Sunday, May 04, 2008
Shadow MPC votes 5-4 to hold rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its latest quarterly meeting (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) narrowly voted to leave Bank Rate unchanged on Thursday 8th May. In particular, five members of the shadow committee voted for rates to remain on hold, while four members voted to cut the official interest rate.

The advocates of a rate cut were divided, with two wanting a ¼% reduction and two a cut of ½%. The SMPC gathering was held on Tuesday 15th April. However, the vote was re-opened following the announcement of the Bank of England’s Special Liquidity Scheme on 21st April. One member changed his vote from a ¼ % reduction to a hold in response.

Members of the SMPC remained concerned by the problems that had arisen with sub-prime lending. However, whilst some members wanted a reduction in interest rates, others expressed the view that interest rates were not an effective tool for dealing with the serious problems in the UK banking sector. Furthermore, a number of members felt that loosening monetary policy could damage the Bank of England’s credibility given the serious inflationary pressures in the economy.

Members also stressed the importance of non-interest-rate measures in the current circumstances. There was general agreement that the Bank of England should provide liquidity to the markets. However, members stressed the crucial importance of mopping up liquidity after the crisis was over, in order to avoid the severe inflationary problems that have appeared after some previous financial markets shocks.

David B Smith invited Trevor Williams to give his assessment of monetary conditions.

The Monetary Situation – world credit market conditions remained intense.

Trevor Williams referred the other SMPC members to the briefing charts he had presented to the committee. He began by stating that credit market conditions and financial volatility remain intense. Bond yields are reflecting a flight to quality. Banks are still worried about counterparty risk. However, OECD money supply has not collapsed and individual country money supply growth remains strong. Inflation is increasing everywhere, even in Japan. The reason is the rise in producer prices. Dollar commodity prices are rising sharply. But wage growth across the OECD, although accelerating, remains low. Output gaps of the major economies are slightly positive or close to zero. However, the latest International Monetary Fund (IMF) forecast is for a generalised growth slowdown even in the fast growing far-East.

Global house price gaps (the extent to which house prices cannot be explained by fundamentals) have increased sharply indicating the vulnerability of major economies. Yet there is little sign that the credit crisis has affected economic activity. Industrial production continues to grow at a solid pace and GDP growth globally has not shown a significant downturn. Labour market conditions remain favourable and the unemployment outlook is benign. In general the major economies are rebalancing the structure of growth from domestic demand to exports.

David B Smith thanked Trevor Williams for his presentation and opened the meeting up for discussion.

Discussion

Gordon Pepper commenced the discussion by suggesting that adjusting the broad money figures for securitizations may indicate tighter conditions than shown by the raw numbers. Roger Bootle said that the continuing growth in money supply represents a substitution from capital market borrowing to bank-borrowing and agreed with Gordon Pepper that the numbers had to be treated with care. Andrew Lilico said that the weakness of the inflation targeting approach - rather than a trend price-level targeting approach - is that there was no pressure to deal with a build up of liquidity, despite the threat that this could pose to inflation discipline in the long run. In reply, Roger Bootle said that we are starting from where we are now, not where we would like to be. Raising rates would compound the policy mistakes of the past. Gordon Pepper added that banks have to recapitalise. The role of the Bank of England is to provide liquidity and then mop up the excess liquidity after the crisis has abated.

Anne Sibert said that the crisis was the outcome of a market failure. Bad corporate governance has led to counter party risk. The Bank of England should respond by allowing the commercial banks to borrow using less than the very best AAA rated collateral as security. Trevor Williams said that this was what the Federal Reserve was doing in the USA but the problem is whether the excess liquidity would be withdrawn after the crisis. Roger Bootle said that the arguments for tackling the fundamentals that caused the crisis are good ones. However, the scale of the risks are so great and the potential outcome too serious to avoid anything but immediate action to stop the financial system from collapsing. Andrew Lilico said that we should do more about addressing the fundamentals and the problems of moral hazard.

There followed a general discussion about the merits and de-merits of deposit insurance. Andrew Lilico was critical of the deposit insurance system as creating excessive and costly regulation. Kent Matthews said that while it would be useful to provide a statement of what should be done in the SMPC Minutes we have to make a recommendation on interest rates. David B Smith said that one of the strengths of the SMPC was that it did not have the same restricted mandate as the actual Monetary Policy Committee (MPC), which was to achieve the inflation target using just the one policy instrument of the short-term rate of interest. This meant that the SMPC had – and should employ - the freedom to look at the wider institutional framework, as he had tried to do in his April 2007 publication for the Economic Research Council Cracks in the Foundations? A Review of the Role and Functions of the Bank of England After Ten Years of Operational Independence (www.ercouncil.org), which had forewarned of the difficulties that would arise if the Bank of England ever found itself in a lender of last resort situation.

In particular, David B Smith thought that there was now a case for the re-imposition of mandatory reserve asset ratio requirements on banks whose deposits were insured by the tax payer – this was partly because Basle agreement style capital controls had been tried and seemed to have failed – and also for introducing a second monetary pillar into the UK approach as a check against boom/bust credit cycles. This would be in addition to the traditional role of money and credit monitoring as a longer leading indicator of inflation pressures beyond the conventional macroeconomic forecasting horizon. David B Smith wondered whether the UK financial system would be facing such extensive problems if the Bank had used variable liquidity ratios as an additional tool to limit the growth of broad money and credit over the past three years to significantly below 10%.

Votes

David B Smith then asked the members of the committee to vote on a rate recommendation. In one case, a member (Gordon Pepper) changed his vote subsequent to the 15th gathering from a ¼% reduction to a hold following the announcement of the 21st April Special Liquidity Scheme.

Comment by Philip Booth
(Cass Business School and Institute of Economic Affairs)
Vote: Cut by ¼%
Bias: Neutral

Philip Booth said that he could see the dangers to the macro-economy from not cutting interest rates but the fact is that there is insufficient information within the banking system about the location of bad loans for the interbank market to start functioning again. This is not a problem that will be resolved by reducing interest rates. The risks are that policy is too slack to maintain inflation discipline in the long run. On balance he voted for a reduction of ¼% in Bank Rate on 8th May with a neutral bias thereafter.

Comment by Roger Bootle
(Deloitte and Capital Economics Ltd.)
Vote: Cut by ½%
Bias: To cut

Roger Bootle said that the situation was extremely dangerous. The general lack of confidence and trust across the banking system compounded by weakness in the housing market poses strong dangers for the macro economy. He said that the danger to the macro economy warranted a reduction of ½% in Bank Rate in May alongside a widening of the collateral requirements for lending by the Bank of England. A strong signal had to be sent to the markets that the Bank was prepared to act.

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

Andrew Lilico said that the situation could become very serious but this is not a crisis of capitalism. He said that interest rate cuts are likely to be ineffective anyway. The worst danger at this point is that the central bank acts ineffectively, costing it credibility and the ability to be effective later in the crisis in providing support and preventing matters slipping into recession. He voted to hold with a neutral bias.

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

Kent Matthews said that he supported the Bank’s moves to inject liquidity into the inter-bank market by accepting less than AAA paper as collateral. There was also a purpose in cutting rates even if the full cut is not passed on to consumers. The commercial banks have to rebuild their capital and widening spreads is one of the ways in which they can do this. A cut in Bank Rate will be passed down to consumers on a less than 100% basis but the effect on confidence cannot be discounted. Consumer spending has not collapsed and the economy has not taken a serious downturn. Inflation risks remain and so the cautious approach adopted by the Bank is the correct strategy. Cuts have to be measured and the Bank has to show that it is in control of financial events. He voted for a cut of ¼% in May with a neutral bias subsequently.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Great uncertainty - wait and see how things develop

Gordon Pepper stated in his revised submission that, in normal times, steering the UK economy has been described to be like driving a car looking out of the back window. Analysis of the latest trends in economic data is of little use at present because the credit crunch could be overwhelming. The forward-looking monetary indicators are also currently jammed. What matters is whether the supply of money is greater or less than the demand for it. The published data for M4 suggest that supply is still excessive but this is most likely wrong. First, an unknown adjustment should be made for asset-backed commercial paper. If the same adjustment had been made in the UK as in the US, the growth of the money supply prior to last August would have been increased; since then it would have reduced. Further, the demand for liquid assets in general has risen because credit is no longer freely available and the demand for bank deposits in particular has risen because the market in competing liquid assets has dried up.

Back to the credit crunch - a week ago the outlook was grim. The head of the IMF had described it to be the worst crisis since the 1930s. The prime minister was so concerned that he flew to New York for discussions, surely aware that his visit would be over-shadowed by that of the Pope and would attract poor publicity. A few days later it appears that the problem may be on its way to being solved.

The danger lights were flashing because quite a few banks were deliberately attempting to cut back on their lending. They were raising rates to avoid doing business. They did so for two reasons. The first was that they are afraid of being caught with insufficient liquidity, as per Northern Rock, with the inter-bank market not functioning properly. The second was that they have insufficient capital to support their businesses.

The Special Liquidity Scheme announced by the Bank of England on 21st April should go a long way to solving the liquidity problem but not the capital one. Huge quantities of illiquid assets can now by swapped for gilt-edged stock but only if a bank has the necessary capital to put up substantial margin, for example, 12% for residential mortgaged-backed securities and credit card asset-backed securities that are either floating rate or fixed interest with under three years to maturity. The margin rises to 22% for fixed-rate ones with between ten and thirty years to maturity. In addition, an extra 5% has to be put up for own-named securities. Swapping such assets uses up capital at a time when it has been depleted by large losses. The Bank’s measures by themselves would not alleviate the crisis.

Royal Bank of Scotland’s huge rights issue, if it is a success and other banks follow suit, is the other half of the solution. It will provide the capital to put up margin. A danger now is that a huge volume of new issues, in combination with a decline in surplus savings from China, will produce a fall in the stock market. This could trigger another round of bad debts, and so on. It would not be the first time stabilising one market has destabilised another.

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

Anne Sibert said that the inflation outlook for the UK was uncomfortable. It won’t be long before the Governor will have to write another letter explaining the overshoot of the target. If not for the financial crisis, we would be talking about raising rates. Without concrete evidence of a slowdown in the economy she voted to keep rates on hold and to ease liquidity in the market with a neutral bias.

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

David B Smith commented that it was always uncomfortable pushing against a crowd going in the opposite direction, particularly if some elements of the crowd were seized by panic, and others were whipping up the sense of fear for their own financial motives. He also accepted that it was legitimate for market traders to concentrate on the very short run. His contacts in hedge funds for example were now concentrating on forecasting intra-day volatility, because the markets were so efficient that any non-random element in inter-day movements had been largely ironed out. Central banks are in a different position, however, because it can take five to ten years for the consequences of today’s policy actions to fully work their way through to the price level. While the output gap seems to be the main influence on changes in the rate of inflation over horizons of up to eighteen months or so, movements in the price level beyond that period appear to be dominated by the behaviour of broad money in a largely closed economy, such as the Euro-zone, and international prices and the exchange rate in an open economy, such as Britain’s. Movements in the exchange rate are themselves reflections of the relative tightness of domestic monetary policy compared to that being pursued overseas. However, other factors also matter, and currencies often exhibit speculative over- or under-shooting in the short run.

Britain has a more open economy than the US or the Euro-zone. This means that any downwards movement in the external value of the pound poses more of an immediate inflation threat than would be the case with the US$, Euro or Yen. In the long run, a 1% depreciation of sterling appears to be reflected in a 1% hike in the UK price level, although this long-run appears to be around ten years or so. Even so, the 10½% decline in the sterling index over the past year represents a substantial depreciation by any standards. Indeed, it is not far short of the devaluation of 1967 and the depreciation of sterling in 1992, which followed Britain’s expulsion from the Exchange Rate Mechanism. Incidentally, the government of the day lost office after both depreciations. However, the pound was strong a year ago and the annual average depreciation since the new sterling index was introduced in January 2005 has averaged a more modest 2% per annum.

The MPC is not too concerned about the weak pound because its model of inflation is a closed economy one, which emphasises the importance of the deviations of demand about the economy’s long-run supply potential. From the MPC’s perspective, the depreciation of sterling allows for a re-balancing of the British economy from consumption to net exports and will not lead to high inflation as long as the economy is running below its full potential. The MPC also appears to believe that the balance of probabilities facing the world economy contains a serious risk of a 1930s style meltdown of the financial sector, negative money and credit growth, and the emergence of serious deflationary pressures.

The problem with this scenario is that there is no sign of it in the data. Outside the US, global activity remains satisfactory, the growth in the international broad money supply has been accelerating, the ‘headline’ consumer price measures that best reflect the experience of ordinary people have been running at high rates, and the prices of oil, gold and non-oil commodities have all risen sharply, in a manner that is more reminiscent of the build up of global inflationary pressures in the early 1970s than it is to the experience of the 1930s.

As far as Britain is specifically concerned, it is worth stopping to ask what a 2% CPI inflation target implies in a long-run steady state for other elements of the economy – on the assumptions that annual CPI inflation is downwards biased by around ½% compared to other inflation measures, and that the long-run increase in productive potential is around 2½%. Under these circumstances, one would want ‘double-core’ retail price inflation excluding house price depreciation and mortgage rates to be running at around 2½% - compared with 3.4% in March - annual house price inflation of around 5% (the Department of Communities and Local Government index was up 6.7% in the year to February), M4 broad money growth of no more than 9.0% (it was 12.0% in March); and a rough balance on the current account of the balance of payments, not the deficit of 4¼% of national output recorded in 2007. One would also want international inflation to be no higher than 2½% - the latest OECD figure is 3.4% - or sterling appreciating to offset the excess.

The conclusion was that the British economy, had still not entered the neutral zone consistent with hitting the inflation target in the long run, but was still in the overheating zone, a view that was supported by the 3.4% increase in non-oil private-sector Gross Value Added in the year to 2007 Q4. David B Smith did not believe that Bank Rate had a powerful impact on the economy, and was not too perturbed by the relatively modest reductions so far. However, he could see no case for further cuts in the absence of firm evidence of a slowdown, and thought that policy would need to be tightened – perhaps, abruptly and in the context of a run on sterling – at some stage over the next eighteen months or so.

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

Trevor Williams said that he voted for a hold with a neutral bias. What to do next will depend on the data and how the economy develops in the coming months. The Bank should use non-interest methods of increasing liquidity, accepting longer maturity paper as collateral and considering under funding. The negative feedback from the financial crisis to the real economy depends on the ineffectiveness of central bank policy. Furthermore it was not just a matter of a lack of liquidity but liquidity not being in the right place.

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 one such vote was required since eight SMPC members were present at the physical meeting.

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

Patrick Minford said that the economy will slow to below 2% growth this year but that the downside risks are severe as long as the excessive tightness in the three-month money market continues. The housing and mortgage markets were clearly fragile. The risk of the UK having the same problems as the US was clearly present if current tightness continues. For the inflation outlook he distinguished between terms of trade shocks via the commodity prices boom and a domestic inflationary process. So far wages growth, the main element determining domestic inflation, had been consistent with the inflation target. With the current problems in the mortgage and housing markets and the effect of these on consumer confidence, the Bank does not have to worry that its credibility will be undermined by an easing. He voted to reduce Bank Rate by ½% in May with a bias to ease even further in subsequent months. Additionally he supported the Bank’s policy of attempting to unblock the inter-bank lending market in order to bring down the high risk premium, defined as the three-month London inter-bank offered rate (LIBOR) minus Bank Rate. The market rate represented by LIBOR should be brought down to 4.5%.

Policy response

1. By a narrow margin of five to four, and following a change of view by one member, the committee voted to hold Bank Rate at the 5% announced on 10th April in May.

2. Two SMPC members voted to cut Bank Rate by ½% on 8th May and two members voted for a cut of ¼%.

3. Of the five who voted for leaving the official discount rate unchanged in May three had a neutral bias, one had a bias to tighten, and one thought that ‘wait and see’ was the best policy.

4. Among the four SMPC members who voted to reduce Bank Rate on 8th May, the two ¼% rate cutters had a neutral bias, while the two advocates of a ½ % reduction had a bias towards further easing.

5. There was strong support at the 15th April SMPC meeting for non-interest policy to increase the injection of liquidity into the money markets. This was before the announcement the Bank of England’s Special Liquidity Scheme on 21st April, which SMPC members were not aware of at the time.

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.