Monday, September 01, 2008
Still too soon to cut rates, says shadow MPC
Posted by David Smith at 09:00 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 that UK Bank Rate should be held at its current 5% on Thursday 4th September.

The two dissenting members both favoured a ½% reduction to 4½%. The bare vote understates the underlying ‘dovishness’ of the shadow committee, however, since both cutters had a bias to ease further, five holders believed that the next move in rates should be downwards, and only two of the holders had a bias to tighten.

Several SMPC members drew attention to the downwards revision to UK national output in the second quarter, which suggested growth was weaker than earlier believed. However, there was also concern that the Bank of England’s credibility would suffer if interest rates were reduced at a time when it was still uncertain when - and at what level - inflation would peak.

One member was concerned about the limitations that the UK’s lax fiscal stance placed on the MPC’s freedom of manoeuvre. There was a general acceptance that this was an unusually tricky period for monetary policy makers and that the inflation outlook was heavily dependent on the essentially unknowable future price of oil.

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

Money supply growth – after adjusting for deposits created by lending between banks and within banking groups – is falling sharply. The result is a severe squeeze on UK companies’ liquidity, similar in character – if not yet in intensity – to that in the mid-1970s, the early 1980s and the early 1990s. Takeover activity has slowed dramatically, and companies are shedding land and subsidiaries to keep their balance sheets under control. Falls in share prices and property values are exerting adverse wealth effects on demand, and the outcome is likely to be at least two quarters of falling domestic demand and (depending on net exports) output.

But a recession isn’t really needed. Even in late 2007, which was the peak of activity in the cycle now coming to an end, labour shortages were mild. Output must be roughly in line with trend and, given the latest money numbers and business survey indicators, will be 1% - 2% beneath trend by late 2009/early 2010.

Inflation must now be near its peak. I accept that an immediate cut might have some untoward effect on inflation expectations and the public’s perception of the Bank of England’s seriousness. Nevertheless, unless the pound weakens dramatically in the next two or three months, I am in favour of at least one 25 basis point rate cut before the end of 2008, and believe that Bank Rate should average about 4% in 2009.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: To ease

Having mistakenly allowed banks, non-bank financial companies, non-financial corporations, and households to leverage up their balance sheets in the period 2004-07, the Bank of England now finds itself in the uncomfortable position of having to supervise the deleveraging of all those balance sheets - an inherently deflationary process - while trying to prevent too sharp a contraction in nominal spending.

Fundamentally there are only three ways to deleverage or repair balance sheets. First, banks and companies can raise capital (although households cannot). However, banks’ and companies’ ability to raise capital depends on potential subscribers having a positive view of their prospects – a view that is not widely shared in financial markets at the onset of a recession. In addition, with all the major domestic sectors over-leveraged, the only obvious source of net new capital will be overseas. In any case, aside from the Governor urging banks to raise capital as he did earlier this year, there is little the authorities can do to accelerate the raising of new capital.

Second, assets can be sold and the proceeds used to pay down debt. But firms and households generally resist asset liquidation because nobody wants to sell assets into falling markets. Although they may be able to procrastinate for a while, eventually denial turns into acceptance, and the process is reluctantly started. Again, the authorities have little to contribute to the process and can only watch passively.

Third, balance sheets can be repaired by generating earnings. For households, repairing their balance sheets by earning their way out essentially means cutting consumption and/or raising savings. Both will exacerbate the economic downturn. Banks and companies can earn their way out by generating profits that strengthen their balance sheets, but this takes years and requires a strongly positive yield curve to enable them to generate earnings substantially greater than their cost of funds. Here the authorities can facilitate the process by cutting short-term interest rates, but they must be careful not to trigger a renewed round of increased leveraging and spending that would exacerbate inflation. When will it be safe to cut rates without triggering such effects?

In my judgement, it is too early to assume that easier credit conditions will not result in adverse “second round” effects on inflation (e.g. via higher wage demands) and inflation expectations. Although, based on the latest (June) figures, money and credit growth have shown some deceleration (particularly non-financial corporate holdings of M4), inflation from the earlier period of rapid money and credit growth is still working its way through the system, and there are as yet few signs of excess capacity either in capacity utilisation or in the labour market. Accordingly, the Bank should keep rates on hold until there are more widespread signs of a larger output gap (actual output below potential output).

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

The economic mood has darkened considerably over the past month. The Bank of England’s August forecast was much gloomier than in May (which, in turn, was much gloomier than in February). The Bank expects output to be broadly flat (year-on-year) in the first half of 2009 – which clearly suggests that there may be a couple of quarters of falling output.

The UK Office for National Statistics (ONS) made a significant downward revision to its 2008 second quarter GDP figure – from a preliminary estimate of a 0.2% quarterly increase to no change. The latest ONS data show that domestic output fell in both the first and second quarters of this year and only a drop in imports had prevented GDP going into negative territory. Fixed capital formation fell over 5% in the second quarter. Granted, these figures are likely to get revised again at the time of this year’s ONS Blue Book (September), so there is an element of “flying blind” in analysing the economy, but the downward revision cannot wholly be dismissed. The economy is clearing skirting recession and there is a rising probability that output will indeed fall in the second half of this year.

Even though consumer price index (CPI) inflation is expected to rise to around 5% in the second half of this year, there are few signs that wages inflation is picking up. Indeed earnings inflation is, if anything easing. With unemployment picking up and trade union power limited in its potency, employees appear to be accepting falling living standards. Oil prices have eased significantly in dollar terms and, even though the impact of oil prices will be dampened in sterling terms as the pound falls against the dollar, this should help the overall CPI numbers in the coming months. I would be reluctant to cut rates when CPI inflation is rising and the pound is falling. But I would have no hesitation to cut by ½% if the economic data continue to worsen.

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

The current inflation spike will pass, and within a couple of years we may be worrying about misses of the inflation target at the bottom end, especially given the fall-off in (adjusted) broad money growth, the rapid slowdown in aggregate demand as the economy goes into probable recession, and the disinflationary effect of rapidly falling house prices. In that sense the money-quantitative work is already done, and policy could afford to be up to 100 basis points looser. However, inflation is currently far above target, and likely to rise further yet. In my view, a cut at this stage would tend to raise already-elevated inflationary expectations still further and undermine what little confidence remains in the public sense that the Bank of England is in control of events. This might potentially lead to wage rises over this winter that could be disastrous in terms of their impact on unemployment in an economy perhaps in recession, causing recession to be deeper and the negative effect on aggregate demand - and hence on the risk of deflation - worse.

Consequently, I am still of the view that it is too early to cut. Indeed, I would still not dismiss altogether the case for a quickly-reversible interest rate rise, implemented for pure signalling reasons at some point in the autumn if the headline inflation rate continues to rise markedly. Once the peak in inflation is passed, however, I shall very probably favour deep and rapid cuts, with a preference for rates reaching 4% in the Spring and perhaps 3.5% or even 3% by the end of 2009.

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

It now looks as if monetary tightening is taking effect in many emerging market countries; this has been helped by the recent strengthening of the dollar which means these countries no longer need to buy dollars and print more money in the process. Indeed they may even do the opposite which will assist tightening. Credit conditions have tightened in the developed world of course. Hence world monetary conditions are now unambiguously tightening; and this is starting to reverse the commodity price boom and slow world inflation.

The dilemma as seen by the Bank has been that there has seemed until recently to be little sign of any let-up in world inflation. Faced with this prospect, the Bank was uncertain how domestic inflation would respond; this uncertainty was most clearly articulated by Tim Besley, the one Monetary Policy Committee (MPC) member who voted for a rate increase in the last meeting. Now matters are a bit clearer. Wage increases have actually fallen - to 3.4% - and are therefore signalling that domestic inflation is unlikely to respond. In addition world monetary tightening has begun to reverse commodity prices which are now falling.

I have argued before that there was little likelihood that domestic inflation would respond because of wide understanding of the inflation targeting regime. In practice UK monetary tightening has further guaranteed that it would not - policy has been cautious because of the perceived uncertainty just described. Under inflation targeting we should not be misled by the sharp terms of trade movements that have occurred because of world overheating. It is well understood that these will raise consumer prices and lower living standards - what else could they do? But rational working households are unlikely to want to compound their misery by losing their jobs and demanding offsetting wage increases- even less so when the cost of credit is high and rising. Thus, and contrary to forecasts based on 'broad money' however defined, there has not actually been any domestic inflationary rise. As the Bank notes in its last Inflation Report indicators of long-term inflation expectations have not moved from 2%.

It is now time for the Bank to reduce the cost of credit to avert the risk of a severe downturn in the UK economy. Everyone has now fully discounted the prospect that the CPI inflation rate will rise to around 5% before it starts to drop back down to the 2% target. Real interest rates - eg the real mortgage rate - if one adjusts by the underlying inflation prospect, are now running at 5% or so, and that is to good-quality borrowers. Availability to lower-quality borrowers, whom a properly-functioning market ought to cater for, seems to have dried up entirely except at quite penal rates.

In its latest press conference, the Bank appears to have suggested it lacks any capacity to control the economy: that the prospect of recession is one it has no power over. This is frankly incredible and threatens to undermine the Bank's independence. Politicians of both left and right will argue that if the Bank will not use its powers responsibly as the Act suggests to reach its inflation target without damaging growth, if that can be done, then it is not fit and proper to be in charge of monetary policy. With growth having stalled in the second quarter and domestic demand apparently falling, it is time now to take some counteracting action on interest rates, given that the inflation risks are diminishing. I would support a cut of ½% now, with a bias to cut further.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Stand ready to lower interest rates sharply.

The seeds of inflation or disinflation are sown about two years before the inflation or disinflation materialises. Two years ago monetary growth correctly warned that a rise in inflation was on its way but, as usual, not the precise timing or the exact way in which it would occur. The MPC can be severely criticised for not paying attention to the warning from the behaviour of the monetary aggregates and, predictably, for raising interest rates by too little too late when the first signs of rising inflation occurred.

Currently, the published data for the monetary aggregates are not suggesting that substantial disinflation is in the pipe line. The data are however seriously distorted by special factors. The situation is somewhat similar to the second half of 1980 after the constraint on banks’ growth of interest-bearing-eligible liabilities (the so called ‘corset’) was scrapped. The published data for the money supply were distorted upward as the previous distortions caused by the corset unwound and the Treasury thought that money supply policy was expansionary when it was in fact tight. Currently, there has been a sharp fall in underlying monetary growth, indicating that there is no need for interest rates to be raised further. The credit crunch is doing the MPC’s dirty work for it. The result will most probably be overkill.

The immediate task now is to minimise the pain of the coming recession. The trade unions are almost bound to claim higher wages in an attempt to protect their members’ real incomes. The more they succeed the worse and more prolonged will be the pain. A reduction in interest rates now would be likely to encourage trade union militancy and therefore increase the pain. Interest rates should accordingly be left on hold for the moment but the MPC should stand ready to reduce them sharply. There is a danger that last year’s mistake will be repeated and rates will be changed by too little too late on the way down as they were on the way up.

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

There have been four developments since last month that have potential consequences for British interest rates.The first is the downward revision of 0.2% to the level of UK real GDP in the second quarter and of 0.3% to OECD GDP in 2008 Q1. These revisions suggest that the outlook for both domestic and international growth is weaker than it appeared previously. The current figures show that the year-on-year growth of UK real GDP fell from 3% in 2007 to 2.3% in 2008 Q1 and 1.4% in Q2, while OECD growth slowed from an annual average of 2.7% last year to 2.5% in the first quarter of 2008 and 1.9% in the second quarter. In the light of the revised data, it now seems likely that UK growth will average around 1½% this year, 2% next year and not quite 2% in 2011 and 2012. However, the ONS has not re-balanced the national accounts since mid-2006 (this used to happen annually in late June). There is correspondingly a strong possibility that the whole UK forecasting profession, including the Bank of England’s staff, will be wrong footed when the re-worked national accounts are released on 30th September.

The second major development has been the publication of dissapointingly high ‘headline’ inflation numbers for a number of countries. Annual US CPI inflation accelerated to 5.6% in July, when Euro-zone inflation was 4%, and even ‘deflationary’ Japan experienced an inflation rate of 2% in June.The acceleration in UK CPI inflation to 4.4% in July once again seems to have caught the London financial markets by surprise. But it does not look so out of line in an international context. OECD inflation was also 4.4% in June - the July figure will appear on 2nd September. However, the acceleration in UK ‘headline’ RPI inflation to 5% in July, and the pick up in RPIX inflation to 5.3% looks rather more excessive. The ‘double-core’ RPI, which excludes both mortgage interest rates and house price depreciation and is the most consistently defined UK inflation measure over time, showed an annual rise of 5.5% in July, compared with 4.9% in June. Fortunately, the third major piece of news has been the declines in the price of oil – which fell from a peak of US$146.1 for a barrel of Brent crude on 3rd July to US$114.6 on 26th August – and non-oil commodity prices, with the weekly US$ index published by The Economist magazine dropping by 12.5% between its 1st July peak and 19th August. These developments suggest that inflationary pressures could abate once lower input costs have worked their way down the production pipeline.

The fourth important development was the revelation that UK public sector net borrowing (PSNB) was £11.0bn more adverse in the first four months of fiscal 2008-09 than it had been a year earlier and the cumulated public sector net cash requirement (PSNCR) was worse by £13.0bn. Annualising these differences and adding them to the 2007-08 outcomes would yield a PSNB extrapolation of £68bn for 2008-09 and a PSNCR of £66.4bn. This is almost certainly too gloomy and the latest Beacon Economic Forecasting (BEF) model-based forecasts are for a £51¼bn PSNB and a £50½bn PSNCR this year. Nevertheless, these remain horrifying borrowing figures for an economy which has only experienced the early stages of recession so far. The enormity of the budget deficit implies that the policy inconsistency between the lax fiscal stance and the MPC’s inflation target is a constraint on future rate cuts. The fact that monetary policy and fiscal policy are institutionally separated in Britain does not mean that they are economically separated, or that the MPC can ignore the adverse consequences of high tax and regulatory burdens for the supply side of the economy.

The continued downwards drift of sterling, which was 13.1% lower on 26th August than it had been a year earlier, suggests that international investors are becoming increasingly wary of investing in the UK. One reason appears to be the fear that the political background will lead to even more fiscal debauchery over the next two years. The fact that Britain has a small open economy also means that the inflation consequences of any sustained depreciation of the currency are likely to be stronger than would be the case with a large continental economy such as the US or the Euro-zone. Overall, it seems reasonable to keep UK borrowing costs on hold this month. However, there is little justification for a cut until it is clear that inflation is nearing its peak and it is possible to have some feel for how high that peak is likely to be. Reported ‘double-core’ RPI inflation has accelerated by 2.1 percentage points since UK Bank Rate was cut to 5% on 10th April and CPI inflation has risen by 1.9 percentage points. This represents a substantial cut in the real rate of interest. As such it probably represents an adequate easing in monetary conditions, especially as the trade-weighted sterling index has come off by 1.8% since 10th April. Longer-term, my bias to tighten remains. Even so, the recent fall in the price of oil has improved both UK and international inflation prospects. On the cautious assumption of a US$119 oil price, CPI inflation is expected to ease to just over 3½% in the final quarter of 2009, 3% in late 2010, and just over 2½% in late 2011. That would represent three years of target busting price increases, however, and one must have reservations about the credibility of the current institutional framework under these circumstances.

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

Every week that passes brings confirmation of the debilitating effects of the credit spasm on the UK economy. The release of the output, income and expenditure accounts for the second quarter of 2008 lays bare its constricting impact. In the nominal accounts, GDP at market prices rose at a 3.5% annualised rate in the first half of 2008, down from 6.0% in 2007, emphasising the deflationary impact of the crisis. The proper focus of domestic monetary policy is the current and prospective inflationary climate of the whole economy, not merely the consumer sector. It is true that consumers’ expenditure shows a 6% annualised pace of growth in the first half, higher than the 5.6% increase for 2007. But, for domestic final expenditure in total, the equivalent comparison is 2.5%, down from 6.2%.

It is deeply regrettable that the MPC should regard the prevailing annual inflation rate of the CPI as an obstacle to the immediate easing of policy. The 4.4% rate of CPI for July, possibly to become 5% at its imminent peak, is spilt milk and not worth crying over. What we have learnt in the past twelve months is that an inflation target is no substitute for a controlled expansion of broad credit and broad money. The bitter twist is that such control can no longer be achieved reliably within a national context. Until the global credit system is exposed either to market discipline (preferable) or regulatory discipline, inflation targeting has no future.

The MPC should not worry about its loss of credibility in relation to the 2% inflation target. It will suffer far greater criticism, justifiably, if it fails to react to the intensification of the credit crisis. Nor should it fret over the forthcoming negotiations over public and private sector pay awards: the economic pressures are so great as to deny the feasibility of faster earnings inflation. Public sector finances have deteriorated alarmingly in the past six months, leaving no scope for concessions. Public sector employees should expect to take a real pay cut in these circumstances.

The August Inflation Report highlighted several disturbing aspects of the economic constriction. The abrupt loss of household confidence in employment and earnings prospects and the sharp deceleration in corporate money balances underline the severity of the situation and the urgency of response. Domestic credit conditions are demonstrably tight, with the cost of borrowing generally higher for households than a year ago and little changed for corporations. A Bank Rate cut of 100-150 basis points over the next three months would seem to be the appropriate scale of adjustment if a material impact on end-user borrowing costs is to be achieved. To reiterate, the deceleration of the nominal economy that is in progress will be more than sufficient to deliver the CPI inflation target by end-2009. The MPC’s indecision risks a far more destructive outcome for real activity.

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

The debate about what to do with interest rates is getting even more intense, with the MPC itself split three ways. But the facts seem to speak for themselves. Growth in the economy is slowing sharply but it is not yet in recession, though it does seem possible there could be a modest fall in the third and fourth quarters of this year, meeting the definition of technical recession. The credit crisis continues, with banks tightening credit spreads and hoarding cash and not lending to each other as freely so keeping interbank rates well above central Bank Rate. This has hit mortgage markets much more than any other sector. Company surveys suggest that the availability of credit is not as much of a concern as weak demand conditions and the general economy. But industrial output has slowed sharply in the last few months, explaining why overall economic growth has slowed.

Firms appear to have taken the fall in the currency in profits margins rather than trying to expand market share in overseas markets, but domestically retail sales have also weakened in the last two months. However, inflation is still the main risk facing the economy and has increased, not abated, in recent months. Weak - below trend - economic growth is required and necessary to keep inflation from rising even faster. Annual money supply growth has stopped declining and published M4 grew by 11.2% in the year to July. With inflation yet to peak and core CPI rising and set to rise even further into next year rather than decline as many seem to expect, interest rates have to be maintained at what are still relatively low levels in order to keep inflation expectations down. Although unemployment is rising and wage inflation is low, this is necessary to prevent a rise in rates and is not a reason for cutting them.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (Visiting Fellow, London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group and Global Vision), and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.