Sunday, March 02, 2008
Shadow MPC votes 7-2 to hold Bank rate
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its latest monthly E-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted by seven votes to two to leave UK Bank Rate unchanged at its current 5¼% on Thursday 6th March.

The two dissenters from the majority vote both wanted to cut the official discount rate by ¼% (to 5%) on this occasion. Looking further ahead, both the SMPC rate cutters had a bias towards further rate reductions, while three of the holders had a neutral bias thereafter, two had a bias to cut, one was prepared to cut - but only if the credit crunch worsened - and one ‘hold’ had a bias to tighten.

Virtually all the SMPC members involved expressed concern about the problems that had arisen in the global market for credit, but a number also pointed out that the putative UK recession appeared to be everywhere, apart from in many of the official statistics for the domestic economy. There was also a substantial minority who felt that earlier policy mistakes, which had meant that UK monetary policy had been too lax for too long, meant that a further reduction in Bank Rate was not appropriate.

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

Even though there are undoubted signs of weakness in the housing market and the real economy, the indicators recently released remain remarkably, arguably deceptively, robust. In particular, January’s retail sales were firmer than expected, buoyed by price cutting, with the Office of National Statistics’ (ONS’s) ‘main message’ being a ‘steady underlying growth in retail sales’.

But my expectation is still for a sharp slowdown in consumer spending in 2008. Furthermore, the housing market continues to look vulnerable, given the continuing tight credit market conditions. This year’s ‘reset shock’, in which, on some calculations, at least 1.4 million homeowners face a sharp jump in loan repayments as their fixed interest mortgages expire, can only exacerbate the situation. But, provided unemployment does not rise rapidly, a replay of the early 1990s housing crash looks most unlikely. And, if it does, the Bank is in a good position to respond by cutting rates sharply.

Inflationary pressures are rising and Consumer Price Index (CPI) inflation is expected to pick up to around 3% in the first half of the year, despite the weakness of the prices of retail goods, partly driven by higher utility bills. Unless the housing market does deteriorate rapidly, aggressive cuts in interest rates are quite inappropriate. My bias is, nevertheless, for further cuts. But there is no urgency and, after February’s widely anticipated ¼% cut to 5¼%, the Bank Rate should be left on hold in March.

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

The two key variables towards which monetary policy is directed are inflation and growth. At present the future outlook for the one is fairly clear - inflation is going to rise, and will very probably exceed 3% again this year, after which it may drop back a little, but is likely (based on the current policy stance) to be above target for most of the time over the next few years. The outlook for the other is far from clear - growth will surely decelerate, but it is difficult to say by how much. Data is very mixed. Retail sales, which some evidence suggested was slowing rapidly in December, picked up again in January. Gross Domestic Product (GDP) data remains robust. Input price rises are disturbingly rapid, but wage growth is still moderate. House prices fell for a brief period, but may have stabilised. It remains possible that the growth slowdown will be very mild indeed - perhaps only down to a little below 2% growth - but equally there remains the possibility of a much sharper slowdown - to perhaps only 1% growth.

At present, my key point of difference with the Monetary Policy Committee (MPC) relates not to the interpretation of events but, rather, to the interpretation of the MPC's role within them. In early 2007 inflation rose above 3% - an event that the MPC had assigned a non-trivial probability to in August 2006, but made no material effort to prevent. The MPC is now predicting, as its mainstream scenario, that inflation will exceed 3% in 2008, and yet has been cutting rather than raising rates.

It is asserted that the MPC's target is always 2%, and that the only material difference between inflation of 3.0% and 3.1% is that in the latter case the Governor is required to explain to the Chancellor why this is so. As I have done on previous occasions, I again now dispute that this is the correct way to understand the UK's inflation target. In my view, the correct way to understand matters is that there is a target of 2%, a tolerance band of 1% either side within which the MPC has discretion to allow inflation to fluctuate away from target for fairly brief periods (employing its two-year-ahead horizon), and inflation should not be permitted to go below 1% or above 3% except as a consequence of significant surprises or force majeure. The MPC disagrees with this interpretation, but it is not a matter for the MPC to interpret its own target. That is a matter for the Chancellor. What we lack (as we lacked last year) is any comment from the Chancellor clarifying his interpretation of the target. Last year, that was perhaps excusable (it may not have been necessary to provide such a clarification for just a one-off one-month event). But now we need such a clarification, and I hope that the Chancellor can provide it soon. Indeed, more than that. It seems to me that the MPC believes that an appropriate target for inflation in 2008 is 3%. Maybe it is correct. If so, it is for the Chancellor (not the MPC) to set the Bank of England a 3% target for 2008 inflation (after all, an inflation target is always for just the next year's inflation).

As things stand, the UK's inflation targeting regime runs the risk of gradually dissolving into un-clarity. For if the target is always 2% and there are no consequences to its being 3.1% rather than 3%, are there consequences to its being: 3.2% rather than 3.1%?; 3.5% rather than 3.2%?; or 4% rather than 3.5%? It will seem that policymakers have decided, as they have done so many times in the past, that it is better to have a little more inflation today - perhaps 3.5%, this time - than a little less growth. And if growth does not pick up as swiftly in 2009 as expected? Or if it seems as if it might fall further? Will we say that it is better to have inflation rise a little further (perhaps 4%, by then) rather than growth slow further? Once we lose the discipline of an upper limit to inflation - once the aspiration becomes a vague ‘We'll get inflation down to target sometime in the future’ then monetary credibility will suffer, economic agents will respond (as they are now responding) to lower interest rates by raising their inflation expectations, and monetary policy will lose its bite over growth. Then we will have the counterproductive consequence that being too greedy for growth will mean that we are less able to control growth at all.

Inflation targeting is an excellent monetary policy regime that allows policy-makers to communicate with the public their views about the future path of the economy, and thereby to manage growth subject to the achievement of the inflation target. But it should be regarded as a policy of constrained discretion - and the nature of the constraints needs to be clear. At the moment, who knows what upper limit to inflation the MPC would consider acceptable in order to avoid an ‘excessive’ slowdown in growth? And that is not the MPC's fault. That is something that the Chancellor must tell us.

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

Despite the recent cut in rates, monetary conditions remain tight. Signs of a cooling housing market, and slowing consumer spending, will add to the pressure to cut rates further. However, the effect of rate cuts are more psychological than real. Commercial banks will want to rebuild their degraded balance sheets and will not necessarily be passing the full extent of the cuts through to the consumer. There are short-term inflationary pressures but these have not fed into long-term inflation expectations, as yet. The Bank of England has not lost credibility and the markets still expect it to do the right thing on the first sign of a resurgence in inflation. It is all the more important that the Bank should not be impetuous in its action. There is sufficient uncertainty in financial markets to warrant a cautious reaction. Interest rates may have to fall but this should be done in a measured way. This implies that Bank Rate should be held in March, but with a bias to cut thereafter.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: To ease

The current situation is one of considerable uncertainty about real activity, with problems surfacing almost daily in the financial markets, as major institutions continue to write off massive losses in the sub-prime market. This uncertainty centres on future growth more than on future inflation. It is true that commodity and food prices have been very strong recently and also that there is serious inflation in China. China needs to tighten monetary policy and allow its currency to float upwards as part of that - it is awash with dollars procured in large scale foreign currency intervention. However external inflation does not cause internal inflation in an economy with a floating exchange rate like the UK. At most, it causes temporary inflation and it may be part of an unfavourable movement in the terms of trade to which households need to adjust. If one examines the degree of UK monetary tightness through the lens of real interest rates, it appears somewhat excessive, with activity weakening. The risk premium between bank rate and the money markets, while down from its peaks, has recently risen again to 0.4%. Indicators of domestic inflation are consistent with the inflation target being met in two years' time; the major one, wages, is consistent with 2% inflation in the longer term. In these circumstances I would support a further ¼% cut, with a bias to some further easing.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: It is still possible that interest rates may have to be reduced aggressively

The main criticism of the Bank of England is not that it supplied insufficient liquidity when the credit crunch broke but that the MPC allowed inflationary momentum to develop, there having been yet another example of rises in interest rates that were too little, too late. The MPC has actually been lucky. It has not had to take the unpopular action of raising rates further. The credit crunch has done the dirty work for it.

People and companies borrow from a bank to raise money to finance expenditure on goods and services and on assets. If banks will not lend, the expenditure will not be incurred. Most people realise the way in which a fall in bank lending would curtail economic growth. But this is not the main effect. A bank loan creates a bank deposit. A deposit is not destroyed when someone spends the money. It is merely passed to the provider of the goods and services or the seller of the asset. Money is like the ‘hot potato’ of the childrens’ game. One child can pass it to another but the group as a whole cannot get rid of it. If money and the economy are out of adjustment it is mainly the economy that does the adjusting. This continuing effect, which is most important, is not widely appreciated. When the credit crunch broke in August 2007 I wrote that the main threat was that there would be a fall in bank lending leading to insufficient monetary growth. If this had happened, I had thought that I would quite likely be arguing that the MPC was reducing interest rates by too little, too late!

In the event, bank lending has continued to grow, albeit at a slightly reduced rate, and monetary growth has only declined a little. The provisional estimates for growth in January were published on 20th February. The year on year growth of M4 has fallen only slightly, from a peak of 13.9% in May to 12.9%, whereas that of M4 lending has fallen from 14.6% in January 2007 to 12.4%. It must be admitted that the data for the explanation of M4’s behaviour are very difficult to interpret. There is, for example, doubt about the effect of securitisation of loans and its unwinding. Nevertheless the main reason for the decline in the growth of M4 appears to be not domestic factors but the extraordinary behaviour of non-resident and foreign currency deposits and of non-deposits liabilities. The gale appears so far to be international and not domestic. Further, the large UK banks appear to have avoided the huge depletion of capital experienced by some banks. Put simply, the alarm bells for the UK economy are not sounding, at least not yet. It follows that UK interest rates should not at the moment be reduced further.

Some may even argue that the MPC has already relaxed too much. I disagree. People’s demand for money rises when they fear that credit will not be easy to obtain and when the markets in liquidity assets dry up. Such a rise in demand mops up supply and a rise in interest rates is not needed. My conclusion is that interest rates should be left unchanged.

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

Monetary and credit market conditions remain very tight. The end-year crisis in the money markets has passed, but three month inter-bank rates are still 40 basis points above bank rate, reflecting the shortage of bank capital. The bank reporting season should help to ease the problem of counterparty risk in the banking system, but will do little to resolve the problem in the hedge fund and Structured Investment Vehicle (SIV) sectors, which remain completely opaque. It will do nothing to ease the pressure on regulatory capital.

Mortgage lenders are very short of funds and have been tightening their loan criteria and pushing up their lending rates, despite the recent reductions in Bank Rate. This situation could have serious consequences for the housing market unless it is resolved quickly. The housing market and the high street have held up remarkably well in the face of these pressures, but Bank Rate may have to be cut sharply if the situation deteriorates.

To set against this, world food and energy prices are pushing up the CPI and the pound has fallen back against other currencies. Public perceptions of inflation appear to be on the increase. In view of this, I would keep Bank Rate on hold in March. However, the weakness of the domestic market should make it difficult for importers to pass their higher costs on to the consumer, allowing rates to be cut at a measured pace over the next few months. Retailers’ prices are already under strong downward pressure.

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

The sterling index is currently some 8¾% lower than it was a year ago, while the pound has fallen by 11¼% against its main trading partner, the Euro, although it has risen by not quite ½% against the weak US$. The extent to which one is concerned by this development depends on ones’s fundamental model of inflation. Where the MPC is concerned, the prime determinant of inflation appears to be the domestic output gap, which can be influenced by its interest rate policies, so the main effect of the weaker pound is to allow a much needed re-balancing of the UK economy from domestic consumption towards net exports. In an alternative ‘international–monetarist’ model of the inflation process, however, one would expect that the logarithm of the domestic price level would eventually equal the logarithm of the overseas price level less the logarithm of the exchange rate plus a constant term. The empirical evidence suggests that the latter model provides at least as good an explanation of the movements in the UK price level over the past four decades as the output gap. However, the two approaches can be combined, with the output gap being used to explain short-term accelerations and decelerations in the rate of inflation, while overseas prices and the exchange rate are used to explain the long-term low frequency trends in the price level. The main reason for not panicking at this point is that it seems to take a long time for movements in the external value of sterling to be completely reflected in the domestic price level, although the effect of overseas price level trends appears to be far more rapid. Indeed, there is evidence that inflation trends are increasingly being generated at the global level and that the external world output gap is an increasingly important influence on inflation in individual countries.

If one regards the depreciation of sterling over the past year as being the equivalent of a ‘half devaluation’ under the old fixed-exchange rate system, then it is clear that none of the measures required to make a devaluation work, without risking a serious feed through into domestic inflation, have been implemented. In particular, fiscal policy has been loosened, not tightened, interest rates have been cut not raised, money and credit growth have not been reined in, and the labour market has not been rendered more flexible by de-regulation and other supply side reforms. The massive expansion in the size of government employment over the past decade - and the sharp reduction in the numbers employed in important net-export producing sectors, such as manufacturing - also imply that the British economy no longer has sufficient supply side flexibility to make a devaluation work. In particular, the price elasticity of demand for UK imports appears to be approaching zero these days, while the overseas price elasticity of demand for UK exports appears to be too low to offset this and ensure that the volume gains from a de facto devaluation of sterling offset the adverse effects on the terms of trade.

All of this suggests that the UK economy could be on the brink of something extremely nasty, particularly now that the entire political class appears to have lost its authority, and the credibility of the Bank of England has been damaged by the Northern Rock debacle, albeit unfairly so. The risk of a sudden rupture in the foreign exchange market’s confidence in sterling, or simply an inability to continue funding the current account deficit at anything like the present level of sterling and/or real interest rates, suggests that the MPC is now treading on egg shells to some extent. A minor mystery with the January CPI figure was why it was only 2.2% up on the year when the ‘double-core’ retail price index (which excludes both mortgage rates and house price depreciation) rose by 3.1%. The normal gap between the two series is 0.5 percentage points and not 0.9 percentage points. There may well be an explanation for this – it is definitely not being suggested that the figures were fiddled - but it may also be that CPI inflation was fortuitously low in January, and might blip the other way in subsequent months. The March MPC decision will be announced six days before the 12 March Budget. It must be presumed that the MPC will be given some indication of the main fiscal balances likely to be involved, as has been the practice in previous years. There seems little reason to expect that Bank Rate will be altered in March, and there is certainly almost no justification for a further cut. Longer-term, I maintain my bias to tighten.

Comment by Peter J Warburton
(Economic Perspectives Ltd)
Vote: Cut by ¼%
Bias: To cut

Last month’s Bank Rate reduction, to 5¼%, leaves the overall posture of UK macroeconomic policy much too restrictive. The 12 March Budget will confirm a more stringent fiscal policy stance, making an even stronger argument for the easing of monetary policy.

Purchasing manager survey responses for January may not have plummeted in the UK, as elsewhere, but there is ample evidence of a material loss of economic momentum dating back to last August. Comprehensive data for the UK private service sectors are available only to November but it will be very surprising if the outcome is not a more decisive confirmation of the downturn when the December and January readings arrive. Business services and finance have slipped to barely a 2% annual growth pace, from 7% recently, and a composite of post, telecom, hotels, restaurants and motor trades have shifted below the zero line, from having 9% growth momentum in the early part of last year. This leaves only distribution and transport to carry the growth flag. The message from the retailers after their busy season suggests that their trade has also suffered. The January GfK consumer confidence reading, at minus 13, was the weakest for any year since 1993.

In the industrial sectors, the level of output has edged lower since last summer. Government and other services continue to contribute modestly to GDP, but even this stimulus is in doubt as fiscal policy is forced into pro-cyclical mode: tightening into a private sector contraction. The Institute for Fiscal Studies estimates that an extra £8bn per annum in taxation would be required to restore credibility to the Treasury’s fiscal arithmetic over the coming year. While such stringency is unlikely in March, this is the probable direction of adjustment. Bearing in mind that the private sector’s CPI inflation annual rate has fallen to 1.5% (ex-heating and lighting), a real interest rate of 3% should be more than sufficient to contain inflation expectations. An easing of monetary policy is not only desirable for its own sake, but as a necessary foil to the inadvertent tightening of the fiscal noose.

Moreover, the risk of fuelling inflationary pressures should not be considered a serious obstacle to a further 75 to 100 basis points of easing in the context of the non-linear threat to domestic economic activity, particularly in the sectors strongly connected to asset market turnover. The prevailing loss of potential for securitising loans is roughly equivalent to a 25% to 30% cut in lending capacity in the residential property market: this is already bearing fruit as a sharp decrease in mortgage approvals and will soon affect housing transaction volumes. Alliance & Leicester went further, indicating that they planned to shrink their mortgage book over the next twelve months. Commercial property is likewise.Finally, it should be noted that little if any of the decrease in short-term market interest rates between August and December has been reflected in the interest rates faced by households. The February Inflation Report (Table 1A, page 14) reports that interest rates for new loans and mortgages averaged 14 basis points higher in the period and for the outstanding stock of loans, 4 basis points higher despite a 25 basis point Bank Rate cut and a 77 basis point reduction in 2-year swap rate. If the purpose of Bank Rate cuts is to alleviate pressure on marginal borrowers, then it will require deeper cuts to achieve this. My vote is for a ¼% cut at the March meeting, notwithstanding the imminent impact of higher utility prices on the consumer price index.

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

The UK economy is not slowing down as fast as many seem to have been warning about and expecting. Data in the past month has been strong overall; from the labour market data - the Labour Force Survey (LFS) jobless rate fell to 5.2% from 5.4% and employment rose 175,000 in the three months to December; to money supply, which accelerated to 12.9% year on year in January and to retail sales volume, which accelerated to 5.6% year on year in January. None of these, it seems to me, suggests an economy on the verge of recession, albeit slowing. With pipeline inflation pressure still high – there were surges in the producer input and output price inflation data for January and surveys suggesting that companies are trying to pass on more of their higher prices – this is not a time to be cutting rates any more than seen so far. Indeed, there would be no case for a rate cut from the earlier 5¾% at all, if not for the ongoing credit crisis and the weakness in the US. Actual annual retail price inflation rose to 2.2% in January, with an even bigger rise likely in February when the data are released in March.

You do not have to be a monetarist to worry why, with so much liquidity in the system, should there be a negative economic impact from the banking and credit crisis at all? In fact, the opposite may be true, and a policy mistake is being made with too much monetary loosening and liquidity being added that - if not drained off at the right time - will lead to an even bigger inflation and asset price problem in future. With this backdrop, it is no wonder that inflation expectations remain high in the UK. Without the benefit of benign labour markets, the UK Bank Rate profile would not justify even the easing of the monetary stance seen so far. I therefore vote for rates to remain on hold in March and have a neutral bias thereafter.

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 (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 a full set of nine votes is always cast.