Sunday, January 06, 2008
Shadow MPC votes 5-4 to cut again
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

The outcome of the most recent Shadow Monetary Policy Committee (SMPC) monthly E-Mail Poll (in conjunction with the Sunday Times) is set out below. The recommendations are made with respect to the UK Bank Rate decision to be announced on Thursday 10 January.

On this occasion, four SMPC members voted to leave Bank Rate unchanged, while five members voted for a reduction. As happened last month, the rate cutters were split, with three desiring a reduction of ¼% but two wanting a cut of ½%. This would deliver a rate cut of ¼%, if the normal Monetary Policy Committee (MPC) voting procedure was adhered to. The same was true of the December SMPC recommendation, which was in line with the ¼% rate cut announced later on 6th December.

However, the shadow committee endeavours to say what should happen to rates, rather than what will. All of the SMPC members were worried about the global credit crunch and the danger that this could lead to a cracking of the robust UK economic conditions reported in the recent data. Several were perturbed by the poor current account balance of payments figures released on 20th December, however, and some thought that this could limit the scope for rate cuts.

Comment by Tim Congdon
(London School of Economics)
Vote: Cut by ¼%
Bias: Wait and see

The monetary situation is puzzling. Clearly banks will react to the crisis of summer and autumn 2007 by restricting balance sheet growth, and that signals slower money growth in 2008. But asset prices should still be benefiting from the high money growth of the 2004 to 2007 period. Instead the last few months have seen a sharp fall in property values and bear markets in some sectors of the stock market. Apparently wealth holders want a higher ratio of money to non-money assets, which is a ‘confidence effect’. Given that the Bank of England has already cut rates by ¼% (when I had advocated a ½% cut), I am in favour of another ¼% cut and continued action to bring inter-bank rates back into line with ‘the Bank Rate’ (as, at long last, it is again being called). But I do not expect 2008 to be a particularly bad year for the economy, with only somewhat beneath-trend growth.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Cut by ¼%
Bias: To ease.

The coordinated action of central banks to offer longer term credit facilities to commercial banks by means of a series of auctions has helped to ease money market conditions in the last week or two, but concerns about counterparty risk in the inter-bank market remain acute. These signs of sustained stress in the money markets point to fears that the balance sheets of banks and other financial institutions are still burdened with structured securities that are either overvalued or of uncertain value. In the case of some banks this requires further balance sheet repair and, possibly, more recapitalisations. Until such concerns have eased, the wide spreads between yields on Treasury bills and money market interest rates will persist.

More broadly, the overheating of the underlying housing market needs to cool further. Signs of such cooling have become more evident in the past three months as - by most measures - house prices have continued to fall on a monthly basis (e.g. according to Halifax, Nationwide and Rightmove, as well as the Royal Institution of Chartered Surveyors poll), and mortgage approvals have declined by 31% over the past year to the low levels of early 2005.

However, when bubbles burst they normally spill over to affect other sectors. Not surprisingly there has been greater price discounting by retail stores against a backdrop of softer official sales figures in October and November, and weaker survey data (e.g. from the Confederation of British Industry). On the industrial and business side of the economy order books have held up so far, but business expectations for future output have slipped, while all service measures were weaker in October and November. As yet employment and unemployment data outside the financial sector have not been affected, but economy-wide earnings have been more subdued than at any time since the period of the global downturn in 2001-03.

These data on economic activity and wages are supplemented by weakening monetary data: in November £M4 broad money again rose only 0.1% over the month, slowing to 11.1% year-on-year. My conclusion is that, at current interest rates, the economy is likely to undergo a more extended period of weakness. This will require a lower level of interest rates to restore credit demand and economic activity - even if bank balance sheets are repaired quickly.

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Hold
Bias: Towards cuts

If a week is a long time in politics then a month is a long time in economics. The gloom over economic prospects, in general, and the housing market, in particular, has sharply intensified since the end of November. This mood seemed to be encapsulated in the minutes of the December Monetary Policy Committee (MPC) meeting which cast aside inflationary concerns and focussed on worsening growth prospects. The deteriorating situation in the credit markets (which has since improved following concerted central bank intervention) and the potential knock-on effects for consumer spending and business activity clearly influenced the MPC’s decision.

There is little doubt that various surveys of business and retail activity have, on balance, turned negative recently but the latest official data on the economy (admittedly always retrospective) were relatively robust. November’s retail sales were firm – they were 4.4% higher than a year earlier – and the overall assessment by the Office of National Statistics (ONS) was that “positive underlying growth (was) sustained”. The current howls of anguish from the retail sector may, however, be justified. But it should be remembered that the retailers are prone to a seasonal cry of “wolf, wolf” and we will have to wait until the official December data are released on 18th January to find out what has actually happened to retail sales in the Festive month. The housing market continues to weaken and will almost inevitably weaken further next year as the “reset crunch” kicks in.

Even though inflation measured by the target Consumer Price Index (CPI) remained at 2.1% year-on-year in November there are undoubtedly further upward pressures coming through from food and energy prices. The MPC, of course, cannot afford to ignore the inflationary implications – especially as the pound is weakening. There is still a case for moderation in easing monetary policy. I vote for no change in January – though my bias is towards further cuts.

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

I believe that the December rate cut was a mistake, and that we should certainly not be contemplating further rate cuts at this stage. One way to express why is the following: it seems to me that from our current situation there are two paths, and neither of them merits a rate cut yet. Along the first possible path the recent credit turmoil and the turnaround in the housing market are short-lived, minor events. Broad money growth, which has stalled in recent months, resumes its 11-14% growth rate, GDP growth slows to perhaps a shade below 2%, the housing market drops no more than 5-10% peak-to-trough, and consumption sails through the recent difficulties fairly serenely. On this scenario, once the recent turmoil has passed, our attention will turn back to above-target inflation, and we will be looking at interest rates rising up above 6% once again. Cuts now will just mean greater rises later.

Along the other possible path, recent events are more lasting in impact. Broad money growth does not resume - perhaps banks reconsider their prudential liquidity ratios for themselves, or maybe new legislation (or interpretation of Basel II requirements) forces a rise. The housing market falls 20% or more, peak-to-trough. GDP growth slows much more sharply, to perhaps a little more than 1% in 2008, and households start to save more and borrow less. If this is how matters are going, I do not believe that interest rate cuts now will achieve anything. Experience of the past twenty years suggests that house price trends, once underway, are very difficult to affect with interest rates. If banks must adjust their prudential liquidity ratios, interest rate cuts won't change that. Instead, it would be better to leave interest rates where they are until changes can be made decisively in order to have a material impact, and to ensure that below-trend growth does not turn into recession. I am not sure which of these scenarios is the more likely, though I incline towards the latter. But, either way, interest rates should remain on hold for now.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%

If the economy is in a credit crunch of the Bernanke-Gertler variety, then cuts in interest rates will not necessarily reduce the ‘external finance premium’ proxied by the spread between the London Inter-bank Offer rate (LIBOR) and bank rate. Credit rationing is a rational outcome of increased uncertainty which can only be alleviated by the availability of funds. To some extent the Bank of England, in concert with the US Federal Reserve and the European Central Bank (ECB), has addressed this issue. The problem then reduces to an evaluation of the effect of further interest rate cuts. It can be argued that large cuts are needed to restore confidence in money markets. The counter-argument is that large cuts signal a loss of control and panic reaction - much like the Bank’s behaviour during the Exchange Rate Mechanism (ERM) ejection crisis of September 1992 - which ultimately will have negative implications for the Bank’s credibility. The alternative is to restore confidence by signalling a controlled and measured approach, in other word cutting rates in stages. The Bank has taken the first step in this direction. It is ready to take the next.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ½ %
Bias: To ease

Since last month, the central banks have injected large amounts of liquidity in a coordinated way in order to bring down the differential between three months’ LIBOR and the rates on government bills. This operation has had some success but it has been only limited. Therefore, the need for a cut, of 0.5% now, remains. Between these operations and further cuts I suggest that the monetary authorities aim for market rates of around 5%, which is still well below current rates.

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

The New Year is a traditional time for looking ahead and it seems appropriate to summarise the latest projections for 2008 and 2009 generated by the Beacon Economic Forecasting (BEF) macroeconomic model. These employ the raft of official statistics for the third quarter of 2007 published on 20th December and the fourth quarter financial market prices. The result is that UK GDP is expected to follow last year's annual average increase of 3.1%, with rises of 2.1% in 2008, and 1.9% in 2009. This is slower than the projected growth rate for the OECD area as a whole of 3.0% in 2008 and 2.8% in 2009, compared with a part predicted 2.8% in 2007. The root cause is the tax and regulatory induced sclerosis of the supply side of the British economy.

The outlook for inflation is determined by the imbalance between the supply of, and demand for, broad money in the long run but it is influenced in the short term by the price of oil (a figure of US$90.5 per barrel of Brent Crude in 2008, rising to US$91 in 2009, has been assumed, compared with US$72.9 in 2007). UK CPI inflation is expected to average 2.9% in 2008, and 3% in 2009, compared with the 2.4% projected for last year on the basis of data for the first eleven months. Equivalent figures for the old RPIX target measure would be 3.7% in 2008, and 3.6% in 2009, against a likely outcome of 3.3% in 2007. OECD inflation is expected to average 2.7% in 2008 and 2.6% in 2009, compared with 2.3% last year.

One factor helping to constrain British inflation in the longer term is that the growth of M4 broad money is expected to slow from an annual average of 12½% last year, to 8¾% this year, and 5¼% in 2009. Such a deceleration has long been a feature of our forecasts, and it is now, rather belatedly, beginning to appear in the data. Britain’s rapid monetary growth has buoyed asset prices, stimulated home demand, and boosted tax receipts in recent years, but poses a long-term threat to sterling, which may be an accident waiting to happen. Apart from the risk of a run on the pound, the other main monetary danger is that the re-entry from the money and credit boom will be accompanied by rising bad and doubtful debts, stepped up credit rationing, a private sector recession and a ballooning fiscal deficit. This is the possibility that the financial markets and the media have concentrated on, and also the MPC, if the December minutes are any guide. However, anyone attempting to traverse a narrow ridge in a blizzard can fall off on either side of the mountain. An exclusive concentration on the risks in just one direction makes a serious accident more likely, not less.

One problem facing the monetary authorities is that Britain’s public finances are in dire shape for an economy that has not yet suffered a recession. This gives rise to problems of ‘policy inconsistency’, and limits the scope for using Bank Rate to stabilise the economy, unless the MPC are prepared to take undue risks with inflation. Public Sector Net Borrowing is expected to be £41¾bn in 2007-08, £50¼bn in 2008-09, and almost £56½bn in 2009-10. However, the really bad news in the 20th December ONS data release was the large upwards revision to Britain’s other twin deficit, that on the balance of payments, for 2006 and the first half of last year, and the very large deficit recorded in 2007 Q3. The current account deficit is now expected to deteriorate from £67¾bn in 2007, to £78¾bn in 2008, and £82½bn in 2009, before easing in 2010. The latest published consensus forecasts for the current account deficit in 2007 and 2008 are £43.5bn and £45.8bn, respectively. There are likely to be a rash of adverse revisions to these figures as the pre-Christmas ONS data are incorporated into published forecasts.

This suggests that the MPC will not have an easy time over the next few years. Three month inter-bank rates, which drive the real economy in the BEF forecasting approach, are expected to settle at around 5½% in the second half of this year and remain broadly at this level through 2009. Bank Rate does not play such an active role and is expected to end 2008 at 5¼%, and hold this level through 2009. The main constraint on rate cuts is likely to be a weakening of sterling, particularly if overseas central banks buy less of it for their reserves. House prices have enough momentum to go up by not quite 3½% 'through' 2008 (Department of Comunities and Local Government index, Q4 to Q4) and 1½% through 2009 but are expected to be broadly flat for some years thereafter. This represents modest declines in real terms from 2009 onwards.

Overall, while recognising that there are serious downside risks to the credit creation process and economic activity, I do not believe that the subsequent data retrospectively justified the unanimous MPC decision to cut Bank Rate in December, and suspect that more damage will be done if inflationary expectations take off, or there is a run on the pound, than will be averted by further rate reductions in the immediate future. This implies that rates should be held in January. Beyond that the only viable policy seems to be ‘wait and see’, while noting that US rate reductions, for example, stimulate the British economy through the trade account and are a substitute for rate cuts at home

Comment by Peter J Warburton
(Director, Economic Perspectives Ltd)
Vote: Cut by ½%
Bias: To cut

The UK banking sector lent £89bn in sterling in the third quarter of 2007, equivalent to 25% of GDP at current prices (strictly speaking, lending was only £76.2bn, because loans of £12.8bn secured on dwellings were transferred out of the sector due to net disposals and securitisations). Where did this £89bn go? A quarter, £22.3bn, was mortgages and other lending secured on residential property; £23.6bn was to financial intermediaries other than insurance and pension funds, credit companies, fund management groups, collective investment vehicles and securities dealers; fund managers borrowed £7.2bn; another £10.3bn was borrowed by “activities auxiliary to financial intermediation” and £10.9bn went to the development, buying, selling and renting of real estate. The rest of the economy borrowed £14.7bn.

If we were ever in any doubt that borrowing has been the principal driver of asset market activity, then this analysis should surely settle the matter. The UK economy sits atop a gigantic peak in transactions activity – in household and commercial property, in large businesses and in equities. The Treasury expects to collect £15bn in stamp duty in the current fiscal year. Frenetic trading of business, property and financial assets has been fuelled by massive amounts of bank and capital market credit. An unavoidable consequence of the global credit downturn, or crunch, is that finance is becoming harder to obtain. Net secured lending to individuals slumped from £9.5bn in September to £7.3bn in October. The value of gross mortgage approvals fell from £29.3bn in September to £25bn in October. Property transaction volumes in England, Wales and Northern Ireland fell in November to stand 29.5% below a year earlier.

These sharp declines illustrate the significant potential that exists for transactions activity to contract. The scope for a co-ordinated slump in turnover values is real and imminent. Some transaction volumes have already fallen back, despite the surge in bank credit in 2007 Q3. The second quarter was a phenomenal period for mergers and acquisitions activity and the likely peak of private equity deals in the UK. The further in time we move away from this frenzied quarter, the starker the comparisons are likely to become.

Third quarter national accounts data revealed the extent of the imbalances that have developed. A current account balance of payments deficit of 5.7% of GDP and a large inventory accumulation, equivalent to 70% of the gain in real GDP, are examples. It is reasonable to expect a significant deceleration in quarterly growth during 2008, with an increasing likelihood of negative real growth. M4 growth has plunged from 1.3% in August and 0.9% in September to 0.2% in October and 0.1% in November.

In the light of these dramatic developments, the obstacles to a reduction in Bank Rate have been swept aside. It is now a question of how far and how soon to cut. On the basis that the additional liquidity injection by the Bank of England cannot be guaranteed to have a permanent effect on LIBOR spreads, there is a strong case for a double-cut in January. Interest rates should fall, not only to forestall a sharp deceleration in economic activity but also to counteract the unintended tightening implied by unusually wide LIBOR spreads.

The November ONS retail price First Release continues the recent pattern of slowing private sector inflation balanced by rising inflation of administered and exogenous prices, such as oil prices and indirect taxes. With annual private sector inflation back to around 1.5%, Bank Rate has scope to fall to around 4.5% during 2008.

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

The official data published up to now has shown a limited impact so far on the UK labour market from the credit crisis. The number of people claiming jobless benefits fell by 11,100 in November, the fourteenth consecutive monthly fall, taking the unemployment rate down to 2.5% - matching a thirty two year low. The more comprehensive Labour Force Survey (LFS) data showed the unemployment rate fell by 0.1% to 5.3% in the three months to October, the lowest since 2006 Q1. The unemployment level was 1.64m, down by 15,000 over the previous quarter. The employment rate rose to 74.5% in the quarter to October, with total employment at 29.29m, up 114,000 on the previous quarter and 226,000 on the year. Despite the tighter labour market, however, whole economy average earnings growth eased by 0.1% on both the including and excluding bonuses measures, at 4% and 3.6%, respectively, in the three months to October compared to the same period last year. But this cannot continue if economic growth remains above trend and price inflation accelerates further, as is expected.

This suggests that, in order to cut interest rates further, there must be a lot of confidence that UK economic growth will ease sufficiently to deliver enough spare capacity to ensure that a negative output gap begins to exert downward pressure on inflation. Otherwise, the tightness of the labour market, elevated inflation expectations, and high retail price inflation (RPI was 4.3% year-on-year in November), suggest that annual consumer price inflation could accelerate up to, and perhaps top, 3% quite quickly during the course of this year.

UK rates though can be cut further but only on the basis that the economy does slow to a 2% to 2.5% range in 2008. If not, any cuts should be quickly reversed. New methods of dealing with the logjam in the credit markets, which is being reflected in high inter-bank rates, should help to separate the two issues. The central Bank Rate should be set for the real economy. The issue of credit spreads should then be dealt with separately, especially as there appears to have been little adverse impact so far onto the real economy from the credit crisis. The chance of a policy mistake caused by cutting rates – in an attempt to solve a problem that is not due to the level of Bank Rate - is high. I would leave rates on hold in January at 5.5%, but with a bias to ease.

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 (Visiting Fellow, 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 (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics) Ruth Lea (Arbuthnot Banking Group and Global Vision) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

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