Sunday, July 06, 2008
Bank should hold, says shadow MPC
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 eight votes to one to hold UK Bank Rate at 5% on Thursday 10th July. The one dissenting SMPC member favoured a ¼% reduction to 4¾%.

Looking further ahead, six of the SMPC holds had a bias to ease, two of the holders had a bias to tighten, and the sole rate-cutter had an easing bias thereafter. All the SMPC members concerned recognised that the Monetary Policy Committee (MPC) faced the most difficult situation that has arisen since the present British institutional arrangements were established eleven years ago.

In particular, the rise in consumer price inflation to 3.3%, when the problems in the market for credit had not been resolved, and the prospects for the global economy remained uncertain, left the authorities facing an acute dilemma. Some SMPC members were concerned by the rapidity with which the UK’s broad money supply and credit were decelerating. There was also some discussion as to how far previous errors by the MPC were responsible for the deterioration in Britain’s economic performance.

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

These are the most difficult waters that the MPC has ever had to negotiate. There is a serious chance of it making a major policy mistake by not moving interest rates soon enough. The trouble is that it is not absolutely clear in which direction rates should be moved. My own view is that the direction needs to be down but I acknowledge the risks. With inflation still rising, and expectations having taken a worrying upward move, there is a real risk that unless interest rates are raised, inflation could take off and a rate well above the target could get embedded.

However, that is not the only risk. The real economy looks seriously weak and the outlook for the housing market looks dire. We could be facing a real economic crisis and a financial collapse. Meanwhile, I am impressed by the fact that core inflation has not moved much and neither has the rate of increase of average earnings. Although the parallels with the 1970s are superficially strong, the conditions in the economy are fundamentally different. The most likely outcome, I believe, is that although headline inflation moves well above 4%, the core rate moves very little and next year the headline rate comes crashing down, perhaps taking the rate below 1%, at which point the Governor would have to write another letter. This would be accompanied by very weak conditions in the real economy, perhaps amounting to a recession.

The MPC does not have the luxury of waiting until all is absolutely crystal clear. By that time the bird will have flown. So it has to be prepared to take some risks – without being reckless. It might be worth waiting a little longer to see what happens to core inflation and to wages. But I would stand ready to cut and, to make an impression on firms and individuals alike, I would be prepared to cut by ½% in one go.

Comment by Tim Congdon
(Financial Markets Group, London School of Economics)
Vote: Hold
Bias: To ease, but not immediately

A sharp slowdown in broad money growth is now under way. Over the last three years the annual rate of M4 broad money growth has typically been in the double digits. In the six months to May the annualised growth rate of M4 was 10% and in the four months to May it was 6%. Further, Chart 1.18 of the May Inflation Report suggests that much of the growth this year has been in deposits within financial groups, which – like inter-bank deposits – have little wider macroeconomic significance. If these deposits are taken out, the annualised rate of growth in M4 has probably been little better than positive at perhaps 3% to 5% in recent months. With inflation rising, real money growth is virtually nil. (In the year to April corporate money – i.e., money held by ‘private non-financial companies’ – was up by a mere 1.0%. In the last three months it has fallen by 1.9%.)

So the British economy has lurched over the last year from an annual rate of real money growth of about 10% to one of almost nothing. The results are everywhere, falling house prices, sharp rises in commercial property yields, the announcement of bankruptcies in the furniture retailing sector and so on. With other monetary economists in a letter to the Financial Times, I warned in mid-2006 about the possibility that this cycle could develop dangerous tendencies similar to those in previous boom-bust cycles. I have been surprised by how bad conditions have become – and also by how quickly they have changed. The leap in oil prices is part of the story, while the banks do seem to have been taking too many risks and need to retrench.

But, even when allowance is made for all the excuses, the Bank of England’s performance has been poor. The level of understanding of basic monetary economics within the institution remains lamentable. The section on ‘Monetary Aggregates’ in the May Inflation Report has been cut back to a mere two paragraphs. But even this meagre treatment contains an elementary blunder. According to the final paragraph on page 18, “Household deposits continued to grow strongly. That could reflect substitution away from risky assets such as equities…”. This is another example of what I have called “the individual experiment illusion”, i.e., the notion that when an individual sells equities to increase his or her deposits, the quantity of aggregate deposits (and so the “household deposits” in M4) thereby increases. In fact, the quantity of deposits in the aggregate is determined by the size of banks’ overall assets. If the seller of equities has an increased deposit, the buyer of equities has a correspondingly reduced deposit. A change in agents’ attitudes towards the assets in their portfolios does not affect the aggregate quantity of money. When will the Bank stop making this mistake?

With the quantity of money given by banks’ behaviour, the effect of an increase in agent’s liquidity preferences (i.e., what the Bank calls “substitution away from risky assets in equities”) is a fall in asset prices. Alternatively, if the quantity of money falls while liquidity preferences are given, the same effect follows, i.e., a fall in asset prices. A change in agents’ attitudes towards different assets has no effect on the aggregate quantity of money, which is set by a quite separate set of processes. Again, when will the Bank’s economists ever learn?

For the next three to six months, while the inflation news will be bad, I can see no real alternative to keeping base rates where they are. However, I expect domestic demand to be flat in the second half of 2008 so that a negative output gap will have emerged by, say, spring 2009. So my bias will be to ease in late 2008.

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

The economic mood has darkened over the last month. The ongoing impact of the credit crunch and rising inflationary pressures create a toxic brew for the British economy.The credit crunch, with the three-month London Inter-Bank Offered Rate (LIBOR) rising in June to almost 100 basis points above the Bank Rate by the end of the month, is undoubtedly impacting on the real economy with the housing market arguably the most obviously affected area to date. Mortgage availability continues to tighten, housing market activity is now falling rapidly, with approvals well down, and prices are falling. The deterioration in the housing market is, if anything, accelerating and this is now having knock-on effects in the house-building sector.

The growth rate of the real economy is with very little doubt, continuing to slow. May’s 3.5% jump in retail sales was surely erratic. The weather was warm. The labour market, a lagging indicator of economic activity, is now slackening and unemployment rising. In the three months to April unemployment was 38,000 higher than in the previous three months. Job losses will continue to increase, particularly in construction and the retail and financial sectors. The chances of a quarter or two of flat – or even falling – overall economic activity are rising.

The inflation data continue to worsen, reflecting sharp rises in commodity prices. The latest Producer Price Index (PPI) and Consumer Price Index (CPI) data were worse than expected. It is now likely that CPI inflation will touch 4% in the second half of 2008 before, hopefully, falling back through 2009. The Bank’s key challenge now is to ensure that these largely external, commodity-driven increases in inflation do not translate into faster domestically-driven price increases. General inflationary perceptions and expectations are picking up. But so far, earnings inflation shows few signs of accelerating – a situation which is, on balance, likely to continue, given the weakening labour market.

There are, however, some ominous signs that average wage settlements could begin to tick up with the tanker drivers 14% settlement, albeit over two years, a dangerous precedent. The unions, empowered by their financial grip over the Labour party, are squaring up for tough and inflationary pay negotiations backed by industrial action. Even though I take the view that a price-wage-price spiral is still unlikely to develop, these industrial developments dictate monetary policy caution.

Given rising inflation rates, there is no scope for an imminent cut in interest rates. But, conversely, given the signs of a rapidly slowing economy and modest earnings inflation, there is currently no need for a rise. I vote for no change at the July meeting. But with a bias towards easing towards the end of 2008, providing domestically generated inflationary pressures do not build up.

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

There is a great deal of confusion in financial markets about the basis and objectives of UK monetary policy. This is witnessed by the wild volatility in bonds markets, with rapid changes in the expected number and direction of interest rate movements – from cuts to three rises to one rise to who-knows-what, and all this with relatively little change in the underlying data. I believe that a key contributor to this volatility is the fact that inflation has gone above 3%, and the policy framework makes no clear statement about what happens next. As I have urged repeatedly, we need to know what happens now? How high is inflation permitted to go before policy-makers must act? It appears very likely that inflation will exceed 4%.

Must rates then be raised, virtually come-what-may in terms of growth? Some reputable forecasters are even suggesting that 5% might be reached soon. Would 5% be enough to force interest rate rises, come-what-may? Or is 5%, 6%, 10% fine in the medium term, provided only that on a graph somewhere we can see a line that goes down to 2% in three or so years’ time? We really urgently need some guidance from the Chancellor on this point. Until we get that guidance, bonds markets will still be largely in the dark about the likely path of interest rates.

Assuming for the moment that there is effectively no inflation target constraint for us at all at present, and that we act on discretion, in addition to the actual retail and cost price inflation data, I put weight on three other key factors:

1) Broad money growth has fallen rapidly, and now appears likely to fall to around 6% on the current policy stance, driven by sustained credit market problems. Since the Bank of England was unwilling, in 2006, to raise interest rates to control monetary growth, money markets have scheduled their own down-time. Over the next year or two, this will start to bear down considerably upon inflationary pressures, even without further interest rate rises.

2) House prices are in total free-fall. The dangers many of us warned about for many years appear to have come to fruition, and the results may yet turn out to be worse than any of us have felt able to be explicit in predicting. However, as I have argued many times before, house price rises were so excessive for so long that in the early phase of house price falls, the impact on consumption will be largely negligible. I believe that it will only be once prices have fallen more than 15% that a house-price-fall effect on consumption will start to be a factor – so this is an issue for next year, rather than this year.

3) Until recently, it has appeared that economic growth has not been suffering too badly, although the first concrete signs of a significant slowdown may at last be apparent. An economy that grew consistently rapidly for fourteen years has great momentum. When coupled with the hangover of the extremely high rates of broad money growth of recent years, this was always likely to mean that growth would slow only gradually. I continue to believe that 1% growth for each of the two years starting from 2008Q2 is possible, though I admit that this is now at the upper end of plausible predictions. Downside risks are considerable, and at least one two-quarter technical recession is now very likely.

Overall, then, we face an economy in which the monetary stance should soon be moving to interest rate cuts, despite high inflation. The collapse in monetary growth and an extended period of below-trend GDP growth is going to do the necessary work of bearing down on aggregate demand. If the UK still had an inflation target, I would probably be thinking of when we would want to raise interest rates. But without being able to take advantage of the benefits of a constrained discretion regime – and the superior long-term growth, inflation and economic stability performance that would imply versus the discretionary regime – I can see little point in considering interest rate rises. Pay pressures are not great. Oil prices cannot continue to rise much. So this inflationary episode will pass. It has largely destroyed the UK’s inflation target as it passed – because of the poor response to the situation of those that set the target. But we will pay the price for that in later years. For now, my vote is to hold, with a bias to cut.

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

Things are not as straightforward as some economic commentators would have us believe. Certainly terms of trade shocks have pushed inflation above the target and it is likely to stay above target for some time. But despite the talk of inflation getting out of control, there is little sign of this in inflation expectations. Wage response has been muted and according to Income Relations Services annual pay awards are running at only 3.3%. True, inflation expectations as measured by the gap between long-term yields and indexed linked has edged up by 40-50 basis points in recent weeks. This is clearly a cause for concern but it is not catastrophic. The Bank of England has made noises to the effect that it no longer believes in the credibility of its own target. On the real side of the economy, the housing market has slumped, mortgage approvals have declined sharply, and growth has slowed to an almost standstill. Consumer spending has remained unaffected but no one believes that this is sustainable with real disposable income now showing negative growth.

There is nothing the Bank can do about the coming growth slowdown but the issue is whether the slowdown turns into a more serious downturn and if the costs from this are greater than the costs from a short-term rise in inflation. The weakness of sterling and the changing direction of interest rates in the Euro-zone mean that the Bank is unlikely to reduce interest rates in the near future. However, they should be cautious in going in the other direction. The growth slowdown the Bank wants to bring inflation under control is happening. The spread in inter-bank rates over base has remained much the same since March. Interest rates have effectively risen by 50 basis points. A rise in Bank Rate now would be overkill. I recommend putting base rate on hold and would be prepared to cut if the economy weakens seriously.

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

This is a difficult period for the MPC, with two large shocks coinciding- the continuing credit crunch (a demand shock) and the world oil/commodity boom (a supply shock). The first requires a cut in interest rates, the second a rise. The question is what is the balance of forces? It would seem that the MPC's de facto judgment has been that the former more than offsets the latter, since three-month market interest rates are a bit higher than where they were in August last year when the banking crisis broke; if one looks at rates in the mortgage market (the main way in which households smooth their consumption) they are clearly substantially higher. Furthermore the Bank's large-scale assistance to banking liquidity has deliberately not aimed to reduce the three-month risk premium between market rates and base rate, since that very gap is charged as a fee to banks that take up the facility.

The bank is charged with maintaining inflation at 2% in the medium term. One must ask therefore how long the effect of the two shocks are going to last. It seems to me that the potential impact of the credit crisis is much larger - and of longer duration - than that of the world commodity boom.

On the last, it can only be a matter of time before the East Asian countries react to their own inflationary problems, which have become acute because of poor monetary policy (usually obsessed with buying dollars to hold their dollar exchange rates down). Just in the last few days India has raised interest rates for example. In terms of domestic reactions to this terms-of-trade shock we can see that wage growth is barely flickering. Hence the pass-through of the commodity price boom should be fairly quick.

On the first there are signs of a dangerous credit shortage in the housing market. Other indicators have remained so far surprisingly robust - for example the latest retail sales volumes, up 8% on a year ago. But the savings rate is very low and with real incomes falling and credit availability tight, the risks are that consumption will stall and even decline. Once that begins it takes a long time to reverse.

Thus my view would be that rates should be cut by a ¼% now, with a further bias to cut. This will still mean that monetary conditions in the marketplace will have been tightened since August last year - an excessive reaction to the twin shocks the economy is facing.

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

Having opposed each of the three ¼% UK Bank Rate reductions carried out since last December - and having consistently warned that the depreciation of sterling indicated that Britain was pursuing relatively high inflation policies in what already looked like an excessively inflationary world – the issue that has to be confronted is whether there is anything other than a lack of moral fibre preventing one from advocating an immediate Bank Rate hike of, say, ½% or ¾%.

After all, if a 5¾% Bank Rate was considered appropriate when CPI inflation was running within 0.1 or 0.2 percentage points either side of 2% last autumn, why should a rate of 5% be appropriate now that CPI inflation has accelerated to 3.3% and is expected by the Bank of England to breach 4% during the next few months?

It is also worth noting that in terms of the three-equation Conventional Theoretical Macroeconomic model (CTMM), which underlies the current institutional structure of the Bank, its conceptual framework and its main forecasting model, one has to over-react to any deterioration in inflationary expectations if rising inflation is not to feed on itself.

Opinion polls carried out in the US, Euro-zone and Britain indicate that inflationary expectations are indeed increasing, although they are still generally running below the ‘headline’ inflation numbers. This may be because people ‘rationally’ believe that some of the recent upward pressure on the rate of price increase reflects transitory commodity price shocks. But it may also be because they form their expectations of the future rate of price increase using an ‘adaptive-learning’ approach.

It is well known that putting adaptive-learning into the CTMM can generate stagflation. I have long believed that the CTMM is a dangerously over-simplified model of reality, for the reasons set out in my April 2007 Economic Research Council paper 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). However, the US Federal Reserve and Britain’s MPC appear to set great store by the CTMM. This implies that they are playing with inflationary fire in terms of their own intellectual approach. The European Central Bank is more sensible and has realised that a strong currency and firm monetary discipline are the only ways in which the Euro-zone’s inflation prospects can be protected from the inflationary international background.

The main reason why Anglo-Saxon central bankers are not just behaving recklessly is to do with the balance of risks, particularly the unknown consequences of the global credit meltdown that commenced in August 2007. Credit rationing effects are not incorporated in any of the forecasting models employed by the leading central banks.

It is certainly conceivable that tighter credit standards could act as a major negative blow to output and employment in the major economies. However, monetary economists normally distinguish between the first round effects of a credit shock, which are considered to be transitory, and the sustained second round effects that follow once the banking sector’s liabilities and the broad money supply have adapted to the new situation on the assets side of the balance sheet. I would advocate aggressive rate reductions if there were indications that the global money supply was imploding, as happened in the Great Depression of the 1930s, for example. However, there is no evidence that this has happened. Aggregate OECD broad money has recently been rising by some 8¾% to 9% year on year, if high inflation countries are excluded. This figure was last observed in the late 1980s when ‘core’ OECD inflation was running around 4½%, compared with 3¾% in the year to May.

There does appear to be an observable deceleration in Britain’s M4 broad money stock. However, the 10% increase recorded over the past twelve months is still on the high side of what would be consistent with achieving the inflation target in the long run. A further modest monetary deceleration should be accepted – and, perhaps, even welcomed - provided that the pace of the slowdown is not so rapid that it leads to a recession

The Office for National Statistics (ONS) data published on 27th June revised the previous estimate of UK real GDP in 2008 Q1 down by 0.2 percentage points, although the balance of payments figures released simultaneously showed a reduction in the current account deficit from £12.2bn in 2007 Q4 to £8.4bn in the first quarter of this year.

Unfortunately, the improvement in the deficit on net exports was modest, from £14.6bn in 2007 Q4 to £13.5bn in 2008 Q1, and the overall improvement was due to temporary favourable ‘wobbles’ in net investment income and government transfers. Non-oil market sector gross value added, which excludes the government’s contribution to national output, rose by 2.7% in the year to the first quarter, while total GDP rose by 2.3%, both including and excluding North Sea oil.

Having incorporated the new figures into the Beacon Economic Forecasting (BEF) model, total UK GDP is now expected to rise by an average of not quite 2% this year, 2% next year, and 1¾% in both 2010 and 2011. The balance of payments deficit is expected to fluctuate between 5% and 6¼% of the basic-price measure of GDP throughout this period; it was 4.9% last year.

There must be reservations as to whether deficits of this scale and duration can be funded without posing a further threat to the external value of sterling. The pound has already fallen by 11.2% on a trade-weighted basis over the past year.

The most ‘scary’ aspect of the latest BEF projections, however, is the persistent high inflation expected over the next few years. This is partly to do with the price of oil. The BEF projections assume that it averages US$130 for a barrel of Brent crude in the second half of this year, giving an annual average of US$119.8 and sticks there throughout 2009, before rising by US$½ in each subsequent year.

In contrast, the current independent consensus oil price assumption reported by HM Treasury is US$112 for this year and US104.6 in 2009. An even more important factor, however, is the weakness of sterling at a time when international inflation is already running well above the rate consistent with a 2% domestic inflation target. This makes Britain a relatively high inflation country in an excessively inflationary world.

This more than offset the disinflationary benefits that arise from a widening of the domestic output gap in the BEF predictive framework, but not the official one. As it is, annual CPI inflation is expected to peak in the third quarter of this year, but still be around 4¼% in the fourth quarter, before easing to around 4% in the final quarter of next year, 3½% in late 2010, and just over 3% in late 2011. It would require a major reduction in the price of oil, not just a stabilisation therein, to bring UK inflation back within its target range over the MPC’s predictive horizon.

The issue that arises is what can be done to improve this rather unprepossessing medium-term economic outlook? The short answer is probably not very much, at least where the next eighteen months or so are concerned. One reason is that the UK’s economic openness means that the rather weak effects of the domestic policy instruments can be easily swamped by economic conditions overseas, and these international factors are unlikely to be helpful over the next few years.

Another reason is that it has taken approximately seven years of fiscal fecklessness and more than three years of money and credit indiscipline to create the present economic situation. Getting out of it could either require many years of tight monetary and fiscal discipline or the imposition of the sort of draconian policy package that has been associated with International Monetary Fund (IMF) bail outs of the British economy in the past. Finally, the political realities mean that the inconsistency between fiscal laxity and the monetary stance needed to bear down on inflation is likely to get worse as a demoralised government marks time until its likely nemesis in a 2010 general election.

Overall, it seems reasonable to keep UK borrowing costs on hold this month. However, I maintain a bias to tighten in the medium term, if higher rates are not forced on the authorities by a run on the pound. One justification for this ‘wimpish’ recommendation is that that the evidence suggests that small changes in Bank Rate do not have a significant impact on the economy. A necessary condition for improvement to Britain’s medium-term prospects is the implementation of a fiscal stabilisation package to improve the supply side. One can only hope that the Conservative opposition is swotting up on the subject of fiscal stabilisation. Somehow, one doubts it.

Comment by Peter J Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: To cut on confirmation of a sharp loss of economic momentum

The release of the full national accounts for the first quarter of 2008 has laid bare the constricting impact of the global credit crunch. Quarterly growth fell to 0.3% in Q1 from 0.9% in Q2 of 2007; the household saving ratio slumped to 1.1% from 3% in the previous quarter; and inventory accumulation of £5.3bn in the second half of 2007 was replaced by a small reduction in Q1. In fact, real domestic expenditure fell by 0.3% in Q1. On the output decomposition, four service sectors recorded falling activity in the first quarter: hotels and restaurants, real estate, renting and business activities, post and telecommunication and public administration.

In the nominal accounts, GDP at market prices rose at a 4.5% annualised rate in Q1, down from 6.0% in 2007, suggesting that the credit downturn is also having a contractionary impact. Once again, it is the domestic components of GDP where the constricting effects are most in evidence: a mere 3.2% annualised pace of growth in Q1 versus 6.2% in 2007. Hence, amidst the eruption of concern over measured CPI inflation, it is important to keep hold of the broader reality that domestic nominal activity has decelerated since the credit crisis began.

Meanwhile, the growth rates of bank credit and money holdings have declined steadily in the past few months. The annualised six-monthly pace of M4 lending has slipped from 13.7% in September 2007 to 10.5% in May. Annual growth rates for lending to private non-financial corporations and to households for loans secured on dwellings have fallen from 17% to 13% and 10.2% to 8.5%, respectively.

M2 money growth has been little changed over the past year, slowing from 7.0% last September to 6.6% in May, but wholesale deposit growth has dropped from 24.4% to 16.5% over the same period. Despite the re-absorption of conduits and attempts to accommodate “friends and family”, bank balance sheets are growing less rapidly than immediately before the crisis broke. This suggests that the internal pressures on the financial system are more than sufficient to achieve credit discipline in the months ahead.

Events of the past year have fired ‘Exocet’ missiles at the received wisdom about the UK economy and its policy framework. It is becoming apparent that:

1) The consistency and resilience of GDP performance over the past decade has been purchased at the price of profound balance sheet deterioration, principally through the assumption of colossal household, corporate and financial sector leverage, and the escalation of public sector off-balance sheet and contingent liabilities.

2) Credit and capital market innovations and structures have defended the UK economy from the inflationary implications of excessive domestic credit growth. The closing of these credit channels has necessitated a re-intermediation of credit through the banking system where its inflationary impacts are likely to be greater.

3) While the inflation target has served an important purpose in helping to anchor domestic inflationary expectations, the framework of inflation targets offers no defence against a material shift in the relative price of imported fuel and food – itself a symptom of global credit excess.

The powerful headlines created by successive CPI releases, showing a jump from 2.5% in March to 3.0% in April and 3.3% in May, cry out for a policy response but there is no rational response available. The argument for interest rate reductions can still be made on the basis of a forward-looking assessment of nominal activity in 2009-10, but there is an obvious danger that, in present circumstances, such a move would be interpreted as a neglect of duty on the part of the MPC.

If, as seems likely, the abrupt loss of economic momentum will be confirmed by incoming data for Q2, and will follow through in the second half of the year, then the opportunity to implement a rate-cutting agenda will return. My sense is that we are nowhere near the darkest hour in this crisis, as the UK banking sector remains complacent about its exposures to doubtful debts and balance sheet risks. Only when the consensus economic forecasts for 2009 come crashing into negative territory – as ours has been for some time – will this inflation panic subside.

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

This is not a time to raise interest rates but inflation remains the biggest risk to medium term prospects of price stability. The economy is slowing, though I think it could bounce back modestly somewhat in Q2 from the revised lower 0.3% rise in Q1. Retail sales are resilient, as consumers refuse to buckle under the pressure of higher borrowing costs, a falling housing market, lower confidence and a reduced availability of credit.

This would seem to support my perception that the credit crisis, by itself, would not be enough to derail the economy, although it would hit financial markets and wreak havoc on commercial banks’ balance sheets and business models. But with the credit crisis still unfolding, the Bank still has to wait to see if its effects are spreading into the wider economy before being sure that a rate rise will not plunge the banks back into difficulty and threaten recession.

Consumer spending will slow eventually, under the weight of reduced real income from higher inflation and the rise in energy costs, but the MPC has to wait until that happens to assess its economic impact and then to judge whether it is enough to lead to a reduction in inflation so that it has a realistic chance of hitting the 2% target in two years time, i.e. 2010. The prospects are good that the slowdown will be enough to help ease inflation pressure so that only a modest rate rise is necessary.

The slowdown in M4 is a good sign also that the income effects of higher oil prices and of tighter credit and higher cost of borrowing are impacting money growth. And most of the effects of this adjustment may already be evident in the slower pace of financial markets activity in the UK in the last month. Moreover, the Purchasing Managers (PMI) surveys for services and manufacturing are confirming that the pace of economic growth has eased.

Hence, there has been some slowdown in the rate of M4 borrowing by companies and, more modestly overall, by individuals. This is signalling slower economic growth ahead. But the fall in the sterling exchange rate and the rise in inflation expectations do mean the MPC cannot yet rule out a rate rise. To do so would send a message to wage bargainers that the inflation target has been abandoned, which could cause just the wage-price spiral the authorities want to avoid.

In addition, the risks remain that the pound could slip further against the dollar and deliver another inflation shock to the economy. This is why I believe that, even if the economy weakens as expected, the eventual fall in inflation will not be sufficient to justify a cut in Bank Rate. The world backdrop is much more inflationary than at any time since the early 1990s and, without a strong exchange rate, the UK’s domestic interest rate simply cannot be sustained below 5% without continuing sub-trend economic growth.

What is the MPC?

The SMPC is a group of independent economists who assemble once a quarter at the Institute of Economic Affairs (IEA) in Westminster. The inaugural SMPC meeting was held in July 1997 and the Committee has met regularly since then. That it is the first such body in the UK, and meets regularly to discuss the deeper issues involved, distinguishes the IEA’s SMPC from the similar exercises now carried out by several publications.