Sunday, April 06, 2008
Shadow MPC votes 6-3 to cut
Posted by David Smith at 08:59 AM

In its latest monthly E-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted by six votes to three to cut UK Bank Rate from its current 5¼% on Thursday 10th April, rather than wait until 8th May, when the next set of Bank of England Inflation Report forecasts will be available to the Monetary Policy Committee.

Five SMPC members wanted to cut the official discount rate by ¼% on 10th April, one wanted a ½% reduction to 4¾%, and three were ‘holds’. Looking further ahead, five of the SMPC rate cutters had a bias towards further rate reductions, while two out of the three holders also had a bias to cut. Virtually all the SMPC members were concerned about the problems that had arisen in the market for credit, including the widening spreads between money-market and official discount rates. However, several SMPC members also pointed out that the official statistics and industrial surveys showed only limited evidence of a UK hard landing so far.

One SMPC member was concerned about the inflationary consequences of the weak pound at a time when global inflation was already running above the UK target rate.

Comment by Tim Congdon
(Financial Markets Group, London School of Economics)
Vote: Hold
Bias: To ease

So far the ‘liquidity crunch’ (if I can call it that) has not checked the growth of bank lending and deposits. The M4 definition of the broad money supply rose by 1.6% in December and 1.3% in January, after very low growth in October and November. The falls in the stock market and house prices since spring 2007, and the increasing signs of weakness in economic activity, seem to reflect increased bearishness (i.e., a rise in the desired ratio of money to assets) rather than a squeeze on broad money balances.

However, closer inspection reveals that the big rises in deposits (42.9% in the year to January) and in bank lending (81.6%, also in the year to January) relate to ‘activities auxiliary to financial intermediation’. A reasonable conjecture is that these numbers arise partly from an involuntary shift of business from Structured Investment Vehicles (SIVs) and similar devices, which are unable to finance themselves in the wholesale markets, to the banks. Other types of lending are being restricted, by a harshening of terms and a widening of margins. Sterling unused credit facilities – which admittedly have not been a reliable advance indicator in the past – fell by £30bn., or about 10%, in the second half of 2007.

My surmise is that the remainder of 2008 will see slow growth of bank balance sheets and money, with the lowest increase in M4 since 2002 and perhaps since the early 1990s. The level of interest rates is relevant here, but more important are banks’ efforts to improve their solvency (i.e., capital/asset ratios) and liquidity (i.e., ratios of liquid assets to assets rather than cash to assets, although cash is very important).

In my view, the Shadow Monetary Policy Committee (SMPC) should discuss the Bank of England’s money market operations in recent months and the structural changes in UK banking due to the liquidity crunch. In the housing finance market specialist lenders, reliant on wholesale funding, are being smashed, whereas the UK clearing banks have cut lending volumes only slightly. The clearers’ margins are widening because of the slackening of competition.

Economic activity is weakening, but the UK is not in a recession as yet. I favour keeping rates on hold for the moment, but I am in favour of steps by the Bank of England: firstly, to keep all UK banks liquid in coming months; and, second, to investigate the sharp change in the balance of competitive power in UK banking which now seems to be under way, as banks dependent on wholesale funding struggle against the clearers with their branch networks and good connections with the Bank of England.

The conclusion is that I expect a cut in rates to become necessary later in 2008, but I am not sure of the timing or the scale because ‘all the uncertainties lie in the future’.

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

Like the US economy through most of 2007, the UK economy is proving surprisingly resilient in the face of both the Bank of England’s rate hikes (between August 2006 and July 2007) and the credit crunch of the past eight months. Recent retail sales have been substantially stronger than generally expected, suggesting that despite the house price declines of the past five months and tighter credit conditions for mortgage borrowing, consumers have not yet started to rein in spending. Thus retail sales in February increased by 1.0% on the month and 5.5% year-on-year, following (revised) gains of 1.1% and 5.9% respectively in January. This is despite the persistent decline in consumer confidence since August as recorded by the GfK Survey to its lowest level since 1992, and despite the Confederation of British Industry (CBI) distributive trade survey showing retailers’ confidence levels distinctly weaker than last October/November.

Moreover, business spending has also continued well above trend. For example, total business investment in 2007 Q4 was up 1.8% on the third quarter and 5.3% higher on the year. This is supported by business surveys that have shown an upbeat sentiment. Thus, the CBI industrial trends survey showed that orders, export orders, and finished stocks for March, as well as expectations for output and prices for the next three months, were all improved relative to January and February.

In addition, the labour market has continued to be firm, with unemployment on the claimant count basis remaining at a low 2.5% (the lowest since 1975), while on the Labour Force Survey (LFS) basis it has been trending down (to 5.2% on the latest reading) since May 2007. Wages in January were up 3.7% year-on-year, neither significantly weak, nor as strong as the temporary surge to 4.4% in 2004-05. As yet, therefore, the labour market cannot be said to be showing any signs of softening as a result of the credit crunch.

The main problem for the Monetary Policy Committee (MPC) is how to balance the apparent strength of the real economy against the evident weakness in the financial sector, and what conclusions to draw for its inflation target from these seemingly contradictory trends. The February Bank of England Inflation Report predicted that inflation would rise before falling back later in the year as the economy weakened.

The latest surge in inter-bank rates (since mid-March) implies continued stress for financial sector lenders and borrowers, and suggests that the on-going balance sheet problems are far from settled. Indeed, mortgage rates are now rising in response to the credit market strains. As in the US, the weakness of household and financial sector balance sheets combined with severe credit tightening could lead to an abrupt weakening of economic activity and inflation later in the year. To offset the renewed tightness in the credit markets and to guard against a sudden downturn in economic activity, a cut in Bank Rate to 5.0% is now justified.

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Cut by ¼%
Bias: Towards further easing

The real economic data remain remarkably upbeat. Retail sales growth in February was, in the words of the Office of National Statistics (ONS), “positive” and the labour market data, admittedly a lagging indicator, have continued to improve. Business surveys have also tended to have a positive tone. The housing market is, however, undoubtedly weakening, prices are slipping and activity is sharply slower. This year’s “reset shock” can only exacerbate this weakness. But, for all the lurid tales in the media, a repetition of the early 1990s slump looks most unlikely.

The most significant event since the MPC’s March meeting has undoubtedly been the twist in the ferocity of the turmoil in the financial markets and the pressures on the London Inter-Bank Offered Rate (LIBOR) – with UK three-month LIBOR touching 6% by end March. This has effectively tightened monetary policy, which I believe should be offset by a ¼% cut in Bank Rate at the April MPC meeting. The credit crunch is clearly some way from resolution and its eventual impact on the real economy can, therefore, only be guessed at. The Budget was economically of little significance and roughly neutral for 2008/09.

Prices inflation continues to pick up. Producer prices inflation has picked up sharply and Consumer Price Index (CPI) inflation, touching 2½% in February, looks set to reach 3%. The Bank’s latest survey of inflationary expectations shows worsening expectations. But inflationary pressures in the labour market are currently reasonably contained. Pay settlements seem under control and earnings inflation was just 3.7% in the three months to February. Even though it is right that the Bank of England concentrates on controlling inflation, the evidence from the labour market suggests that there is a low risk of a wage-price spiral being established. This means that I am voting for a ¼% cut at the April meeting. And I have a bias towards further easing.

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

LIBOR rates have risen since the Bank of England last cut Bank Rate on 7 February. Spreads have widened not just because of increased volatility in financial markets but also because of a weakened risk appetite by the banking sector. It is the psychology of bank behaviour that needs to be addressed at this stage. While there would appear to be plenty of credit available with M4 lending growth still in double digit figures, the rates of increase in mortgage lending and unsecured lending to households have been falling. The belated acceptance by the Bank of its necessary role of providing liquidity to the markets has yet to influence bank psychology. Until this happens the risks from inflationary pressures are secondary to the danger of a cumulative downturn that could develop into a recession. While there is widespread expectation that the Bank will cut rates, by taking measured and cautious steps it is signalling the correct policy that it is in charge and will not be panicked into sharp cuts that would have to be reversed shortly after. My recommendation is that Bank Rate should be reduced by ¼% on 10 April, with a neutral bias thereafter.

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

Behind every world financial centre stands a central bank charged with maintaining order and providing the necessary guarantees of the banking system’s integrity. This is a task taken seriously by the Federal Reserve Bank of New York (behind it the Board of Governors of the Federal Reserve System) and used to be taken seriously by the Bank of England for the centuries that London has been a world financial centre. Just recently the Bank has been slipping in its performance; first the unwillingness to provide liquidity last August that gave us the Northern Rock disaster, then more recently its failure to ensure the liquidity of our banks in the continuing bank crisis. This latest episode led to the banks requesting a special meeting to press their problems on the Bank and subsequent statements from the Bank indicating it will meet their requirements at some point in some unspecified way. It is extraordinary that these sorts of meetings and statements should even be needed; they show how out of touch the Bank has become with its main client base and its fundamental task as a central bank. As a result of this situation three-month money-market rates have risen to over 6%, against Bank Rate of 5¼%; monetary policy has effectively been allowed to tighten unintentionally.

Then we come to its direct conduct of monetary policy. This has been marked by uncertainty and a complete failure to communicate what it thinks could drive inflation and therefore its own interest rate policies. We have had speeches from members of the Bank’s MPC (the last one was from Rachel Lomax) saying that because commodity prices have been rising sharply the MPC will be unwilling to cut interest rates as much as otherwise. By what logic? Commodity prices are world prices affecting the UK’s terms of trade; they are not indicators of UK inflationary pressure. From a general member of the public such a lack of logic would be pardonable; but from the MPC it is unacceptable.

The question the Bank needs to address is whether UK costs and prices will rise steadily faster than the 2% target as a result of recent events. For this it needs to have some economic model of inflation that it believes in and acts by; it is not enough to have the Inflation Report with all its indicators of ‘up’ and ‘down’, as these simply are facts which without a coherent theory imply nothing at all about the course of future UK inflation.

The Bank’s statements reveal a vacuum of theory; only nervousness about anything that goes up or down. Thus if inflation goes above 2% even if this is due to temporary factors the Bank goes into a state of nervousness about lowering interest rates. Presumably if inflation fell below 2% it might get into a nervous state about deflation. Yet the terms of the Bank’s remit require it to forecast inflation and react to those predictions; for that remit it needs a theory of what drives inflation, not just indicators.

Of course at the centre of that theory is its own prescribed behaviour: it is mandated to react to inflationary pressure. The main other factor is the prospective state of the UK business cycle. On both counts the MPC should at present be lowering interest rates. All the signs are that wage growth, the key component of domestic costs, is being tightly restrained by the credibility of the Bank’s counter-inflation commitment; it has remained impressively solid around 4% for a very long time. Meanwhile the UK is slowing as the bank crisis swirls around it, spreading from the US. It could stall completely; so far mercifully the indications are that it is not but the situation is fragile, with the risks strongly on the downside. This is exacerbated by the money-market risk premium noted above. The Bank should act to inject liquidity to reduce that premium and it should cut rates to mitigate the slowdown. It needs in short to take action to cut money-market rates (not Bank Rate which is now increasingly irrelevant) by around 1%, with a further bias to easing. The aim should be to get market rates down to 5% now, ready for further falls. On the assumption that the Bank manages to inject liquidity sufficient to bring down the term premium to 0.25%, then I would propose another ½% cut in Bank Rate to 4.75%, with a strong bias to ease thereafter.

Comment by Peter Spencer
(University of York)
Vote: Cut by ¼%
Bias:To cut further

The MPC faces an extremely difficult situation at the moment. On the one hand the wholesale money markets have suffered another relapse, threatening a serious and unwarranted downturn in economic activity. On the other hand, public perceptions of inflation are increasing and there is a clear risk that the CPI will move above the target range this summer.

However, any inflation overshoot is likely to be temporary and there is in any case little that the MPC can do about it at this stage. We are experiencing a massive once-in-a-generation shift in world relative prices and this was always going to be difficult to manage without risking a temporary overshoot. Monetary conditions remain very tight and this should ensure that the upward pressure from world food and energy prices is offset by weakness in core inflation over the MPC’s two-year horizon. Against this background, upward pressure on prices will continue to mean reductions in disposable income rather than increases in wage settlements and long term inflationary expectations.

In my view the credit crunch now poses a more serious threat. UK three-month inter-bank rates have moved back up to a premium of 75 basis points over base rate. The premia over three-month swap and treasury bill rates - which are arguably better indicators - are now well above 1%. Recent moves to boost money market liquidity appear to have had little impact. 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 base rates. On this assessment, base rates must be reduced again this month.

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

The official sterling index has fallen by 10.8% over the past year and the pound has declined by 17.9% against the Swiss Franc, 14.9% against the Euro, and 14.6% against the Yen, even if sterling has gone up by 1.3% against the weak US$. The recent depreciation of sterling can be compared with the 12.9% fall in the sterling index that followed the 1967 devaluation, and the temporary 14.6% depreciation that accompanied Britain’s expulsion from the Exchange Rate Mechanism in 1992, after which the pound floated upwards. It is surprising that the weak pound has not given rise to concern, especially as global inflation is above the rate consistent with the 2% CPI inflation target, even after allowing for the fact that CPI inflation tends to run some ½ of a percentage point below the rate shown by other UK price indices. Consumer price inflation in the OECD area is currently 3.4%, while inflation in the leading economies ranges from 0.7% in Japan, to 2.4% in Switzerland, 3.5% in the Euro-zone, 4% in the US, and 8.7% in China. For a small, open and trade-dependent economy, such as Britain’s, one would expect that domestic inflation would equal overseas inflation plus the annualised depreciation of the exchange rate in the very long-run.

The 12th March Budget contained no major surprises and had no immediate Bank Rate implications, but still showed an unduly insouciant attitude to what are remarkably large structural budget deficits. This means that there is a problem of policy inconsistency between the cyclically-adjusted fiscal stance and the MPC’s commitment to fighting inflation. The consistent over-shooting of HM Treasury’s forecasts for government borrowing a year or more ahead also does nothing for the credibility of the fiscal authorities and could tarnish that of the monetary authorities by association. The political realities suggest that fiscal discipline will be compromised even further in the run up to a general election in possibly two years’ time. The markets could come to believe that the MPC was pursuing lax monetary policies in an attempt to keep private activity and government revenues buoyant ahead of the general election, so that the structural imbalance in the public accounts could be masked. This suspicion, together with the falling pound, and the excess of Retail Price Index (RPI) inflation over that in the CPI, could all serve to undermine the MPC’s credibility over the next few years.

Recent economic indicators have yet to show any marked signs of recession, and some worrying signs that the early stages of the inflation ‘pipeline’ are coming under pressure – producer output prices rose by 5.7% in the year to February and input costs by 19.4%, for example. The reduction in the deficit on the current account balance of payments from £19.1bn in 2007 Q3 to £8.5bn in 2007 Q4 was a relief, but seems to have been partly the result of overseas owned securities houses having no UK generated profits to repatriate. The current account deficit for 2007 as a whole was £57.8bn (4.2% of GDP) compared with a revised £50.7bn (3.9%) in 2006. Such figures suggest that there was quite a lot of suppressed inflationary pressure in the British economy last year. Market sector Gross Value Added (GVA), which broadly corresponds to the private sector component of GDP on which monetary policy operates, rose by an average of 3.6% in volume terms last year, compared with the 3% reported for total GDP, and by 3.4% in the year to 2007 Q4, compared with the 2.9% reported for total GDP. This is consistent with the balance of payments data in suggesting that the UK economy was in the overheating zone throughout 2007.

The February CPI was 2.5% up on the year, while the ‘double-core’ retail price index (which excludes mortgage rates and house price depreciation) rose by 3.5% over the same period. The normal gap between the two series is 0.5 percentage points, not 1.0 percentage point, and CPI inflation may have been fortuitously low recently. RPIX inflation, at 3.7%, was above its old target range in February, while the ‘headline’ RPI inflation rate of 4.1% appears to be being increasingly cited by wage bargainers. With retail sales remaining strong, the labour market tight, the Department of Communities and Local Government house price index up by 8% in the year to January, and broad money and credit growth still running at 12% plus in February, there is little concrete evidence that the UK economy is heading for a hard landing, let alone a crash. There seems to be a growing opinion in the financial markets that Bank Rate will be cut in April. It remains my view that there is no justification for a further cut. However, the Bank does need to re-consider its money market operations in order to alleviate the ‘pass through’ problem that movements in Bank Rate do not trickle down the yield curve. Longer-term, I maintain my bias to tighten. One reason is that I believe that current international monetary conditions are far closer to those of 1968 to 1972, which preceded the ‘Great Inflation’ than they are to those of 1928 to 1932 that brought about the Great Depression.

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

With 3-month sterling LIBOR back to 6%, representing a 75 basis point premium to Bank Rate, we have entered a third episode of unintended credit tightening within nine months. Net mortgage lending has settled at around £7bn per month, down from a peak of £12.5bn last June. Hundreds of mortgage products have been withdrawn by lenders in recent weeks and interest rates to new borrowers have been increased in some cases. In the mortgage market and elsewhere, credit is scarce and is being rationed other than by its price. Despite the liquidity initiatives that have been undertaken, and those that are under consideration, there is little prospect of re-opening the primary market for mortgage-backed securities. There are justifiable market concerns over the implications of maturing mortgage securitisations, which have been reflected in the share prices of major banks. The failure of open market operations even to prevent a recurrence of liquidity squeezes underlines the severity of this credit crisis and the importance of supporting the profitability of the banking system through these troubled times.

MPC member Timothy Besley hit the nail on the head in a recent speech to the Institute for Fiscal Studies.

“… the impact that the level of Bank Rate has on activity will depend, to some extent, on the conditions that obtain in financial markets. Judging whether a given level of Bank Rate is restrictive depends importantly upon the conditions that prevail in financial markets at the time.”

With financial markets at the mercy of torpid credit market conditions, there is ample scope to cut UK Bank Rate without risk of stimulating a resumption of reckless borrowing.

Developments in real economic activity and the pricing environment suggest that an easing of monetary policy is well overdue. Fourth quarter national accounts data confirmed that consumer spending slowed dramatically in the final three months of 2007, rising a mere 0.1%. Spending abroad by UK residents fell by 3.2%, while expenditures on household goods and services dropped by 1.4% and recreation and culture, by 0.6%. Spending in restaurants and hotels declined 0.6% between the first and second halves of the year. Despite the frolics of the retail sales volumes, the weight of evidence suggests that a deep retrenchment in UK consumption is underway. The GfK consumer confidence barometer slipped to -19 in March, its lowest reading since February 1993. The CBI distribution survey reported a sales balance for March that points to slower retail growth also.

As of December, sectors representing 39% of UK GDP registered output levels below the average for the months June to August. These include all the main headings of manufacturing industry, mining and quarrying, motor trades, wholesale distribution, post and telecommunications, hotels and restaurants and financial intermediation. Within three to six months, there could well be a majority of sectors, weighted by output, that have slipped into a technical recession.

Despite the incorporation of four months’ worth of utility price increases into the February CPI, the index rose much less than expected and the core, ex-food and energy, measure of inflation fell. The Bank of England’s Agent’s survey of pass-through pressures confirmed that the inflation of input prices was being absorbed in the supply chain and scarcely passed on in consumer prices, presumably because final demand would not tolerate it.

While the body of economic information remains partial, fragmented and ambiguous, it nevertheless points strongly to an abrupt loss of nominal and real momentum beginning around August last year. There is ample scope for Bank Rate to fall by around 100 basis points from its current level by the summer and every reason to resume easing in April.

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

My vote is to hold Bank Rate at 5¼%, but with a bias to ease. The latter is due to the rise in LIBOR spreads and the broadening of the credit market crisis to a wider segment of financial market players, in particular the threat of collapse of investment banks important in underpinning the activities of the securities business and related asset backed activities.

There are many reasons why I would hold Bank rate at its current level. One is certainly the 13% or so fall in the trade-weighted exchange rate index from its 2007 peak, at a time that global inflation is rising faster, so compounding the potential impact that this will have on the future path of inflation in the UK economy. A second is the rise in inflation expectations, to an all time high in the February Bank of England NOP survey of 3.3%, which sends out a warning that if the economy does not slow to a below trend pace of growth quickly then the current benign labour markets will not be as benign for much longer and could embed inflation in the UK economy. It is clear from history that excessive inflation is very hard to get rid of, and usually does not happen without a recession. This implies it is better to accept a little weaker growth now in order to ensure that inflation stays low later and so maximise growth in the longer run. This lesson is in danger of being lost by the continued talk about this being the worst crisis since the Great Depression and that inflation concerns should be set to one side for the duration of the crisis and dealt with later on. The problem with this approach is that it ignores that fact that monetary policy has been asymmetric, cutting more in reactions to financial markets shocks and not raising rates as quickly when the shocks dissipate or the shock is in the opposite direction.

Purely on the basis of UK data released since the March MPC meeting, however, I see no reason to ease Bank Rate this month. Growth is holding up better than expected, with the retail sales, CBI and manufacturing data all stronger than expected in the last month. Moreover, price inflation was also uniformly strong in March, with CPI, producer price, and inflation expectations all rising to very high levels. Unless there are signs of a stronger negative follow through from the credit crisis, or the economy is slowing sharply, cutting Bank Rate now looks as if the fight against inflation is secondary to one of maintaining growth.

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.