Sunday, July 01, 2007
Shadow MPC votes 8-1 to hike
Posted by David Smith at 08:59 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 Monetary Policy Committee’s (MPC’s) Bank Rate decision to be announced on Thursday 5 July.

On this occasion, seven SMPC members voted to raise Bank Rate by ¼% on 5 July, one wanted the shock therapy of a ½% increase, and one member voted for leaving rates unchanged, meaning that the ¼% increase won the day. Six SMPC members had a bias to raise rates further after July, however, while two of the ¼% hikers together with the one hold had a broadly neutral bias thereafter.

The SMPC is a group of independent economists 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.

Comment by Roger Bootle
Vote: Raise by ½%
Bias: Raise Further

It is becoming increasingly likely that the level of interest rates needed to keep a lid on inflation over the next two to three years is 6% or over. I favour moving to 6% in one go in order to deliver a shock. Although there are some signs that previous interest rate rises are starting to have an effect, this is not the time to ease off. On the contrary, there are worrying signs of pricing power returning to firms and inflation expectations creeping up. The rate of growth of the money supply is 13.8%. It looks as though the US economy may be about to shrug off the effects of housing weakness. Meanwhile all the signs are that the euro-zone will grow reasonably well this year, with favourable effects on our exports.

The balance of risks is skewed towards higher inflation and, if higher inflation rates do emerge, the costs of getting inflation down again could be high. This is no time for the MPC to be taking chances. Bold and decisive action is required.

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

Not much has happened to change the economic outlook or the case for higher interest rates. The annual rate of M4 growth increased to 13.8% in May, with the money holdings of the financial sector continuing to expand at well over 20% a year. Buoyant lending to corporates to finance takeovers has to be singled out as a key influence on the surge in money growth. Nevertheless, the rise in interest rates has – to some extent – discouraged credit to the personal sector. The annualised rate of growth of lending to individuals in the three months to April was 9.7%. This is well down from the 12% - 13% rates seen in 2004 and very much in line with the sort of figure that the equation I reported to the House of Lords Economic Affairs Committee last November would predict with 5½% base rates. (See the numbers in the box below and the chart on which the equation is based.) But – from any long-run perspective – 9.7% growth is too high.

As ever, the Bank of England doesn’t know what to make of financial sector money and – stupidly (there is no other word) – some of its officials continue to deny that money holdings inside the financial sector are relevant to anything. This has been a repetitive feature of all the cycles in the last thirty-five years. What was that someone said about those who can’t learn the lessons of history?

More parochially, price-raising intentions in the Confederation of British Industry (CBI) and Institute of Purchasing managers (IPM) surveys are high at the moment, at any rate by the standards of the last few years. In the five months to October 2006 the consumer price index rose by 1.0%. The summer months are usually good for the Consumer Price Index (CPI) because of seasonal food effects. All the same I wonder if there is a risk that this year the CPI will go up 1.6% or more in these months and so take the annual increase in the CPI through 3% again this autumn. I don’t follow announcements on the price of wheat, bread, milk etc. on a regular basis any more, but one can hardly overlook the newspaper reports of recent quite big rises in these areas.

I favour a rise of ¼% in base rates, but – as before – expect the peak in this cycle to be at least 6% and probably higher.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Raise by ¼%
Bias: Tightening

For two years now I have been concerned about excessive growth of money and credit. Initially asset prices responded in 2006 with a renewed surge in house prices after the pause of 2004-05. However the process has now moved on. Not only are asset prices still very buoyant, but the economy has also strengthened and is now growing at or close to its full potential rate, which means there is little or no margin of slack for price pressures to ease significantly.

If asset prices were strong and the economy had remained weak (or vice-versa), there would be grounds for maintaining monetary policy on its present course, or at least not tightening further. However, there are only the slimmest signs that the housing market is starting to respond to the last four rate increases (e.g. mortgage applications have slowed, and the buy-to-let sector appears at last to be showing signs of excess supply), and meantime other asset prices remain elevated (e.g. the stock market which is up 5% this year and 65% since the start of 2003, although there is a significant global element to this). Superimposed upon this strong asset price background, economic activity in both the consumer sector and in the business sector is vigorous, again with only tentative signs of any weakening. Retail sales volumes in May were up 3.9% year-on-year, stronger than most analysts expected. The CBI measure of business orders in manufacturing rose again in June and output expectations for the three months July-September strengthened further.

The Bank of England has argued that the demand for money may have increased (which could be true), but this is likely to explain only a percent or two at most of the monetary acceleration. Continuing strong growth of both £M4 broad money and bank and building society lending despite higher interest rates imply that the Bank has done no more than raise rates in response to strong credit demand. To curtail credit demand the MPC needs to restrict aggregate demand by restraining the supply of money, slowing the growth of £M4 from 13.8% in May to a single-digit rate. Interest rates must rise to achieve this.

Comment by Ruth Lea
(Centre for Policy Studies and Arbuthnot Banking Group)
Vote: Raise by ¼%
Bias: No further tightening

The real economy continues to look strong and, despite some very tentative signs of slowdown in the housing market, there is little reason to expect that growth will weaken significantly in forthcoming months. Following on from the “at trend” GDP growth of 0.7% (quarter on quarter) in the first quarter, growth has remained firm in the second quarter. For example, retail sales growth “continued to be firm”, in the words of the Office for National Statistics (ONS), in May.

The Governor of the Bank of England is clearly concerned about the inflationary risks in the economy and rightly voted for a ¼% increase in June. Despite the continuing slippage in CPI annual inflation (down to 2.5% in May) the risks to inflation surely remain on the “upside”. Money supply growth remains uncomfortably high.

Even though wage settlements have not risen significantly this year, and not as much as feared by some including myself, the risk remains that, with employers arguably feeling in a stronger position to raise prices, they may then be more prepared to concede higher pay increases. Given the undoubted squeeze on real disposable incomes in recent quarters exacerbated by higher interest rates, especially for the heavily indebted, there has to be the risk that the push for higher wage settlements will intensify.

It is increasingly clear that the Bank needs to tighten further. I vote for a ¼% hike in July. But I do not anticipate the need for another increase.

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

Monetary growth continues apace; the Bank's own model in the May Inflation Report suggested inflation at above target on a two-year-ahead basis (and that, without making allowance for the credibility lost from exceeding the permitted corridor in March); and there is little sign of relief on oil prices. Meanwhile 2007 Q1 GDP growth of 0.7% was robust, with little sign of the autumn interest rate rises having a material negative impact, unemployment is falling rather than rising, and other negative shocks (e.g. from the housing market) remain speculative at best. Interest rates have to rise. It is best to get on with it.

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

Clearly the economy is still moving ahead with momentum. But the economy needs more than a few months to respond to the accumulated effect of the rate increases of recent months. While money and credit growth are a cause for concern, the problem is that in a world of rapidly advancing financial innovation and deregulation of banking, it is not easy to distinguish between money supply and money demand shocks. Hence the gravitation to interest rate instrument control by central banks.

But what this means is that we need to look at all other signals as well as the monetary aggregates. These other signals, such as bond markets, sterling and wage inflation are striking amber and not red. Based on long-term inflation expectations for the CPI, real interest rates are close to 3%. This is above any historical neutral rate. Therefore, there is a strong chance that raising rates further would create the Friedmanite over-steering effect, which might see additional volatility to the economy from the result of inside and outside lags.

Comment by Peter Spencer
(University of York)
Vote: Raise by ¼%
Bias: Tighten Further

Monetary growth remains too high for comfort and there is a growing danger that the balances that are accumulating in the non-bank financial sector will leak into household holdings and spending. The economy remains strong, with only tentative signs of a response to earlier rate increases. It seems that at least one more base rate increase will be necessary to moderate this expansion. There seems little reason for delay. A move in July should have a bigger impact than one in August when most people are on holiday.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise by ¼%
Bias: Tightening

The minutes of the 6 and 7 June MPC meeting were fascinating, because of the closeness of the vote and the extent to which the five to four decision to hold appeared to be a non sequiter to the preceding analysis that had brought out the continued strength of the world economy and the risks associated with the rapid growth of broad money and credit. In contrast, the tactical case for delay expressed by some of the MPC holders seemed to be weak, especially if one believed that ‘a stitch in time saves nine’. It looks as if a bureaucratic fondness for due process, and trimming at the margin, has got in the way of the aggressive and rapid response required to stabilise a potentially deteriorating situation in monetary economics, as in war.

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 ( argued that Britain’s economic openness means that UK inflation and growth are more heavily affected by international monetary growth than they are by domestic monetary developments. One concern about the UK inflation outlook is that core OECD broad money growth seems to have jumped out of the 5% - 6% range that has characterised most of the past decade to some 6½% in the final quarter of last year, and perhaps 7% currently. This may explain why equity markets have remained reasonably robust, despite deteriorating inflationary expectations in global bond markets, and why international growth has tended to surprise on the upside. Other central banks are now tightening, and there is a chance that this could lead to overkill if they all march in step. However, the risk at present is that any inflation surprises in the international economy as a whole will be on the upward side.

Britain’s large current account balance of payments deficit, which is currently estimated as 3¾% of GDP last year (this was written before the release of the 2007 Q1 data on Friday 29 June, which may have led to revisions to this figure – one should also beware of revisions to the national accounts released at the same time) also suggests that the country is suffering from a suppressed inflation that could become actualised if cheap international credit ceased to be available to plug the UK’s current account deficit. If one estimates an ‘open-economy’ statistical relationship for the UK three-month inter-bank rate using quarterly data for the past four decades, the steady state that emerges has the properties that the British short rate equals the real ‘world’ short rate of around 2¼% plus ‘double-core’ retail price inflation – which is roughly ½% above the CPI rate – plus the current account deficit expressed as a share of GDP. This suggests that the UK short-term rate of interest would be around 8½% in the absence of the wall of money coming in as a result of the currency manipulation being practiced by Eastern and Middle-Eastern nations. The 8½% figure is not intended as a forecast, but it does indicate the level of risk involved if the Chinese authorities suddenly decided to float their currency, for example.

Annual CPI inflation eased to 2.5% in May, and will average 2% in 2007 Q4, before picking up during the course of 2008, according to the latest projections of the Beacon Economic Forecasting model. The forward looking nature of MPC rate decisions, which have a forecasting horizon of roughly ten quarters, means that the MPC should be looking through the short-term energy price induced dip in inflation to the prospects for a pick up further ahead. It is tempting to advocate a ½% increase in Bank Rate but the strength of the sterling index at 104.9 (January 2005=100) on 26 June suggests that a ¼% hike on 5 July would be preferable, even if this is unlikely to be the peak. There is no case for waiting until the August Inflation Report forecasts are available as a risk adverse official might prefer. The MPC have shilly-shallied enough already.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Raise by ¼%
Bias: Neutral, but only if growth slows below trend

The economy simply is not slowing down fast enough. The broad M4 measure of money supply continued to rise at a strong pace in May, signalling upside risks to inflation. On the month, M4 rose 1.2% and this pushed the annual rate to a seven-month high of 13.8%. Figures from the British Bankers' Association showed a surge in net mortgage lending to £5.8bn in May, compared with £5.1bn in April, which was at odds with some evidence of slowing housing market activity. There are signs that the economy is slowing and that inflation is easing back somewhat; retail sales growth in May was less than expected and firms' output price inflation is easing back alongside annual retail price inflation, which slowed a bit more than expected to 2.5% in May. Moreover, wage inflation dipped from a revised 4.4% in March to 4% in April, and should fall further in May.

However, these indications are not enough, given that the economy is operating with a positive output gap and economic growth remains above the long run average. Further, surveys suggest that growth is likely to remain around 0.7% per quarter for at least 2007 Q2 and Q3; the Confederation of British Industry (CBI) monthly industrial trends survey showed a rise in the total orders balance to 8 in June from 5 in May. The expected output balance also increased to 25 from 18. The Purchasing Managers Indices (PMI's) for services held up, as did those for manufacturing in May.

Although wage inflation is not yet an issue, it will be if growth persists at the current rate of 0.7% per quarter with no spare capacity, with core CPI likely to continue to rise towards 2% plus. For these reasons I think a further rise in rates is appropriate. Whether it is the last in the present cycle will depend on whether growth slows and spare capacity appears in product markets and labour markets.

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 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 (Centre for Policy Studies and 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 a full set of nine votes is always cast.


Interesting that the shadow MPC is so hawkish when compared to the real MPC. Does this mean that in the grand scheme of things the real MPC can be seen as dove-ish, or neutral?

Posted by: Labarte at July 3, 2007 08:51 PM

I think I have always told you David that they will be 6.5% by the year end and 7.5% by this time next year but you have always disagreed.

Posted by: Pete Balchin at July 17, 2007 10:48 PM