is needed.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: Neutral, provided that CPI inflation stays below 3%


The UK experienced acceleration in its broad credit aggregates (loans and bonds) during 2002-05, but deceleration in 2006. While the UK’s credit excesses are more serious, proportionately, than those in the US, the UK has at least entered the correction phase. Over the past five years, both countries have failed to reflate their economies by means of private sector credit expansion, since most of this growth has occurred in the non-bank sector and has had its primary impact on asset markets. In the US, nominal GDP has fallen below a 5% annual pace, slower than most points on the Treasury yield curve. Notwithstanding an upward lurch in UK nominal GDP last year, it is probable that the growth rate will fall through the course of 2007.

In setting UK Base Rate, a key judgement concerns the outworking of existing macroeconomic forces. My judgement is that a combination of zero real household disposable income growth, slowing net borrowing trends and a prospectively higher tax burden will restrain the growth of private consumption over the next twelve to eighteen months. Fixed investment spurted last year, aided by lumpy construction and utility projects, but is likely to moderate its pace this year. Export growth is clearly hindered by the painful strength of sterling and the material slowdown in the growth of US domestic non-service expenditures. In the light of these judgments, my belief is that no further rate increases are necessary or desirable.

Supporting evidence that the gradual weakening of the pace of nominal and real activity will continue is provided by the deceleration of housing transactions, mortgage lending and house price inflation. Also, by rising unemployment and declining employment, moderation of wage growth and prospectively, of consumer price inflation on the target measure of CPI. What is particularly pleasing is the fall in the inflation rate of the private sector components of the retail price index. The most that the MPC’s interest rates stance can hope to achieve is influence over the context for domestic pricing of goods and services in competitive markets. Contrary to a raft of survey evidence, there is nothing in the published data to suggest that retailers have the scope to enhance their pricing power over the remainder of the year. Indeed, food manufacturers are complaining loudly that they are unable to pass on their raw material costs.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: To raise

I am not yet convinced that 5½% base rates will be insufficient to keep inflation on track for around 2% over a two-year view. After all, economic growth is hardly roaring away, at 0.7% on provisional estimates for 2007 Q1 and 2.9% on the year, and could hover around this before weakening later in 2007 and into 2008. UK economic growth happens to be bang in line with the ten-year average, suggesting that the pace of growth is healthy but not booming. If one looks at growth in retail sales, (down 0.1% in April), manufacturing activity (up 0.6% in March), Purchasing Managers Indices (PMI’s) suggesting stable rather than accelerating activity, there seems to be more a stabilisation around current growth rates rather than acceleration. More importantly, wage inflation is easing back (‘headline’ measure) or remains low, consistent with near trend growth and the Labour Force Survey (LFS) measure of employment fell and LFS unemployment rose. Inflation is falling back on the price front and I would want to see more evidence of where this is going before taking any further action on rates.

Money supply growth is too fast at 13.3% pa in April but one has to look more closely at the details and it is clear that credit, mortgage and company borrowing are slowing or stabilising, behind its recent acceleration is ‘Other Financial Institutions’. I would want to know more about what is driving that and hence do not consider it a sufficient reason by itself for raising rates at this time.

Moreover, the rise in market interest rates of nearly 0.25% since the May decision to raise rates has meant that it is now doing part of the MPC’s job and tightening credit conditions. Harsher talk from the MPC in my opinion has always been required, and it has been too reactive to the financial markets reading of the economic data rather than proactive itself, i.e. behind the curve. For the Maradona theory of setting interest rates to work, the MPC does have to feint and suggest that it is moving. That said, clearly the effects of base rate increases since August have not come through so I would keep rates on hold but remain willing to move them up if there are signs of accelerating growth and stubborn inflation, especially since the economy does have a positive output gap.

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 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 Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (AMVESCAP), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Director, Centre for Policy Studies and Non-Executive Director, Arbuthnot Banking Group) and Trevor Williams (Lloyds TSB Corporate Markets). 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.

Comments

So given the SMPCs recent record of predictions, this should mean that the MPC will raise rates on Thursday. ;)

Posted by: Minh at June 3, 2007 10:08 AM

Dear David,
The money supply debate is still with us. Delivering the Bernard Corry Memorial Lecture (last Thursday), David Blanchflower explained (again) why we should not worry (too much) about M4. The lecture is available from:
http://www.bankofengland.co.uk/publications/speeches/2007/speech310.pdf

Recently, the MPC has adopted a tough language, but in my view, priority should be given elsewhere. The MPC has made no effort to explain the differences/similarities between RPIX targeting and CPI targeting. This lack of information has added to the criticism that CPI targeting is inappropriate, and has increased calls to go back to the previous measure. Restoring CPI credibility is the first step towards convergence of inflation expectations back to the target. So simple, yet so difficult to work more on this?
Many thanks.

Posted by: Costas Milas at June 3, 2007 10:31 AM

Broad money supply is the only value that will slow in its tracks with IR increases. I agree with Costas that CPI credibility needs to be examined for better targeting.

Posted by: Hitesh Damani at June 5, 2007 10:03 AM
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