Sunday, September 02, 2007
Shadow MPC votes overwhelmingly for no change in rates
Posted by David Smith at 09:29 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 6 September.

On this occasion, eight SMPC members voted to leave Bank Rate unchanged on 6 September, while one member, Patrick Minford, voted for a ¼% reduction. Looking further ahead, five SMPC members had a bias to tighten after September, two of the holds thought that the next move in rates should be downwards, one had a broadly neutral bias, and Patrick Minford thought that more than one ¼% rate cut would be required.

Comment by Tim Congdon
(London School of Economics)
Vote: Hold
Bias: Tightening

Money growth has – almost certainly – peaked in the current cycle. The rise in interest rates has already discouraged some residential mortgage loans, while the latest over-trading imbroglio in the financial markets seems likely to lead to extensive loan repayments. (The problems seem to have arisen because of commercial banks’ lending, first, to investment banks which then on-lend to hedge funds in order to boost ‘prime brokerage’ business, and, secondly, direct to hedge funds against the collateral of illiquid securities sometimes with a bogus credit rating. Much of this stuff will now unravel.

The US sub-prime mortgage element is there, but it is not the whole story. I don’t know the scale of the unravelling, but it may be £20bn to £50bn in the UK case. It’s little better than a guess, but M4 may drop by 2% to 3% as this business falls away. Even I would not expect the long-run real economy effects of the cancellation of the puff to amount to much.)

The July Consumer Price Index (CPI) number was much better than I expected. The sharp rises in international wholesale food prices and the upward blip in energy prices seem to have been offset by the strong pound, renewed competition between supermarkets and the expected fall in utility prices. I am nevertheless expecting the annual CPI number to go above 2% in the next few months, partly because the recent international commodity price news has been poor.

I don’t feel the slightest bit sorry for the investment banks and the hedge funds, but big asset price falls could hit commercial bank capital. So – for the moment – I’m in favour of a hold on Bank Rate. But I expect some further rate rise (or rises) will be needed in due course. Broad money growth has peaked, but the underlying annualised rate in coming months will probably continue in the 7% - 10% area. With inflation in the 2% - 4% area, that still gives rather high real money growth and implies – for the time being – resilient domestic demand.

Comment by Professor Gordon Pepper (Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Raise again without delay if clear evidence that monetary growth has subsided is not forthcoming.

My comment appears as a series of specific points that are set out below.

The fall in the stock market: The recent fall in the stock market is a welcome development. Excess money can be spent either on goods and services or on assets. Financial markets respond more quickly than the economy. If money-supply policy is insufficient to produce a fall in asset prices it will be insufficient to slow the economy.

Lender-of-last resort operations: Lender-of last-resort operations by a central bank are desirable if the failure of one bank is likely to lead to a chain reaction. Theoretically, the aim should be to allow the first bank to fail, as a warning to others not to be imprudent, but to stop banks further down the chain from failing. If an important financial market, like the inter-bank market, ceases to function because banks cannot assess the credit worthiness of other banks, action by the central bank becomes essential. It is not inflationary providing the additional liquidity is mopped up soon after the crisis is over.

Lessons from the past: A secondary banking crisis occurred in 1974 and the Bank of England was forced to launch a lifeboat. The background was rapid monetary growth, a real estate bubble and inflation in double figures. I was concerned at the time that the Bank’s injection of liquidity would lead to even higher inflation. I was wrong. In the atmosphere of crisis the liquidity was not spent. Another lesson occurred in 1987. After the stock markets’ collapse in October, Greenspan quietly mopped up access liquidity in the US but Lawson failed to do so in the UK. After the crash I warned Lawson that the economy was becoming ‘loaned up’ and that a recession would ensue. My timing was wrong. The recession did not occur until 1990. The lesson was not to base a forecast on a prediction of a slowdown in bank lending and monetary growth but to wait until the data confirm that the slowdown is taking place.

The Credit Crunch’s Threat to Asset Prices: Many people are worried that the credit crunch will cause further routs in asset prices. Borrowing to purchase existing assets involves two transactions. This is clearest when someone does not borrow from their bank. The result of being granted a loan is an increase in one’s bank deposit. This ‘credit transaction’ comes first. The deposit is then spent acquiring the asset. This second transaction is a ‘monetary transaction’. When someone borrows from their bank the two transactions occur simultaneously. Asset prices are not affected by credit transactions. Asset prices change because of the associated monetary transactions. Money and not credit affects asset prices.

When someone finances the purchase of an asset by running down a bank deposit the deposit is not destroyed but is merely passed to the seller of the asset. Money is similar to the hot potato of the children’s game. One individual may pass it to another but the group as a whole cannot get rid of it. If the economy and the supply of money are out of equilibrium it is the economy that must do the adjusting.

The amount of money in the economy is often not in accordance with the current demand for money. Suppose there is a surplus. If it is spent on goods and services, economic activity will increase and inflation will follow after any spare capacity in the economy has been used up. If it is spent on assets, asset prices will rise; wealth and confidence will increase; and expenditure on goods and services will follow. With the latter the time lag before the economy responds is longer.

The recent past: During recent years, monetary growth has been well above that needed to keep it in line with the growth of Gross Domestic Product (GDP). This is why the economy has been more buoyant than many forecasters predicted and inflation has risen. Importantly, it is also an explanation for the rise in asset prices. Abundant money is the explanation for the prices of most assets rising above the levels suggested by traditional methods of valuation. The driving force behind a monetary expansion often changes as an economic upswing develops. During the early stages of the recent upswing money created by the buoyancy of personal borrowing was a major factor. Money created by corporate borrowing, for example to finance Merger and Acquisition (M&A) activity, then took over. This is likely to subside abruptly because of the credit crunch.

The current danger: The main threat to asset prices is the possibility that bank lending to the private sector will start to fall. If this happens, monetary growth may become inadequate and the process of monetary growth leading to asset price inflation will reverse. In general, upswings and downswings tend to be symmetrical during the initial stage of a downswing. A downswing gathers momentum if asset prices drop to a level at which the value of collateral in general is no longer sufficient to cover the loans being secured. The conclusion is that the effect of the credit crunch on asset prices will be temporary if the fall in bank lending does not lead to inadequate monetary growth.

Overall conclusion: Interest rates should not be reduced until there is clear evidence that monetary growth has subsided. If such evidence is not forthcoming rates should be raised again without delay.

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

The data for the second quarter looked strong. GDP was up 0.8% (quarter-on-quarter) to be 3.0% higher than a year earlier. This, arguably, was above trend growth. Moreover, the Bank of England’s latest inflation forecast, published on 8 August, implied that their 2% CPI target would be missed if interest rates were unchanged at 5¾%. This led markets to assume, at that time, that interest rates would almost certainly rise further.

But there is tentative evidence of slowing activity – not least of all in the housing market. On these grounds alone, I believe there is little justification for a further rise and certainly not in September. August’s financial market volatility adds to the reasons for not raising rates in September. It would clearly be unwise to undermine markets with costlier money at a time of great uncertainty. The potential damage to the British economy of current market woes should not, however, be exaggerated. Global stock prices fell by 25% in 1987 but they hardly dented growth trends in the major economies and there is no reason to believe that matters are significantly different in 2007.

I vote for no change in September. And I do not anticipate the need for another increase.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: To tighten one more time, probably in November

As discussed in the last minutes, the judgement then was very finely balanced between a sustained period of holding rates at 5¾% and a sustained period at 6%. My view now is that, although real economy data continues to be quite strong and I still anticipate rates rising to 6% eventually, it is appropriate now to pause - probably until November - to consider the impact of rate rises already seen and to see whether anything more threatening arises from the credit market problems of recent weeks (though I should remark that, from the UK perspective, little material, from a monetary policy perspective, appears to have arisen so far).

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

The turbulence in financial markets means that central banks everywhere will avoid doing anything precipitous like raising rates in the immediate future and that is how it should be. If there was an argument for raising the rate of interest, it has been superseded by events. Widening spreads means that the market is raising rates without help from the Bank of England. The effective increase in the price of credit means that an already moderating consumer sector will slow even faster. The danger is that the market could switch from feast to famine and a credit crunch could develop into an unexpected downturn in the economy. Bank Rate should definitely stay on hold - with a bias to cut - but that cut may come sooner rather than later.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Down ¼%
Bias: Further easing

The latest inflation figures (down to 1.9%) and the sharp cooling of credit markets in the wake of the sub-prime crisis have changed the mood and market conditions. It seems to me clear that the peak in rates has been reached in the UK; indeed I think rates have been pushed too high. Aggregate demand is likely to cool quite sharply into the autumn, with household real incomes stagnant and corporate borrowing risk premiums increased. The next move in rates should be down a quarter point. In the long run, I think that the ‘natural’ rate of interest is 5%, or maybe just below.

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

The US sub-prime crisis is likely to have a significant spillover effect on the UK economy and interest rates must remain on hold until we have a clear view of this. Business and financial services account for about half of the growth in M4, M4 lending and GDP over the last eighteen months and this is now likely to slow. However, M4 growth could be swollen temporarily as banks take onto their balance sheets the various debts that they were planning to sell on to hedge funds and other investors. Private equity funds are particularly dependent this type of funding.

The boom in the financial markets was excessive and was threatening to unbalance the economy, making it too dependent upon the City. The correction in world financial markets was overdue and will head off the risk of a much larger crash later on. Stock markets have been inflated by global liquidity but should now be supported by global growth and profitability, which remain phenomenally strong. These developments will help to rebalance UK growth by slowing private equity and related financial industries that were moving ahead too rapidly, largely immune to the short term interest rates set by the MPC. The private equity business model is likely to be very sensitive to the cost and availability of structured credit. However, it seems unlikely that this situation will resolve itself quickly.

In the meantime, the Bank of England, unlike the Fed and the ECB, has used the shortage of liquidity to force banks to borrow at penal rates, driving up money market rates. Short term, this seems a sensible tactic. It would be a mistake to underwrite bad investment decisions. Moreover, mortgage rates have lagged Bank Rate and the pressure on the homeowner needs to be maintained until clear signs of a slowdown in the housing market and the high street are evident.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Strong bias towards further tightening

The recent shake out in world equity markets seems to represent the blowing off of excess froth from what was increasingly looking like a speculative bubble and international and UK equity prices may have to come off by a further 10% to 15% over the next six or eight quarters before they are in line with economic fundamentals. A disturbing feature of the shakeout has been the uncovering of what looks like Professor Galbraith’s ‘bezzle’, that is funds that have been misappropriated but where the fraud had not yet been revealed. It is not the job of central banks to protect investors against the consequences of their own poor internal financial controls, greed or stupidity, and central banks need to be aware of the risk of the ‘regulatory capture’ familiar in areas such as utility regulation, where the regulator ends up acting on behalf of the industry it is supposed to be controlling rather than in the public interest.

In making Bank Rate recommendations, one is implicitly assuming that there is only one rate of interest that matters – the official REPO Rate – and that changes in that one rate feed through smoothly to all other interest rates and the wider economy. 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 there were many distinct interest rates at work in the system, the pass through from Bank Rate to other rates was often weak, and that different parts of the economy responded to different elements of this interest rate vector. The US Federal Reserve’s 17 August decision to cut its Discount Rate by ½% to 5¾%, while leaving the Federal Funds rate unchanged, illustrates that there are more monetary tools available than is often assumed.

The sharp reduction in annual CPI inflation from 2.4% in June to 1.9% in July was superficially good news, and was accompanied by an easing in ‘double-core’ retail price inflation (excluding mortgage rates and house price depreciation) from 3.0% to 2.3%. However, the large downwards contribution from food prices appears anomalous, given the effects of the weather on agricultural production, and it will be interesting to see the next set of inflation figures on 18 September. Meanwhile, the GDP figures released on 24 August show that the non-oil private sector of the economy – which is what monetary policy operates on - is somewhere between strong and rampant, with non-oil market sector Gross Value Added (excluding rental income from housing) having followed last year’s 3.5% increase with yearly rises of 3.8% in 2007 Q1 and 3.7% in 2007 Q2. This may explain why both measures of unemployment are falling and employment and vacancies going up. M4 broad money growth remained rapid, at 13.0% in the year to July, and total lending was up by 12.0%, while annual house price inflation on the DCLG index accelerated from 10.8% in May, to 12.1% in June. The 3.8% increase in the GDP deflator in the year to the second quarter, is another concern.

Overall, British monetary policy is still appears too loose for comfort – unless the country is enjoying a supply-side miracle, which seems unlikely given what is happening to government spending, regulation and the tax burden – and Bank Rate probably needs to rise further before one can be confident that inflation will not bounce back next year. The tactical question is whether one should pull one’s punches and vote for a hold in September, or stick by one’s guns and vote for a rise. With the sterling index at 104.1 (January 2005=100) and three-month inter-bank rate at 6.53% on 28 August, a phenomenon which should boost the demand for broad money, it can be argued that overall monetary conditions are tighter than the 5¾% Bank Rate suggests. On that basis, it just about seems appropriate to vote for a hold in September but with a strong bias to increase Bank Rate as soon as possible thereafter.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: To Cut

Over the past month, global credit conditions have tightened noticeably. Interest rates for sub-investment grade borrowers have increased materially and credit access for the purpose of mergers and acquisitions has become restricted. UK commercial property and London residential property markets have been caught up in this global credit contraction. At long last, there are signs that credit excesses are being disciplined by internal market dynamics as delinquency rates soar in many US contexts.

UK monetary developments, specifically the strong growth of broad money and credit aggregates, remain open to many shades of interpretation. The M2 money stock, being the retail component of M4, rose by 7.6% in the year to June 2007, down from a peak of 9.8% in March 2006. Household sector holdings of M4 grew at an annual rate of 8.4% in June, similar to the rate prevailing in the past two years. Individuals’ outstanding M4 debt rose 10.2% in the year to June, close to its recent average, but given that there is a significant amount of secured borrowing attached to investments in second properties and Buy-to-Let, it is reasonable to subtract 2 or 3 percentage points from the growth of debt in order to assess the underlying trend. Overall, the financial behaviour of households could be held consistent with an expectation of consumer price inflation in the region of 2-3% per annum.

The growth of wholesale money deposits and the non-household components of M4 borrowing have clear connections to asset market behaviour but very poor explanatory power of consumer price inflation. Technical financial developments in the use of short-term borrowing and deposits by non-bank financial corporations appear to be primarily responsible for the persistence of rapid headline rates of M4 and M4 lending.

In the real economy, the latest statistics show that UK output growth, outside the heady spheres of business services and finance, has fallen back in the past few months and retail price discounting has returned with a vengeance. Presuming that financial turmoil is bad for the high fliers, the transition to economic weakness looks assured. Between April and June, the 3-monthly output growth rate of the distribution sector has dropped from 1.1% to 0.6%; of hotels and restaurants from 1.5% to 1.0%; of transport and communications from 2.1% to 0.9%, and of government, health, education and social work, from 0.6% to zero. The annual pace of growth in industrial production is 0.5%.

The wild card, and it has become increasingly wild, is the contribution of business services and finance. Here, the quarterly pace picked from 0.8% in April to 1.5% in June as world equity markets shrugged off the first US sub-prime hiccup and trading volumes recovered. Takeover activity was virulent in Q2, generating massive fees and commissions, but the mood has weakened materially in the past couple of months as the credit-fuelled bid has been repriced or withdrawn. The business and financial services sector, representing 17% of the economy, is still delivering more than half the 0.8 percentage points of economic growth. The vulnerability of the UK economy to global financial turmoil and tighter corporate credit conditions is disproportionately large.

Another paradox is the mere 3.3% growth in whole economy average earnings and the even more disturbing 3.6% annual growth of employee compensation in Q2 (as compared to 16.2% for corporations’ gross operating surplus). The threat to the UK consumer may seem more remote than that to the US consumer, but the distance may be actually little more than three months in time. July’s consumer price release contained a barrage of evidence that retailers are struggling to implement price increases. Private sector inflation (ex-fuel and light) fell by around 0.5 percentage points. As far as the eye can tell, we are out of the inflationary woods. Consumer demand is likely to soften further in the coming months and there is no justification for a move to 6% rates. My bias is to a cut in Bank Rate, but this will become clearer as the effects of global credit tightening and past rate increases work through the UK economy.

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.


Seems as though a split is developing in the SMPC. Five show a bias (in most cases a strong bias) towards further tightening, and three have a bias towards easing. Only one has a neutral bias.

Anyway, we will know far more next month when the summer hiatus in the credit markets finishes and we see whether the current crisis of confidence persists. If things aren't fixed by this time next month, we will know that the problem is not a temporary one.

Posted by: Minh at September 2, 2007 10:44 AM
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