Sunday, February 01, 2009
Keep Bank Rate at 1½% in February but Adopt Quantitative Easing, Says IEA’s Shadow MPC
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its latest quarterly meeting (in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted to leave Bank Rate unaltered at 1½% on Thursday 5th February.

In particular, six members of the Institute of Economic Affairs’ shadow committee voted to hold Bank Rate in February, while three members advocated another reduction of ½%.

There was a widespread view on the SMPC that further reductions in Bank Rate would only have a limited further stimulatory effect on activity. Instead, a majority of the shadow committee’s members thought that direct action should be taken to ensure that a collapse in the broad money stock did not lead to a depression.

However, the SMPC also stressed that any unconventional measures to directly increase monetary growth needed to be rapidly unwound, once they had done their work, to avoid a longer-term inflation problem. There was concern that political considerations, and co-ordination problems between the Bank, HM Treasury, and the Debt Management Office, might make it difficult to achieve this unwinding in practice, however.

Chairman’s Comments
David B Smith began the meeting by paying tribute to the late Sir Alan Walters who had been a founder member of the SMPC in 1997 and a regular contributor until illness stopped him from attending. He also welcomed Professor Mike Wickens to the committee at his first meeting. He then asked Peter Warburton to provide his briefing on the international and domestic monetary situation.

The Monetary Situation

The International Situation – Plummeting Global Activity.

Peter Warburton stated that the charts (which are available from rosa@economicperspectives.co.uk) were self explanatory and said that he would go through them to give an update on the international situation. He said that the past six months has seen global activity plummeting, with Asia being disproportionately affected, and particularly economies with large external sectors.

The figures indicate a sharp downturn, with growth in China falling to 4% to 6% per annum. With the rest of Asia showing a sharp downturn in export orders, goods are being stacked up as involuntary inventories accumulate. In the USA, nominal consumer spending has fallen in the second and third quarters. Indicators of durables spending have seen a sharp drop and jobless figures have risen sharply. Similarly the Euro-zone, which has lagged the USA, has also experienced a sharp rise in joblessness along with a steep downturn in GDP. World broad money growth has fallen during 2008 led by US broad money growth, which accounts for 28% of the share.

Tim Congdon questioned Peter Warburton’s figures for US broad money growth. The Lombard Street Research figures showed a much steeper fall. There followed a discussion about the measures of broad money. David B Smith said that Peter Warburton’s figures were consistent with the estimates of broad money supply growth in the developed economies as a whole supplied by the Organisation for Economic Co-operation and Development (OECD). Peter Warburton then discussed the chart of US corporate bond spreads showing that these had widened sharply. The current spreads are similar to those prevailing in 1932.

The UK Economy – Slowing Nominal GDP Growth

Peter Warburton next stated that nominal GDP growth in Britain has fallen to its lowest rate since 1992. Transactional activity has declined sharply and consumer confidence has plunged in the autumn and winter. Growth in the aggregate measure of M4 does not show a problem but its decomposition shows that retail deposits are growing much more slowly.

The growth rates in sterling lending to Private Non-Financial Corporations (PNFCs) and Households have slowed but lending to Financial Corporations has been remarkably strong. There then followed a discussion about why sterling lending to Other Financial Corporations (OFCs) had shown such a sharp rise.

The issue was important because the annual growth of broad money and credit was falling sharply after OFCs were taken out of the figures. However, the effective exchange rate has fallen back to the levels last seen in the mid 1990s, following the pound’s eviction from the Exchange Rate Mechanism (ERM) in 1992. The decomposition of retail price inflation shows that, in competitive domestic markets, the inflation rate (ex-fuel and light) has eased back to 1.5%.

Summary of Presentation

Peter Warburton summarised his view of the outlook as follows: the economy is facing a depression rather than a recession scenario as global credit remains in crisis. While the focus of the SMPC is properly on monetary developments and remedies, it is imperative that monetary measures are accompanied by measures to restore the functioning of the credit system. Fiscal stimulus is largely a waste of time, as saving is merely transferred from the public to the private sector. A progressive monetisation of credit is underway in the financial sector, bringing a significant inflationary threat in future years. The economy is reacting to a negative shock to both supply and demand.

Discussion

Quantitative Easing to Avert Depression

The Chairman thanked Peter Warburton for his presentation and threw the meeting open to discussion. In response, Roger Bootle said that the movement of the exchange rate is significant as the trade-weighted index is now where it was immediately post the ERM crisis. This will make a huge difference to the UK economy. Eventually world markets, which were depended less than the UK on bank credit, would pull UK exports up. The real issue was how we are to tide ourselves over until the stimulus to exports arrived.

David B Smith said that he was cautious about the gains from the depreciation in sterling. His empirical work suggested that the competitiveness elasticities of exports and imports had been falling over the past two or three decades As a result, he thought that the Marshall-Lerner conditions for a devaluation to improve the balance of payments no longer held. One supply-side reason was that the UK was now a relatively highly socialised economy. He could not see the public sector freeing the labour and other resources that the tradables sector required at this point in the electoral cycle.

Mike Wickens said that he was reminded of the 1980-81 recession when most commentators believed that the rise in sterling was killing exports. Trevor Williams said that the difference was that exports markets are more weighted to Europe and that the lack of trade finance in the current situation has a stronger effect. Roger Bootle had to leave the meeting early and registered his vote there and then (see: Votes below). Andrew Lilico said that if the economy were to undergo the significant structural change implied by Roger's assessment that would almost certainly imply a recession during the transition phase.

David B Smith added that the structural change is partly caused by the government sector, which has absorbed labour resources that will not be released to the export sector. In 1964, for example, there were 3½m people working in general government and 8m in manufacturing. Today almost 5½m people worked for the government and just over 2¾m in manufacturing. Trevor Williams said that financial services will release labour resources. Financial services respond to the exchange rate but will grow at a lower rate in the future.

Andrew Lilico then referred to a Reinhart and Rogoff paper looking at the history of previous bank crises (The Aftermath of Financial Crises (http://www.economics.harvard.edu/faculty/rogoff/files/Aftermath.pdf). This shows that the average fall in real GDP per capita, from peak to trough, was 9.3%. Tim Congdon said that no post-war recession has behaved anything like that. Peter Warburton said that the crisis has affected aggregate supply and that this will have had lasting output effects. David B Smith said that the Pre-Budget Report assumptions of a 4% one-off reduction in potential output, followed by a trend rate of growth of 2¾% thereafter, used in the official calculation of future public borrowing were both highly uncertain. It was even conceivable that the minus 4% figure was too pessimistic in the long run but he had no firm views on the matter. He would direct a lot of intellectual resources to this crucial issue if he were in charge of HM Treasury.

Mike Wickens said that oil price inflation is falling out of the system and goods price inflation is falling to zero. He asked what was happening to inflation in the service sector. Andrew Lilico said that the presumption is deflation. David B Smith said that alongside the credit crisis a supply side contraction may also have occurred and that there may be less of an output gap that appeared superficially. Gordon Pepper said that the supply side was relevant. However, the severity of the immediate crisis warranted the measures for quantitative easing which are outlined in his note (See: Appendix to Minutes).

Gordon Pepper added that the subject of quantitative easing needed to be discussed by the committee. He said that the committee has to answer the simplistic press reports that equate quantitative easing with printing money.

Trevor Williams said that it appeared from responses that quantitative easing was not something that the Bank of England was particularly keen on early on. The problem may be that the Bank is dominated by economists rather than bankers and so was worried by ‘moral hazard’. That concern is now unlikely to hold them back given the worsening situation.

David B Smith said that the Bank had suspended the publication of the credit counterparts to the growth of broad money that used to appear as Table 3.2 in the official Bankstats after July 2008 because the nationalisation of Northern Rock and Bradford and Bingley created confusion as to where the border between the public and banking sectors was situated. He was somewhat reluctant to advocate deliberate underfunding – because of its potential inflationary consequences if misused for political reasons – in the absence of regular and reliable published statistics that allowed people to monitor what was going on. Gordon Pepper and Tim Congdon said that the reason given by the Bank’s statisticians was a numerically trivial issue and that the counterparts data should be restored.

Trevor Williams said that the London Inter-Bank Offered Rate (LIBOR) was down to 2.5% (Editorial Note: this subsequently eased to 2.15% on 23rd January) but the government continued to insist on a 12.5% return on their preference stock. No profit can be made from this by the banks. The Bank of England should also be accepting longer dated collateral. Andrew Lilico said that quantitative easing had to be complemented with a credible exit strategy so as not to leave open the build up of inflation expectations in the future. Gordon Pepper said that in nine months time the DMO could be reversing the underfunding and mopping up the excess liquidity so as not to create an inflationary problem.

Votes

The Chairman then asked each member to make a vote on the monetary policy response, apart from Roger Bootle who had voted earlier. On this occasion there was no need for votes in absentia, since nine SMPC members had been present at the meeting. The votes are listed alphabetically rather than in the order they were cast, since the latter simply reflected the arbitrary seating arrangements at the meeting. The Chairman traditionally votes last.

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

The economy is in freefall. Meanwhile, inflation is plunging and will soon turn negative. Although the effectiveness of monetary policy is now reduced, it is vital that the Bank of England does whatever it can to support the economy. It should cut rates immediately by ½% and proceed as quickly as possible to bring rates to zero.

Comment by Tim Congdon
(Founder Lombard Street Research)
Vote: Cut by ½%
Bias: Wait and see

Tim Congdon said that he was of the same opinion as Trevor Williams (see below) with one difference. Where Trevor Williams is talking about the Bank buying private securities he would add the government buying long-dated debt from the non-bank sector.

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

Andrew Lilico said he thought interest rate cuts had already gone further than was productive and supported the use of quantitative easing measures instead, but he contended that these are unlikely to deliver escape from deflation without leading to a considerable rise in inflation on the exit path unless there is a clear exit-path strategy. He contended that a simple re-assertion of an annual 2% inflation target would be far too tough for the exit path (so tough as to lack credibility). Instead, he proposed the use of an average inflation (‘price-level’ or ‘price path’) target (if the price-level path is for average inflation of 2%, this would imply that inflation well above 2% would be tolerated/desired on the exit path). He voted to hold Bank Rate at its present 1½%."

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

Kent Matthews said that it is increasingly clear that cuts in interest rate are not feeding through to borrowing rates. He said that he agreed with the policy of quantitative easing either through underfunding or through the Bank of England purchasing private securities. But he also said that the policy of quantitative easing had to be accompanied with a non-discretionary policy announcement that would anchor inflation expectations. This would work best through the setting of a monetary target. The inflation target worked imperfectly because for a number of reasons actual inflation did not signal the degree of underlying inflation in the system. Since a monetary target is not an option, the reassertion of the inflation target is the best that can be done. He voted to hold with a neutral bias.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold but the government should purchase assets from the non-bank private sector
Bias: Hold

Gordon Pepper observed that last month every member voting bar one had recommended quantitative measures of one sort or another. He had prepared a note about the various types (reproduced in the Appendix to Minutes). The aim might be to boost banks’ capital, banks’ reserves or the money supply. All the evidence indicated that quantitative measures to boost bank capital and reserves were ineffective in a deep recession if monetary growth remained inadequate.

Adequate capital and reserves were a necessary but not a sufficient condition to stop a recession turning into a depression. Monetary growth must be adequate for policy to be a success. Government borrowing from banks was the most important way of ensuring that monetary growth was adequate. Government purchases of assets from the non-bank privates sector had the most immediate impact.

He then turned to the recent leaders in The Times that argued against the government printing money because it would be inflationary. He disagreed. In an atmosphere of financial crisis it was generally true that an economy could be flooded with bank reserves and money without inflation rising. This was because banks would not have the confidence to use reserves and neither companies nor households would have the confidence to spend the money.

As soon as confidence returns, the excess money in the economy should be quietly mopped up to prevent inflation from rising. A disadvantage of employing fiscal policy to fight a recession was the lag before it became effective. It took time for capital projects, for example, to be brought forward. The lesson of the 1960s and 1970s was that the lags were such that the boost to activity occurred after the economy had started to recover. Fiscal policy was destabilising rather than stabilising. He argued that quantitative monetary measures, in contrast, could be deployed very quickly to combat a recession and reversed much more quickly when the economy starts to recover given the political will and expertise to do so.

Quantitative measures could be used to stop inflation from rising after confidence returns. The sixty-four-thousand-dollar question was whether the UK authorities would have the knowledge, expertise and political will to do so. Having ignored quantitative measures when the recession was gathering momentum, would they ignore them when the danger of inflation was again rearing its ugly head?

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

David B Smith said that the long time lags before rate changes influence the real economy mean that the 3½ percentage points cut in Bank Rate announced since early November would not have its peak impact until the end of this year and the early part of 2010. With the negative output consequences of last year’s sharp rise in the price of oil also likely to be reversing around then, further Bank Rate cuts risked over-steering, especially now that all the world’s monetary authorities were pursuing similar expansionary policies.

He did not deny that a nasty recession was in train and expected UK GDP to contract in 2008 Q4 and 2009 Q1 and Q2 before stabilising in the second half of this year. However, it was now too late to do anything to avert this. He was not opposed to quantitative easing in principle and had spent the last decade arguing that the removal of the gilt-edged market from the Bank made it nearly impossible to run a subtle and effective monetary policy. However, the most pressing need was to stop the regulatory authorities and politicians from pursuing damaging and logically incoherent policies with respect to the banking system. Peter Warburton was right to argue that restoring health to the banking system was the priority.

He also thought that quantitative easing was not a panacea and potentially highly dangerous when viewed from a political economy perspective. Overall, he thought that: Bank Rate was low enough for the time being, but that the institutional barriers to future quantitative easing, such as the DMO’s remit should be removed. The Bank’s statisticians should also be ordered to start re-publishing the money supply formation table. He concluded by pointing out that the average UK growth rate between 1933 and 1937 was 4¼%. Major recessions do appear to be followed by periods of catch up growth and it was not sensible to extrapolate current negative trends indefinitely. (Editorial Note: an analysis of the Institutional Lessons from the Financial Crisis in Britain and two tables summarising the UK experience between 1928 and 1938 can be obtained from: xxxbeaconxxx@btinternet.com).

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold
Bias: Neutral

Mike Wickens said that, given the forecast decline in inflation over the next year, monetary policy should aim to stabilise the real economy. Cutting interest rates won’t matter to inflation but it would discourage further savings which are required to help finance lending needed to help the real economy. Monetary policy through quantitative easing should aim to close the gap between Bank Rate and the inter-bank rate in order to make interest rate policy effective once more.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: Neutral

Peter Warburton stressed the importance of restoring corporate and household liquidity over further reductions in Bank Rate. He noted the limited scope for lenders to pass on rate cuts and the risk that savers would desert the banks in favour of better-yielding National Savings products. He said that the DMO should reverse its policy of overfunding and strengthen measures to improve the functionality of the credit markets. He voted to hold.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Cut by ½%
Bias: Cut to zero

Trevor Williams said that rate cuts still help banks to recapitalise. The DMO should underfund and the Bank should buy private securities to help unlock credit markets. He voted to cut by ½% with a bias to cut to zero interest rate.

Policy response
1. On a vote of six to three the committee voted to hold Bank Rate at its current 1½%.
2. Three members voted to cut the base rate by ½% with a bias to further cuts.
3. The committee expressed a strong preference for a policy of quantitative easing (the meaning of quantitative easing is explained in the appendix)
4. Two members felt that a policy of quantitative easing had to be accompanied with the reassertion of the inflation target as a means of anchoring expectations in the medium term.

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.