Sunday, September 30, 2007
One vote for a cut on shadow MPC
Posted by David Smith at 09:00 AM
Category: Independently-submitted research

The outcome of the latest Shadow Monetary Policy Committee (SMPC) monthly
E-Mail Poll (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 4 October.

On this occasion, eight SMPC members voted to leave Bank Rate unchanged on 4 October, but one member, Patrick Minford, voted for a ½% reduction. Looking further ahead, most members found it difficult to make firm judgements until the Northern Rock affair had settled down.

Three SMPC members had a bias to ease, two thought that there might still be a need for higher rates in subsequent months, Patrick Minford thought that more than one rate cut would be required, one was neutral, and two thought that ‘wait and see’ was the only viable policy.

Comment by Philip Booth
(Cass Business School and Institute of Economic Affairs)
Vote: Hold
Bias: Wait and See

In the circumstances it is difficult to see how the current events within the banking system and financial markets will affect monetary conditions and the real economy. Though I am still worried about monetary conditions, I do not believe that this is the right time to be considering increases in interest rates. In particular, if recent events spark a rise in saving and a fall in consumption, monetary tightening would be facilitated with a lower level of interest rates than would otherwise be the case, especially if interest rates are falling overseas. It is therefore appropriate to wait and see.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: No change

‘The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. “We lent it,” said Mr Harman, on behalf of the Bank of England, “by every possible means and in modes we have never adopted before; we took stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every means possible consistent with the safety of the Bank, and we were not on some occasions over-nice.’
Walter Bagehot, Lombard Street (1873) pp. 51-52

The recent liquidity crisis in major economies has highlighted one of the perennial, fundamental dilemmas facing central banks: how to handle a failure of the payments system (as after 9/11), a freeze in the credit markets (as after Long Term Capital Management (LTCM) or as in early August following the deterioration of conditions in the credit markets related to the funding of US sub-prime mortgages), or - more traditionally - a run on one or more banks as illustrated in the run on Northern Rock?

Should there be extensive regulatory controls that pre-emptively restrict the commercial lenders from over-expanding their balance sheets? Or, once the crisis has erupted, should central banks continue to insist on a tough discipline that punishes bank shareholders (and possibly innocent depositors), or should they pay out whatever funds are necessary to end the crisis as soon as feasible?

If central banks follow the tough line, they risk further runs on other banks as the panic spreads. This is exactly what happened in 1930-33 in the United States. In that episode the extensive bank failures and the associated contraction in money and credit as deposits were wiped out by successive bank failures exacerbated a normal economic downturn, converting it into the deepest and longest recession the US economy had ever seen. A similar chain reaction also became a fleeting possibility in the UK on September 13-14th when official reassurances failed to stem the run, and depositors realised that other mortgage lenders might be as exposed as Northern Rock. The threat of further runs was one of the key factors that triggered the Treasury’s decision to guarantee all Northern Rock deposits.

If on the other hand central banks pay out funds immediately and without limit, this will surely save the economy from a severe downturn, but at the cost of another asset bubble or an inflationary spiral sometime later.

The classical answer to this dilemma given by Walter Bagehot (see: the quotation above) and subscribed to by most economists and central bankers ever since the late nineteenth century has been that the right response for a lender of last resort was to make ample funds available, but to impose three stringent conditions. The funds should only be available:

1) on a temporary basis,
2) against good collateral (taking the necessary “haircuts”) and
3) at penalty rates.

Given the current crisis and the urgent need to reliquify the credit markets in developed markets it makes no sense for central banks to be raising interest rates at this time. The Bank of England may be able to preserve its 5¾% Bank Rate and yet comply with these three conditions, but the conditions are being stretched. REPO’s must be done for a longer term (up to three months in the Bank’s latest offer), and the range of collateral that the Bank will accept is being widened. For the moment the penalty rates remain intact.

However, in the face of (so far) small risks that the US economy might stall, the Fed has capitulated, cutting both the Fed funds rate and the discount rate by 50 basis points on 18th September. The current risks to the UK economy are arguably not as great, and the inflation risks remain. In the absence of evidence that the economy could weaken suddenly and sharply, the MPC should hold firm, and not cut rates on 4th October.

Comment by Professor Gordon Pepper (Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Wait and See

With the advent of floating-rate loans banks passed interest-rate risk on to their customers. With the advent of securitised loans banks could pass credit risk on to purchasers as soon as the securities were sold. With interest-rate risk and credit risk thought to have been avoided it is no wonder that banks marketed loans most aggressively.

Security standards were lowered and gearing was increased by the new sophisticated financial instruments.A considerable amount of the risk was not, however, passed on. Banks themselves held securitised loans either as part of their portfolio of assets or ones in the pipeline that had not yet been sold. Although an individual bank could pass on credit risk, banks as a whole did not pass all of it on. The inter-bank market dried up in the UK because banks did not know which of them were exposed to the credit and associated risks that had been passed on by others.

If the problem in the UK banking sector was merely one of liquidity, the Bank of England would have had ample ability to supply the missing liquidity to the system as a whole. They could, for example, have entered the gilt-edged market as a buyer. If an assurance company, for example, had sold, its bank’s balance with the Bank would have risen.

In spite of what the authorities have said, the problem is almost certainly one of solvency, in which case the Bank’s capital and free reserves are too small to cover the credit risks of banks in trouble. The Treasury is the only body capable of covering this risk and has set a precedent.

UK banks have in effect passed credit risk on to taxpayers. If things go wrong the cost could be enormous.

The result is that in the UK, and especially in the US, financial systems are in uncharted waters. There are potential obstacles in almost all directions. The best thing to do in such circumstances is to proceed slowly and cautiously until things become clearer, with everyone alert to take urgent action if need be. This includes leaving interest rates in the UK on hold for the time being.

Comment by Ruth Lea
(Centre for Policy Studies and Arbuthnot Banking Group)
Vote: Hold
Bias: To Cut

Given the ongoing financial turmoil economic prospects are “more than usually uncertain”. But, making the assumption that the Bank of England will act to ease any continuing difficulties in the inter-bank lending market by injecting adequate liquidity and there are no further banking crises, the impact on the real economy of the turmoil may yet prove to be modest.

Even prior to the start of the turmoil in August, the economy was set to slow. Real personal disposable income (RPDI) has been stagnant (it actually fell back 0.3% in the 1st quarter of 2007), the saving ratio is a paltry 2.1% and the full effects of the hikes in Bank Rate since the beginning of the tightening period in August 2006 have not yet fed through. So, even though the latest data suggest a real economy is rude good health (August’s retail sales were robust), it is unlikely that this apparent buoyancy will continue. The recent robustness is surely deceptive.

Whilst I do not expect a significant fall in house prices nationally, the current data have proved singularly unhelpful in determining underlying trends either way. The disruption to the housing market of the introduction of the Home Information Packs is an unwelcome distortion to the market. CPI inflation has recently proved to be better than I expected given the rise in commodity prices. Under these circumstances, a note of caution is probably advised. I vote for no change in October with a bias towards a cut – but not imminently.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Tightening

As last month, what is observable in the data indicates a tight decision between raising one more time in response to continued strong monetary growth and holding, perhaps until November, to observe the effects of past rises. However, as we all know, the judgement from the data has to some extent been overtaken by events and there has even been some discussion of whether a cut in rates would be appropriate. In my view, unless the Bank has access to information about perils that are not public knowledge, all talk of cuts should be ignored. To cut in the current situation would be a panicky over-reaction that would make the market suspect that matters are worse than they appear, and so counterproductively serve to undermine stability rather than to underpin it.

It seems to me that the Northern Rock debacle indicates a weakness in Gordon Brown's widely-lauded monetary and financial regulation arrangements. In the case of the danger of a bank run, there is an unfortunate lack of specific responsibility and authority to act combined with too many constraints on the ability of the key agent - which surely must be the Bank - to do what is required, and excessive and inappropriate transparency. It is surely intolerable that EU market abuse rules force the Bank of England to disclose exactly what lender of last resort facilities it offers, even when such transparency threatens market stability. And it is almost as unattractive that a bank run and possible failure appears preferred to the presentation of a Bank-brokered takeover fait accompli.

We also have extensive discussion of the introduction of 100% deposit insurance up to a high ceiling. Whilst it may be prudent to consider all options in the light of current events, one should not underestimate the implications of 100% deposit insurance - a vast raft of additional regulation that has the potential to significantly undermine the City's position as a pre-eminent global financial centre. The danger of panicky over-reaction must be resisted in this area, also. Insofar as any measure in this area is appropriate, might it not be best contained to institutions officially declared solvent with the funding provided by the Bank and Treasury, rather than the Financial Services Compensation Scheme (FSCS)? So, the point would be "to put one's money where one's mouth is" in terms of backing up the public official declaration that a threatened institution is solvent - thereby adding credibility where otherwise credibility is limited (for of course the authorities have strong incentives to declare institutions solvent that are not, if a declaration of insolvency would threaten financial stability). Thus, I suggest that consideration of deposit insurance might be best contained to insurance of officially solvent institutions.

As to the current interest rate judgement, my view is that we should certainly hold for now, and that matters in credit markets are unlikely to have calmed down sufficiently by November to justify a further rise. But at least one further rise should remain a possibility on the table for some months yet and, as far as I am aware, we are many months away from needing to consider cuts.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Down ½%
Bias: Further easing

The background to the current situation reveals two major monetary policy mistakes by the Bank of England since the beginning of August when the scale of the banking crisis became apparent.

The first was not to act like the US Federal Reserve and the European Central Bank to inject liquidity into short-term money markets against widely defined collateral. The result of this bold experiment in difference is plain to see; whereas there has been no bank run in the US or the euro-zone, here we had the Northern Rock run. It is difficult to avoid the conclusion that the Bank’s policy caused the run, although one can argue about it as with any empirical proposition, of course.

The second has been not to cut Bank Rate sharply as the Federal Reserve has now done. Market three-month rates - i.e. those relevant to the economy - are now some 0.6% above base rate. Thus effectively UK monetary policy has been considerably tightened at a time of crisis. If this was inappropriate before the crisis, it is most definitely highly inappropriate afterwards.

We should not be distracted by glib talk of ‘moral hazard’. Lender of last resort actions to stabilise the banking system and avoid runs are part of the unwritten constitution of our banking markets. This constitution does in a sense ‘cause moral hazard’ but we have it because it underpins an active banking system that is good for the economy - that is the sort of moral hazard we most definitely want. To suddenly turn around in mid-crisis and revert to a much earlier primitive philosophy as the Bank did was its first serious mistake since it was given instrument independence over interest rates. It has now put that independence into play under a government that prizes economic stability and is ruthlessly aiming for early re-election.

Regardless of my assessment of the economic outlook, there is therefore a need to cut the base rate substantially to get monetary policy back on pre-crisis course. I would therefore suggest a half point cut now, like the Fed. Also like it I suggest being alert to likely signs of weakness in the evolving outlook in these weeks as the crisis either deepens or unwinds. Further cuts are likely to be needed- a downward bias.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Neutral in short term but further tightening may be required

The Northern Rock affair was one of those strange flare ups, which are important politically, but whose wider economic significance is uncertain and may be small. One unusual feature of the liquidity crisis that hit Northern Rock was that the problems allegedly occurred solely on the liabilities side of its balance sheet. Banks more commonly get into trouble because a sudden rise in bad and doubtful debts wipes out the value of the collateral used to secure their lending – which is their main asset – beyond the point where the damage can be made good from their capital and reserves. However, Northern Rock’s heavy reliance on the wholesale markets, and its concentration on lending to households, meant that its structure was closer to that of a hire purchase finance house than that of a conventional bank. The Bank of England has been heavily criticised over its performance in the Northern Rock episode. However, the fundamental problem was that the tripartite structure established in 1997 was too unwieldy to permit the rapid response and clear chains of command required in a lender of last resort situation. Attention was drawn to this weakness in my 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 ( published well before Northern Rock appeared to be in trouble, so this is not just arguing from hindsight.

A personal view is that some such fiasco was an accident waiting to happen, and that, rather like the British military in Iraq, the Bank of England simply did not have the appropriate tools available to do a more professional job. At the end of the day, the harm done by Northern Rock will probably prove to be small, provided that institutional changes, such as a more sensible system of (partial) deposit insurance, are implemented. The collapse in Northern Rock shares certainly reduces the moral hazard aspects of the bail out where the shareholders of other banks are concerned. The main principal/agent problem that remains is how the management of failed institutions can be made to share the pain, if their reckless behaviour endangers the organisation concerned. The early Victorian approach of unlimited personal liability where directors were concerned had a certain brutal logic in this respect. It is possible that class action suits on the part of shareholders may come to be the modern equivalent.

The first rule of a good Doctor is that he does no harm, and there seems to be a strong case for leaving base rates unchanged until the dust thrown up by Northern Rock has settled. I still believe that domestic demand remains too strong for comfort, while the US Federal Reserve’s aggressive ½% cut announced on 18th September reduces the need for lower rates in Britain because of the stimulus it has provided to world activity and the financial markets. The benign August inflation data confirms that the slowdown in inflation recorded in July was not simply a rogue figure, however, and this has reduced the immediate inflation concerns. The main reason that I still expect to see higher interest rates at some point is that sterling could weaken quite dramatically, both for fundamental reasons and because the financial markets come to fear that the Bank of England has lost its authority and become politicised post Northern Rock. People who believe that a successful monetary framework can only be achieved if inflationary expectations are tethered must also be concerned by the speed and abruptness of the run on Northern Rock, and the lack of faith that depositors showed in the credibility of all the monetary, regulatory and political authorities. The scope for a sudden upwards ‘gear shift’ in inflationary expectations now appears greater than it did a month ago.

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

The extraordinary departure of three-month LIBOR from the Bank of England Base Rate in the past month has highlighted the capacity for market interest rates to set their own course. Belated concessions on the provision of additional money market liquidity, up to three months, and the broadening of acceptable collateral will doubtless restore a measure of calm to the situation. But the underlying message is clear: that borrowers face larger risk premiums in the months ahead.

To the extent that market interest rates remain higher than the MPC intends, it is logical to consider the merits of a cut in Bank Rate. A second month of lower-than-expected consumer price inflation and a sharp fall in asking prices in the residential housing market support this consideration. However, if the Bank of England is to attach any substance to its warnings over moral hazard in the banking system, then it must satisfy itself that a Bank Rate cut would not provoke a renewed outburst of reckless lending.

In time, the deceleration in corporate takeover activity and in financial sector profits can be expected to weigh heavily on UK economic performance. The Q3 national accounts data, released just before Christmas, will allow a better assessment of the impact of the credit turmoil. The action of the US Federal Reserve to reduce interest rates by 50 basis points on 18th September appears rash and poorly-judged. While this decision will add to pressures for a rate cut in the UK, there is no rush to do so. The public has received a serious jolt from the Northern Rock debacle and it may be preferable to nurture this mood of austerity for a little longer, rather than rushing into a rate cut. But my bias is, nevertheless, to cut within the next three months.

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

I am voting for a hold at 5¾%, with a bias to ease. The rationale for this is two fold. One reason is that the sub-prime crisis has effectively tightened monetary policy and so consumer price inflation is more likely to stay at / under or around the 2% target in the year ahead and economic growth is likely to be weaker than otherwise.

The second reason is that the solution to the credit squeeze is not simply to lower interest rates, although it can clearly help - as the case of the US seems to prove. Excessively low interest rates at a time of ample global liquidity are partly to blame for the current crisis as investors went into ever more exotic and illiquid derivatives, which they did not understand or price properly, in order to enhance returns. However, the opacity about which banks are holding bad loans on their books (mainly off balance sheet), and may therefore have a liquidity problem, combined with worries about commitments to extend loans to bodies such as hedge funds means that banks hang on to liquidity when they get it. This of course means that inter-bank rates are high, and well above historic spreads relative to base rates, implying a tighter monetary policy than intended by policy makers and a gumming up of the key inter-bank market. But even in the US and the Eurozone, where there have been vast injections of liquidity, spreads remain wider than normal, though the spread in the US has fallen now that rates have been cut by ½%.

However, liquidity still has to be provided otherwise institutions that have to access the wholesale money markets or those that have funding requirements linked to it will face high costs. And some, following the example of Northern Rock, could come close to failure. The Bank of England now realises this and is offering money at the three-month inter-bank maturity with a wider range of collateral but with a penal rate to avoid moral hazard issues. There will be pressure on the Bank to lower the penal rate from 1% over base rate, or 6.75%, if LIBOR rates do not fall back soon. However, a reduction in Bank Rate cannot yet be justified by the pace of growth or the easing in consumer price inflation. Retail price inflation and RPIX are too high and wage inflation, although low will not stay low unless output growth slows back towards the forty-year average rate of 2.3-2.5%, given that unemployment is so low. The minutes of the Bank of England’s September MPC meeting, published last week, showed that it voted unanimously to keep interest rates unchanged at 5¾%. The minutes said that upside inflation risks had receded, signalling that interest rates are likely to remain on hold.

My view is that the international growth background will remain solid especially in the emerging markets but also in Europe. US economic growth will rebound next year, helped by the cut in the Fed funds rate to 4¾% but inflation there is likely to be more of a risk in 2008 and rates may rise in the second half of the year once sub prime crisis fears abate. The latter will happen as it becomes gradually clearer about the extent of exposure to risks from the US housing market slowdown.

Annual CPI inflation remained below the 2% target in August, falling to 1.8% from 1.9%. This was the fifth consecutive monthly decline, after the peak of 3.1% in March. This supports the view that interest rates are likely to have peaked at 5¾%. The RPI measure of inflation, however, rose to 4.1% from 3.8%, because it includes the rise in mortgage interest payments. Official retail sales figures were surprisingly strong in August. They rose 0.6% (up 4.9% on the year), compared with prior financial market expectations for no change. However, the data show that the strong rise in sales was boosted by heavy price discounting by retailers. The CBI industrial trends survey showed that manufacturing activity remained robust, particularly for intermediate goods, despite the recent financial market turbulence and the strong pound. The total orders balance fell slightly to 6 in September from 9 in August. All in all, it is too soon to lower interest rates; money supply was up strongly in August (1.2% on the month and 13.5% in the year) and so Bank Rate should remain on hold this year but the next move is down once it is clear that the economy is slowing to a below trend rate.

The SMPC is a group of independent economists who assemble once a quarter at the Institute of Economic Affairs (IEA) in Westminster. The inaugural SMPC meeting was held in July 1997 and the Committee has met virtually every quarter since then. That it is the first such body in the UK and meets regularly to discuss the deeper issues involved distinguishes the IEA’s SMPC from the similar exercises now carried out by several publications. A more profound examination of the monetary policy issues 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).


What happened to Tim Congdon and Roger Bootle?

Posted by: Minh at October 3, 2007 12:20 PM

Unlike the real MPC, which pays reasonably well for its members to turn up at the same time each month, the shadow MPC is a volunteer body. To get nine responses, it has to draw from a larger pool, which currently consists of 14 economists. This is how it puts it:

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.

Posted by: David Smith at October 3, 2007 06:07 PM

What happens when more than 9 of the 14 respond?

Posted by: Minh at October 3, 2007 06:44 PM

First come, first served

Posted by: David Smith at October 3, 2007 06:51 PM