Sunday, November 04, 2007
Shadow MPC votes 9-0 for no change in Bank rate
Posted by David Smith at 09:00 AM
Category: Independently-submitted research

At its latest meeting, the IEA’s Shadow Monetary Policy Committee (SMPC), a group of leading monetary economists that monitors developments in UK monetary policy, voted unanimously to hold interest rates at their current level.

Though three members of the SMPC believed that the next move in interest rates should be downwards, one had a bias to tighten and the other members felt that we should wait and see how the economy responded to developments in the banking sector before taking further decisions on changing interest rates.

A number of members were still concerned about strong monetary growth but there was an expectation that monetary growth should decline after a blip in the next few months. Professor Anne Sibert reflected the consensus view in commenting, “The economy is recording good growth and in the absence of the credit crunch monetary policy was correct. The credit crunch will prove to be a blip and thus there should be no change in interest rates.”

Most members felt that there was no reason to respond immediately to the recent liquidity problems in the banking market by reducing interest rates. The problems related only to the banking sector and they should not be addressed by slackening monetary policy. It was also felt that the Northern Rock crisis would only have a temporary effect on house prices and consumption. Harsh lessons should have been learned, argued a number of members, from previous occasions when central banks responded to problems in financial markets by reducing interest rates.

There were, however, dissenters from the majority view. Professor Kent Matthews believed that higher interest rates in the money markets would justify lower central bank rates in the medium term and Peter Warburton was concerned that there were considerable downside risks from the “credit crunch”

Minutes of the Meeting of 16 October 2007

Attendance: Philip Booth (IEA observer), Tim Congdon, John Greenwood, Andrew Lilico, Kent Matthews (Secretary), Ann Sibert, David Brian Smith (Chair), David Henry Smith (Sunday Times observer), Peter Warburton.

Apologies: Ruth Lea, Patrick Minford, Gordon Pepper, Peter Spencer, Trevor Williams, Allister Heath (The Business observer).

Chairman’s Comments

David B Smith reported that the regular monthly coverage given to the SMPC by Bloomberg Television and the Sunday Times had helped to establish it as a brand identity and it would be useful to try and build on that achievement. In particular, he encouraged members of the Committee to mention their affiliation to the SMPC in their dealings with the media. On a different subject, he requested that submissions to the monthly e-mail poll should be made in Word documents, in black font, using Times New Roman (12) in order to ease production problems.

David B Smith then invited Andrew Lilico to give his assessment of the world and domestic economy.

The Economic Situation

The International Economy – the facts, pre-credit crunch were mildly supportive of a rise in interest rates

Andrew Lilico summarised the key facts about the world economy much of which pre-dated the Credit Crunch. On the basis of the data pre-Credit Crunch, the facts of the world economy were mildly supportive of a further rise in interest rates. Actual OECD growth was solid and the IMF forecast for world growth in 2007 was 4.9% and 4.8% in 2008. OECD broad money growth was 13.3% in the year to Q2 from 10.6% in 2006. Commodity prices were up 6.5% on October 2 and 25.7% on the year and oil prices had resumed its upward march.

Money growth in most other developed economies is also buoyant and it is likely that the ECB will have to raise rates before long. Despite some leading indicators pointing to a slow-down, monetary growth in the OECD is pointing to renewed expansion. In China, monetary growth of 16-17% is appropriate, and, after allowing for velocity movements and GDP growth of 10%, is compatible with an inflation rate of some 2-3%. Japan is the only exception where money growth is still too low but the basic picture for the world economy is one of buoyant growth underpinned by strong monetary growth.

The Domestic Economy – little sign of abatement in money and credit growth

Andrew Lilico referred to the chart of M4 growth on a twelve-month and three-month annualised basis and reported that the yearly rise in August was 13.5%. M4 lending in August was 12.3% year-on-year. Two other charts on the growth of secured lending and consumer credit showed a declining trend even before the credit crunch began to bite. A fourth chart showed housing equity withdrawal in 2007 Q2 well below its peak in 2004 but above the bottom recorded in 2005. Employment is strong and the unemployment rate was 5.4% in the second quarter, down 0.1% from the previous quarter. Earnings growth in the year to July was slightly higher at 3.5% from 3.4% in June. CPI inflation was 1.8% in August and today’s figures showed that it remained at 1.8% in September. RPI inflation was 3.9% in September having been 4.1% in August. House price inflation rose in July but there are signs of a slowing down.

Following the credit crunch the consensus forecast for growth is one of moderate easing in 2008. The feeling in the market is that there will be no further rate rises this year and the next move in rates will be down. The credit crunch appears to have had a similar effect on mortgage rates to that a 25bps rise in Bank Rate would have done. However, if in three months time the interbank rate returns to a normal relation to Bank rate, mortgage rates have fallen back, and the February 2008 Inflation Report implies that at 5.75% Bank Rate inflation will be above 2% for much of the next two years, the credit crunch may well be seen as a blip and we may again be talking about a rate rise.

Discussion and Policy Response


Growth slowdown in 2008

David B Smith said that the published evidence, which almost entirely antedates the August credit crunch, supports the view of a strong domestic economy. The question is has there been a sudden change in the drivers of the economy, as a result of recent money market problems? One shouldn’t be dogmatic about this and it was worth recalling that after the 1987 stock market crash many forecasters – including HM Treasury – wrongly imposed significant negative residual adjustments on their forecasts. The resulting inappropriate monetary easing, gave a final upwards kick to the Lawson boom, and was one reason why the recession of the early 1990s was so severe. Market rates typically lead official rates and a case could be made out that a 6% plus inter-bank rate was not inappropriate for an economy with Britain’s current account deficit, given the rate of inflation, and real interest rates overseas. The expenditure equations in his econometric model actually ran off three-month inter bank rate, not the official Bank Rate. His latest post Pre-Budget Report forecasts suggested that GDP growth would be some 3% -3¼% this year but slow to 2¼% in 2008. This was in line with the official Pre-Budget Report forecast for next year, but above the 2% new consensus.

Kent Matthews asked for clarification as to why the model is forecasting a growth slowdown? David B Smith said that it partly relates to the dynamics of the model, when real household consumption is well above its long-run sustainable level, which is the case at present, the error-correction mechanism drives consumption growth back down. The other depressive factors in his projections are a slowdown in broad money growth and a negative contribution from net exports. However, he was aware that the more recent econometric research suggested that incorporating long-run equilibrium terms in statistical relationships could lead to a worse live forecasting performance in the face of deterministic breaks. But, as an economist, he was reluctant to throw away all the long-run information contained in the low frequency component of economic time series.

Tim Congdon said that the credit crunch was a profound shock to many banks but it is not clear that the growth of real money balances will slow down significantly. He doubted that the predicted slowdown in demand growth to a beneath-trend rate would in fact happen. Banks will raise liquidity ratios following the lessons of the credit crunch, but next year should still see M4 growth in the high single digits at an annual rate. He wondered whether, after subtracting the recent drop in utility prices, actual inflation would still be above 2%. David Henry Smith (Sunday Times observer) said that on a point of fact the full effect of the drop in utility prices expected by the Bank had not come through to inflation yet.

John Greenwood stated that he shared the view that the impact of the credit crunch is likely to be short lived. The credit squeeze was not caused by the central banks but by the market in response to a micro- or sector-level liquidity problem. It is not clear that liquidity in the aggregate sense has tightened. Recessions are generally caused by central banks tightening over a sustained period, and at present the Fed, the ECB and the BOE are doing exactly the opposite. There is currently no difficulty in raising funds for high-grade loans. Only sub-prime loans, structured credits and LBO loans for private equity will face difficulties. There will be a shift of lending from sub-prime loans and mortgage-backed securities towards more traditional plain vanilla borrowers, or from the household sector to the non-financial corporate sector.

Those who predict a recession are ‘bottom up’ forecasters. Their argument is that problems in one sector (housing) will contaminate all other sectors. A ‘top down’ framework starts with monetary and fiscal conditions and predicts an overall level of spending. For example in the USA, overall GDP growth is still quite buoyant and likely to remain so. It is no surprise that after the phenomenal expansion in the housing sector, there will be an extended decline in that sector and related areas. But there will be strong counterweights in the form of a narrowing of the trade deficit through export growth (which is likely to contribute more to GDP than the downturn of the housing sector subtracts from it), and non-residential investment. Real GDP growth will therefore be better than predicted. Talk of a recession is grossly exaggerated.

Peter Warburton claimed that pessimism comes from the ‘top down’ as well as ‘bottom up’. The greater part of the correction to credit spreads is still to come. Aggregate credit growth has slowed and is expected to slow further as a result of the summer’s turmoil. The non-bank sector is embroiled in a solvency crisis which is far from over; other contexts are likely to be infected, in particular commercial property, credit insurance, student loans, and municipal finance. The global credit cycle is turning down but central banks are powerless to stop the concomitant economic slowdown. The final quarter of 2007 and first quarter of next year will be the test for the USA.

Anne Sibert said that the credit crunch effect on interest rates is a one-off that will not cause a sharp change in UK house prices. David Henry Smith (Sunday Times observer) said that he had some sympathy with the view of overstating the effect of the credit crisis. It’s not whether LIBOR comes back to a normal relation to Bank Rate that matters but if lenders change their behaviour in a quantitative sense. He reminded the committee that in 1998 factors such as LTCM, the Asian crisis in the previous year and Russian default led to prediction of a downturn in 1999, which turned out to be a period of high growth. An interest rate response may not be appropriate if there is a quantitative effect on credit.

Tim Congdon said that the Bank of England, the FSA and/or the credit rating agencies would be very likely to be asking for a higher liquid assets ratio. No central bank will wish to see this sort situation again. Philip Booth asked why there won’t be a market solution to the liquidity shortage. Tim Congdon said that private sector credit rating analysis is mostly concerned with solvency issues, leaving liquidity problems the domain of the central bank. He said that the effect of the credit crisis will be more than a blip. Banks will raise liquidity ratios and there will be a slowdown in credit growth over three or four years.

There followed a discussion on the role of the central bank when a commercial bank faces with a liquidity shortage. The consensus view was that the central bank should make liquidity available at a penal rate so that the shareholders of the bank take a hit in lower profits.

Individual Votes

David B Smith then asked the members of the committee to vote on a rate recommendation.

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

Philip Booth said that central banks should not respond to the recent shock to mortgage markets, which he believed to be a temporary real shock, by slackening monetary policy unless the shock led to a future change in savings and consumption behaviour in which case interest rates should be lowered at that time. He voted to hold with a neutral bias for the immediate future.

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

Tim Congdon said that the current UK inflation performance is good and the world economy is strong. Money growth, currently at 12-13% will blip and then slowdown. He said there are a lot of uncertainties and his vote is to hold in November and subsequently wait and see.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: Neutral

John Greenwood said that the private sector is growing strongly. There were threats to the consumer sector but currently retail sales are strong. Interest rates are not excessively high. Unless the fallout from the credit crunch proves to be stronger his vote is to leave Bank Rate unchanged with a neutral bias thereafter.

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

Andrew Lilico said that in the absence of the credit crisis he would have been inclined to raise rates. The current situation warrants that rates not rise. He voted to hold in November with no particular bias subsequently.

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

Kent Matthews said that widening credit spreads and the prospect of banks raising liquidity ratios will have a strong effect on credit availability. This on its own would warrant a hold in rates. But this happening on an economy that is showing signs of slowing in some of the major sectors creates a bias to cut. He voted to hold in November but with a bias to ease looking further ahead.

Comment by Anne Sibert
(Birkbeck College)
Vote: Hold
Bias: Neutral

Ann Sibert said that the economy was recording good growth in the absence of the credit crunch and monetary policy was correct. The credit crunch will prove to be a blip. She voted to hold Bank Rate and had a neutral bias with respect to subsequent months.

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

David B Smith said that the conventional theoretical macroeconomic model was an inadequate framework for understanding the impact of the credit crisis, because this model did not incorporate a banking sector or the stocks of credit and money. He said that, when determining the amount of braking that was needed to slow the speed of a car to comply with the 30 mph limit, everything depended on whether the starting speed was 85 mph or 35 mph. His view was that the economy was running much closer to 85 mph before the August money-market squeeze, and that this could be seen from the 3¾% annual rise in Britain’s real non-oil market sector Gross Value Added in the first half of the year. He still thought that CPI inflation will accelerate from 1¾% in the final quarter of this year to not quite 2½% by the final quarter of next year.

He added, however, that he was concerned that precautionary credit rationing on the part of lending institutions could slam the brakes on the economy too hard and that credit conditions needed watching very carefully. In the longer term, he thought that the liquidity ratio should be looked at as an extra instrument of monetary control in addition to the capital requirements imposed by the Basle agreement. Given that some tightening will occur in the banking sector he said he voted to hold in the very short run, but thought that a further modest tightening would probably still be required in the longer term.

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

Peter Warburton said that he took a different approach to others on the committee. He foresaw three serious downside risks; first the impact effect of the credit crunch, second the widening of spreads and the quantitative effect on credit growth and third, retrenchment in the public sector and possible further tax increases in addition to those scheduled to take effect next year. His vote was to hold Bank Rate in November, with a bias to ease.

Votes in Absentia

The SMPC allows a small number of votes to be cast in absentia and adds their written submissions to the record of the meeting, to ensure that exactly nine votes are cast. On this occasion only one vote was required in absentia since eight SMPC members were present at the physical meeting.

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

My vote is for a hold, with a bias to cut. It is too soon to cut Bank Rate, and at the very least it should not be this year. The economy is still growing quickly (Q3 was estimated at a 3.2% annual rise), money supply growth has accelerated and equity markets are buoyant. Set against that there are some tentative signs of economic slowdown, in the housing markets and in the services and manufacturing Purchasing Managers Indices (PMIs), but not enough to suggest that the economy will soon slow to below a trend rate of growth. Moreover, there are still risks to price inflation from higher food prices and from higher oil prices, despite the weak rate of annual earnings growth, which may be subject to revision and not last if the economy does not slow from its current 3% plus pace very soon.

There needs to be time to let the rises in interest rates so far definitively slow the rate of economic growth before easing monetary policy. That in my view will take another four to six months or so to be sure, taking us into 2008 and either February or May before any monetary policy response is required. The widening of credit spreads may also impact mortgage rates and increase the borrowing costs of companies but it is still too soon to be sure whether this will have any discernible additional negative impact on economic activity. I therefore vote to leave rates on hold, but with a bias to ease should conditions allow.

Policy response

1. In a rare show of unanimity the eight members of the committee that attended the meeting, and the one vote cast in absentia, all voted for interest rates to remain on hold

2. Three members voted to hold rates with a bias to ease in the future.

3. One member voted to hold with a bias to a rise.

4. There was a general agreement that bank liquidity ratios should be discussed at a future date as a possible additional instrument of control.

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.


Congdon has changed his tune vastly. Recently he was saying CPI would hit 5%+ within the next year. Now he says that, despite thinking the impact of the credit crunch will be minimal, inflation is under control?

Posted by: Minh at November 4, 2007 02:45 PM

Oh, and staying with Congdon for a moment - it was amusing to see him on Newsnight the other day defending Northern Rock. Not once in the programme was it mentioned that he is in fact a shareholder!! Not sure what is worse - Congdon failing to declare his interest, or the BBC for failing to do their research well enough!!

Posted by: Minh at November 4, 2007 06:11 PM

To be fair here, Tim Congdon had an FT piece last Friday where he stated himself that he was a NR shareholder.

Posted by: Costas Milas at November 4, 2007 08:24 PM

Hope he loses the lot.

Posted by: Kev M at November 7, 2007 06:51 PM
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