Sunday, March 01, 2009
Keep Bank Rate at 1% but adopt quantitative easing, says IEA’s Shadow MPC
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its latest e-mail poll (in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) narrowly voted to leave Bank Rate unaltered at its present 1% on Thursday 5th March. In particular, five members of the Institute of Economic Affairs’ shadow committee voted to hold Bank Rate, while four members advocated a reduction of ½%.

Before last autumn, such a close vote on the part of the SMPC might have been considered a ‘cliffhanger’. However, times have changed and none of the shadow committee’s members thought that further reductions in Bank Rate were likely to have a powerful stimulatory effect on the wider economy.

Instead, the SMPC membership generally believed that the real monetary action lay with the implementation of the quantitative easing measures announced in the February Bank of England Inflation Report and the attempt to re-structure the commercial banking system so that normal lending practices could be restored.

The IEA’s shadow committee has advocated the adoption of quantitative easing for some time, and may have been ahead of the authorities in this respect. However, the SMPC has consistently stressed that any unconventional measures to increase monetary growth needed to be rapidly unwound, once they had done their work, to avoid a longer-term inflation problem. Concern was also expressed that the prospect of the largest and longest run of budget deficits in Britain’s peacetime history meant that the UK economy had now sailed off the fiscal charts as well as the monetary ones.

Comment by Tim Congdon
(Founder Lombard Street Research)
Vote: Hold
Bias: Neutral

Mortgage approvals in December were only £8.7bn, compared with £25.8bn a year earlier. Given that the figure for mortgage approvals is gross, the implication is that the stock of mortgage debt – which was virtually static in the second half of 2008 – could fall slightly in early 2009. Meanwhile many company announcements indicate a wish to deleverage balance sheets. A reasonable view is that, even with base rates of only 1%, the stock of bank lending to the private sector will at best be constant in early 2009.

A positive rate of real money growth is needed to help a recovery in domestic demand. A range of operations is available to sustain money growth if bank credit to the private sector is flat. The Bank of England has indicated that it is preparing asset purchases to boost the quantity of money. These would have the desired monetary effects, as long as the purchases are from non-banks and on a large enough scale. My view is that they can and should be calibrated to deliver a 5% to 10% jump in broad money in a three- to six-month period. For reasons set out in my Council for the Study of Financial Innovation (CSFI) pamphlet, How to Stop the Recession, due to come out in the next week or two, I favour government borrowing from the banks to finance the PSBR (i.e., ‘under-funding’, as it is usually known) or to buy assets, and am less enthusiastic about central bank asset purchases. (My reasons are largely non-economic.) Nevertheless, I accept that central bank purchases of assets from non-banks are very stimulatory. I am indifferent between a base rate of zero and 1 per cent, and am open to persuasion that one or the other is better.

Finally, I am horrified by officialdom’s emphasis – which is echoed in the media – on an increase in bank lending to the private sector as a precondition of recovery. The lending-determines-spending doctrine is false and dangerous, and is largely to blame for the current mess. The state sector (i.e., the government and central bank combined) can increase the non-bank private sector’s money holdings very simply by making larger payments to the non-bank private sector than the non-bank private sector is making to it. The payments can be either to finance the budget deficit and maturing debt or to buy assets. If it is the government that is making the payments, they should come from money balances created by borrowing from the central bank or (more responsibly and with more sustainability) from the commercial banks. The various operations may seem complicated, but it is in fact technically a cinch for the government and central bank to expand the quantity of money on a massive scale. If the quantity of money were to rise sharply in a short period, the recession would end quickly. No increase in bank lending to the private sector whatsoever is necessary.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Cut by ½%
Bias: To hold

After a period of credit addiction there comes a period of credit revulsion. Private sector demand for credit is falling, and it is pointless for the authorities to mandate specified levels of lending for individual institutions. However, maintaining the overall growth of money and credit at about 5% to 7% is a very different matter, and vitally important.

Having borrowed too much in relation to their income, assets, or capital, UK households and financial institutions are now seeing the value of the assets they bought with the borrowed funds declining. The decline in asset prices together with (largely fixed) excess borrowings means that some face negative equity or technical insolvency (liabilities exceeding assets). As long as asset prices are declining, or as long as balance sheets are not fully repaired by paying down debt (or raising new capital in the case of institutions), individuals or institutions in this situation will want to reduce their debt, rather than add to it, and they will want to restrain their spending not increase it. In this ‘debt minimisation’ frame of mind, over-indebted households and financial firms will not be enticed to borrow more, no matter how far interest rates are lowered.

There are therefore distinct limits on what the Bank of England should expect from Quantitative Easing. Since purchases of government debt by the Bank – even at progressively lower yields - offer no assurance that households or firms will be induced to borrow no matter how low rates fall (due to their focus on balance sheet repair) the authorities should concentrate on other methods of compensating for weak private sector credit demand. While there is no doubt that Quantitative Easing can expand the monetary base, there is no certainty that it will expand or accelerate the broader money supply, especially in the absence of a demand for credit by the private sector. (This is exactly why QE failed in Japan between March 2001 and March 2006.)

The main focus of monetary policy should therefore be to ensure that overall money and credit continue to grow at about 5% to 7% each year - either by having the government borrow directly from the commercial banks, or by inducing the banks to buy gilt-edged securities. Either strategy would replace private sector borrowing with public sector borrowing on the books of the banks, and thereby ensure that bank balance sheets and hence monetary growth continue at rates that are consistent with the avoidance of too low a rate of money growth and thus deflation. In the meantime lowering rates by a further ½% will widen banks’ margins (the spread between their borrowing and lending rates), and thereby accelerate the repair of bank balance sheets, but this is about as far as the authorities should go with interest rate cuts.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold
Bias: To hold

At the February Inflation Report press conference Mervyn King sounded like an old-fashioned monetarist. He said “the problem we face at the moment is that the supply of money is not rising quickly enough. For many decades we had the opposite problem. The problem now is that the supply of money is growing too slowly.” And when allowance is made for the distortions to M4 by the activities of intermediate ‘Other Financial Corporations’ (OFCs), such as mortgage and housing credit corporations, non-bank credit grantors, bank holding companies, and other activities auxiliary to financial intermediation, it is clear that this is the case.

The quarterly M4 growth rate in 2008 Q4 for private non-financial corporations and households was a mere 0.3% (quarter on quarter, just over 1% annualized) compared with 2% to 2½% (8% to 10% annualised) in mid-2006. This is an inadequate level of growth to sustain any recovery in economic activity and is, in itself, a strong reason for quantitative easing.

The minutes of the MPC’s February meeting show the committee agreed to push ahead with quantitative easing whereby the Bank “purchases government debt and other securities, financed by the creation of central bank money”, providing the Chancellor agrees, as an instrument of monetary policy. This is the right move. And the MPC should agree to start implementing the policy at the March meeting. There is little point in cutting interest rates further. Indeed it could prove to be counterproductive as, insofar as the lenders cut the rates on their savings products, it could reduce their deposits thus weakening their ability to lend. The Bank Rate should not be cut any further.

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

In the UK the growth of loans by banks to non-banks has plunged to around 4%. To a large extent this is due to the cessation of loans from banks such as Northern Rock that have exited from the market. It is taking time to get the remaining banks to step into this breach. In the US loan growth stalled after Lehman. In the euro-zone credit growth (for which M3 is a proxy) has fallen sharply; actually it is the least badly affected region of the developed world but even so it is bad. The euro-zone’s worst problem is the collapse of its export markets with the implosion of world trade in recent months - but the credit slowdown is not helping.

Our Cardiff forecasts have been revised downwards in the light of the latest Q4 data. Nevertheless we are forecasting a levelling out of GDP in later 2009 followed by some recovery in 2010. The background to this lies in the extreme actions being taken by governments around the world. They came too late to avert the nosedive in the world economy that followed the Lehman collapse, coming on top of the credit crunch conditions already in place since August 2007. But these actions are now beginning to stabilise the market in intermediation - various spreads have come down.

How much more action is needed? The quantitative easing undertaken by the US Federal Reserve can be clearly seen in the M0 figures for the US; US M0 is now some 100% up on a year ago. So far both the Bank of England and the European Central Bank (ECB) have refused to take these measures. The Bank of England has received permission to expand its balance sheet to do this and is thinking about it. The ECB has so far made discouraging noises about it; but it too must be thinking hard. In my view these actions cannot come too early. While we are forecasting some levelling off in GDP later in the year, the risks on the downside are still considerable - these could trigger deflation which would really upset recovery prospects for some years. Risks also are there on the upside - but at this stage, as noted before, that is a problem we would love to have.

Arrangements to insure bad bank assets are being negotiated- a ‘bad bank’- both here and in the US. It is hard to see how this could be avoided, since banks facing the threat of melting balance sheets will only be willing to conserve cash. Governments have been on a learning curve in this crisis and not surprisingly have made a lot of mistakes. But they are now realizing the priority of stimulating lending and ignoring the risks to their own balance sheets - past experience shows that after some years the assets they take over bloom again (think of the US Resolution Trust Corporation of 1989 that got back every cent of the 5% of GDP it put up). This is because today we are facing a macroeconomic collapse that has driven a wedge between social and private risk; such collapses occur rarely so that we can usually make use of equilibrium macroeconomic analysis in which social and private risk coincide. But today we have a collapse of the basic credit mechanism. Socially, we know that the economy will eventually recover and that investments will pay off; privately everyone is afraid of these. This is what justifies the extreme measures being pursued.

In the current circumstances I would cut base rate by a further ½%. But the most pressing need is for the Bank to purchase risky private assets, such as mortgages and corporate debt, in the effort to ‘reach the parts’ that interest rate cuts cannot reach. This direct injection of money into the financial markets will help the other efforts in hand to get credit flowing again at a price reflecting social and not private risk.

Comment by Peter Spencer
(University of York)
Vote: Cut by ½%
Bias: To reduce to close to zero

The MPC voted unanimously at its February meeting to write to the Chancellor to seek his consent to implement Quantitative Easing (QE). I believe that it is crucial that the Bank implement this policy swiftly and boldly given the dramatic fall in the underlying growth of the money supply. Credit starvation is the biggest problem facing the UK economy and increasing the supply of central bank money via purchases of government securities should help to loosen these restrictions and boost the supply of money and credit.
However, with sterling stabilising and market expectations of a cut building I see no reason not to cut interest rates back further towards zero. I think it is appropriate to reduce by another ½% in March. This will help to support spending for corporate and other borrowers with floating rate debt, particularly those with tracker mortgages. I accept that another rate cut would further squeeze banks’ profitability and might reduce their incentive to lend. However, bank profitability is a secondary consideration given the plight of the economy. Moreover, market rates still remain very high relative to Bank Rate.

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

The operation of British monetary policy has undergone a revolution over the past eighteen months. Bank Rate has been effectively dethroned as the centrepiece of monetary policy and now has an almost purely ceremonial function. Instead, the effective power to influence economic behaviour rests with two newer policy initiatives. The first is the use of quantitative easing to try and directly shore up broad money and credit. The second is the policy measures taken to support and re-capitalise the banking system so that it can start lending again. This was made explicit in the February MPC minutes, released on 18th February, which stated that “the MPC’s ability to influence the value of nominal spending and inflation in the economy ultimately came from the Bank of England’s role as the monopoly supplier of sterling central bank money: banknotes and reserves held by the banking system at the Bank”. This statement marks a decisive shift from trying to control the price of central bank money to an attempt to control its quantity. However, the experience of the US in the 1930s and Japan since the early 1990s indicate that boosting the monetary base may be a necessary condition for stimulating the economy, but it is not a sufficient one. It is only if the commercial banks respond by creating more broad money and credit that the real economy will be stimulated.

However, the interpretation of the broad money stock is not easy at the best of times and is particularly difficult at present for two reasons. The first is that there is now a huge and apparently growing discrepancy between the growth of published M4 broad money – which went up by 16.1% in the year to December 2008 – and M4 excluding the bank deposits of intermediate OFCs, such as: mortgage and housing credit corporations; non-bank credit grantors; bank holding companies; and other activities auxiliary to financial intermediation, where the year-on-year growth rate seems to be stabilising at around 4%.

Unfortunately, it does not increase one’s confidence in the quality of the latter data to read footnotes such as “Bank staff have also adjusted these measures for some additional intra-group business, based on anecdotal information provided by a small sample of banks”. There is a serious risk that people attempting to monitor broad money are being asked to buy a statistical ‘pig in a poke’ where the modified M4 series is concerned. The Bank’s statisticians should speedily publish a long break-adjusted time series for their preferred M4 less OFC deposits so that independent observers can apply statistical tests to check that the officially preferred definition is a better measure than published M4 and that it correlates with the wider economy. (For more on the definitional issue, see Burgess and Janssen, ‘Proposals to Modify the Measurement of Broad Money in the United Kingdom: a User Consultation’, Bank of England Quarterly Bulletin, Vol. 47, No. 3, pages 402–14.)

The other issue is what is happening to the demand for broad money – however defined - now that the nominal and real returns from holding deposits with the banking system have fallen sharply. The bulk of M4 pays interest, much of it at money market rates, and the demand for broad money falls when the real interest returns from holding it become less attractive. It is possible to have rapid monetary growth accompanied by the symptoms of a severe monetary squeeze if the real return from holding money on deposit is rising – this happened in the early 1980s, for example – but it is also possible for slow monetary growth to appear in conjunction with strong demand conditions if the demand for money is falling and the pre-existing stock of money is high relative to private sector output. This is the more likely situation at present. The authorities need to be aware that slow monetary growth could reflect demand as well as supply factors, and need not be inconsistent with economic recovery in the longer term.

The strong likelihood that the next half decade will see the largest and longest run of Budget deficits in Britain’s peace time history accompanied by a huge increase in the ratio of public debt to national output means that the UK economy has now sailed off the fiscal charts, as well as the monetary policy ones. It is correspondingly hard to know what the ultimate result of the current massive monetary stimulus and fiscal interventions will be. There is a clear risk that the worst stagflation since the 1970s will be the ultimate outcome.

However, there is a huge margin of spare capacity in the international and British economies. This could hold down inflationary pressures for several years and produce a mini golden age of rapid growth accompanied by low inflation, as happened in Britain from 1934 onwards, for example. Which outcome eventually predominates will largely depend on what current policies do to aggregate supply. A heavy handed regulatory approach and interventionist fiscal policies will cutback productive potential, leaving the economy with less spare capacity and result in the stagflation outcome. Bold policies of market liberalisation and public spending discipline, on the other hand, would crowd in private activity and make the hopeful scenario more likely.

The conclusion is that there was little to be gained from further changes in Bank Rate and that the real monetary action now lies elsewhere, with quantitative easing and the attempt to re-capitalise the banking system. There are also signs that UK inflation is continuing to surprise the financial markets on the upside. This may be because the weakness of sterling is having more powerful knock-on effects than the consensus view is allowing for. The time lags involved also make it all too easy for the authorities to end up over-steering. The main priority now is to make sure that there is an effective exit plan for when the quantitative easing measures now being introduced have to be rapidly reversed, in a year or eighteen months’ time. The authorities – or the Conservative opposition – also need to be paying serious attention to the fiscal stabilisation package that will have to be implemented in the foreseeable future, if the government’s debt servicing costs are to be kept under control in the medium term.

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

Another dramatic month has passed, containing the return of headline consumer price inflation to 3%, a steadying of sterling at very weak levels and the release of data which confirm that UK economic activity suffered a disastrous fourth quarter. Policy responses have come thick and fast in the past five weeks: another cut in Bank Rate, the imminent arrival of quantitative easing (e.g. Bank of England direct purchases of gilts) and the Asset Protection Scheme that was announced on 19 January.

Contrary to common perception, once the severity and complexity of the crisis dawned on the UK authorities last September, they have not been idle and their interventions have not been timid. There remain some agonising delays in implementation and a few wrong turns, but their engagement with the core issues – the customer funding gap (CFG), the denial of credit to the supply chain and the corporate liquidity crisis – is beyond question. The principal explanation of the procrastination of the Treasury and Bank of England is their deep-seated reluctance to travel down this road. This is not so much the ‘road less travelled’ as the ‘road sealed off for safety reasons’. Now that we have embarked upon it, the only question of importance is: ‘where does it lead?’

The UK financial authorities have followed their US counterparts in providing huge financing facilities and credit guarantees to the banks, building societies and the opaque ‘other financial corporations’ (OFCs). As a result, both governments have embarked on a funding odyssey which will lead them to innovate furiously to ensure that their obligations are held without blowing funding costs out of the water. They will monetise a large proportion of this replacement funding, sending rates of broad, as well as narrow, money growth spiralling higher.

There is a popular diagram of the financial system that looks like an inverted pyramid, with base or high-powered money at its pointed foundation. This is a deeply flawed illustration for our times: broad money growth does not depend upon narrow money growth in any meaningful sense. Under the present regulatory regimes, banks have almost complete control over the expansion or contraction of their own balance sheets. In the UK, government will use its hugely enhanced influence over the banks to head off a prudential contraction of their assets and liabilities.

A Late Surge in Capital Issuance

One of the most frustrating aspects of the UK government response to the credit and monetary crisis has been its desire to keep the use of its various facilities a secret. The Special Liquidity Scheme, introduced in April 2008 had a six-month news blackout attached. The Credit Guarantee Scheme introduced at the same time, is similarly veiled. As an aside, I must correct the impression that the CGS had been used only to the extent of £20.5bn by mid-December; this figure related only to publicly issued debt instruments. The total figure is rumoured to be around £100bn, although the Debt Management Office would not confirm this estimate.

While the confidentiality of the issuer and of individual amounts is perfectly reasonable, secrecy regarding the aggregate usage of schemes and facilities is unjustified and detrimental to the market understanding of the scale and effectiveness of policy interventions. The Asset Purchase Facility (APF) announced recently has a more promising genesis. Mervyn King’s response to the Chancellor’s letter last week confirmed that a new company is being established to undertake the APF transactions. “This will provide a clear, transparent mechanism for monitoring the operations conducted under the facility.” “The Bank will publish a quarterly report on the transactions undertaken as part of the facility, shortly after the end of the quarter.”

However, there is a back door route to the appreciation of the extent to which the schemes and facilities are being used, in the form of capital issuance data released monthly by the Bank of England. Net capital issuance by UK residents in all currencies tripled from £143.8bn in 2007 to £432.3bn in 2008, with almost all issuance occurring since April. Net capital issuance by the banks jumped from £86.6bn to £190.2bn. Issuance by OFCs rocketed from £52.8bn to £221.1bn in 2008. Making up the remainder, building societies’ net issuance rose from £5.2bn to £16.4bn while the private non-financial corporate sector issued £7.7bn in the first half of 2007, redeemed a net £8.4bn in the second half of that year and issued a net £7.7bn in 2008. This latter is almost completely accounted for by the power and water utilities sector. The key message of this data is that a revolution in scheme usage is underway.

To reiterate, Bank Rate changes are largely an irrelevance to the current debate. If the idea is to induce banks to lend to the private sector rather than to each other, then it is the LIBOR premium that needs to be addressed, not the Bank Rate. There are dramatic developments in the realm of capital issuance, government asset purchase and monetary growth which are likely to prove far more significant than the level of Bank Rate. These measures have the capacity to transform the financial landscape within the next six months. Hence my vote is to leave Bank Rate at 1%.

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

Last month, I voted to hold Bank Rate at 1½% but I do not think it now appropriate to raise them back to that level. Clearly, monetary policy is mutating – though too slowly - to something rather different from the past with its exclusive emphasis on interest rates. But I think that this is mistaken. Instead of going down the route currently proposed - in which the Bank of England expands the money supply at the behest of the Treasury - the Government should buy up the remaining shares of Royal Bank of Scotland Group and the newly merged Lloyds-HBOS, then set aside their toxic debt and run these banks as conventional banks lending to the private sector. This should avoid the need for such a large expansion of the money supply as at present I envisage. The current bail-out arrangements are far too expensive for the tax payer and too ineffective.

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

My vote is to cut Bank Rate to ½% from its present 1%. Crucially, the MPC should at the same time also announce a range for Bank Rate of zero to ½%. This would be a similar approach to that taken by the US Federal Reserve. It would also avoid the mistake made by Japan in cutting rates to zero, which prevents the proper operation of money markets and must be avoided. The Bank of England should also announce a timetable for moving to quantitative easing, and do so as quickly as possible. The economic situation is deteriorating rapidly and could get worse as the second-round effects of the cut in output by companies, and the resultant rise in unemployment, has not yet hit consumption. In other words, policy rates must be cut as low as then can be without damaging the money markets. This will hit savers - and marginally damage bank profits - but the point is to encourage spending and lower debt servicing costs.

The monetary side of all of this is that the dislocation in financial markets is persisting and, realistically, will take much longer to resolve than thought hitherto. This is because the plethora of policies announced so far are simply not working but still had to be tried. Money supply growth is at such low rates as to be consistent with a deeper downturn, around the world, than has been seen so far. There needs to be official effort to increase liquidity such that those firms and individuals with sufficiently strong balance sheets can access credit. This means boosting money creation through central bank purchase of private sector securities and of government bills. Thankfully, the MPC seems prepared to do all of these things. But it needs to do as quickly as possible to minimise the economic downturn this year and to prevent it from getting worse and continuing into 2010.

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 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: Roger Bootle (Deloitte and Capital Economics Ltd), Tim Congdon (Founder, Lombard Street Research), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Spencer (University of York), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) 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.