Sunday, May 03, 2009
Maintain QE but publish an explicit exit strategy, says IEA's shadow MPC
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its latest quarterly meeting (held on 21st April in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) unanimously voted to leave Britain’s Bank Rate at ½% when the Bank of England’s rate setters meet on 7th May.

The unanimous SMPC vote reflected the belief that there was little immediate case for a rate increase - while activity was so weak - combined with the view that ½% was the practical lower limit where the money markets were concerned. One member believed that it was technically possible to lower Bank Rate further, using a US-style approach, but accepted that this would not make a noticeable difference to the wider economy.

The SMPC had been one of the earliest advocates of quantitative easing (QE) and expressed a strong preference for its continuation as the main monetary tool. However, the shadow committee was agreed that more specific plans for the implementation and withdrawal of QE were needed.

On the implementation side, several members said that the current £150bn QE target needed to be increased. On the issue of withdrawal, the SMPC was unanimous in believing that the UK monetary authorities needed to publish an explicit exit strategy well before QE had to be put into reverse. The SMPC was disappointed that the Bank of England had ceased publication of the statistics needed to monitor QE and that it was not publishing regular monthly figures for the ‘core’ broad money definition that it appeared to be targeting.

The SMPC gathered on the eve of the 2009 UK Budget and three days before the publication of the weak first-quarter GDP figures on 24th April. Both developments were consistent with the profound concern expressed in the SMPC minutes about the adverse fiscal backdrop and the likelihood of a fiscally-induced collapse in aggregate supply.

At its latest meeting, held at the Institute of Economic Affairs (IEA) on Tuesday 21st April the IEA’s Shadow Monetary Policy Committee (SMPC), a group of leading monetary economists that monitors developments in UK monetary policy, unanimously voted to hold Britain’s Bank Rate at its current level of ½%.

In addition to wanting to hold in May, seven out of nine members also had no immediate bias to change Bank Rate in the immediate future. This was partly because there seemed to be little case for an imminent increase - as long as international and domestic economic activity were as weak as they were - but also because most members thought that ½% was the practical floor for Bank Rate where the money markets were concerned.

However, one member, Trevor Williams believed that it was technically possible to lower Bank Rate further, by adopting the US approach, and so had a bias to ease without a strong view that it should be done. In contrast, Peter Warburton wanted to raise the official REPO rate before the year end.

The SMPC had been early advocates of the policy of quantitative easing now adopted by the Bank of England and expressed a strong preference for the continuation of direct monetary control as the main monetary tool, given that changes in Bank Rate would have little effect, at their 21st April meeting.

However, there was also agreement that this was a potentially dangerous policy and that there needed to be an explicit exit strategy available in the public domain before the policy had to be put into reverse. Otherwise, economic agents could fear that QE was simply a cloak to mask the government’s resort to crude inflationary finance in an attempt to buy votes ahead of a 2010 general election. There was widespread support for the view, advanced by Roger Bootle and Philip Booth at the 21st April gathering, that the authorities should publish an explicit exit strategy, akin to the early 1980s Medium Term Financial Strategy.

Minutes of the Meeting of 21st April 2009
Attendance: Philip Booth, Roger Bootle, John Greenwood, Andrew Lilico, Patrick Minford, Hiroshi Oka (Embassy of Japan), David Brian Smith (Chair), David Henry Smith (Sunday Times observer), Peter Warburton (Acting Secretary), Trevor Williams.

Apologies: Tim Congdon, Kent Matthews, Gordon Pepper, Peter Spencer, Mike Wickens.

Chairman’s comments
The chairman recorded the Committee’s appreciation of the contribution of Anne Sibert (Birkbeck College, London), who had been a member of the SMPC for many years. Anne had been asked to join a Monetary Policy Committee for Iceland and had resigned from the SMPC. The members wish her well with her new assignment. The timing of the next meetings was discussed and the suggested timing is Tuesday 21st July at 6pm. The chairman then asked John Greenwood to present the International and UK economic background.

The Monetary and Economic Background
The International Background

John Greenwood began by considering the shrinkage of global credit and the slowing pace of lending. He noted that most of the credit growth in the past decade had been from outside the banking system. Latterly there had been a dramatic shrinkage in non-bank credit, although bank balance sheets were growing as funds were re-intermediated back into the banking system away from capital markets. John drew the meeting’s attention to declines in the US asset-backed securities and commercial paper markets. He noted that there had been a monetary acceleration with the growth of US M1 well over 10% per annum and of US M2 of almost 10%. Meanwhile, the annual growth of US bank credit has fallen to virtually zero. The compensating factor has been the growth of bank reserves deposited at the central bank. Using the illustration of an inverted pyramid to represent leverage in the US financial system, he explained that there was rapid expansion from the base but contraction from the top of the structure.

John Greenwood added that he found it difficult to see how the authorities could succeed in stimulating the economy while house prices were still falling. Rather than a typical post-war recession, John regarded this as a balance sheet recession in the tradition of Irving Fisher. The distinctive characteristic is the prolonged build up of debt and subsequent deleveraging. A deflation of commodity prices had fed into producer and consumer prices. Deflationary trends were evident in Japan, China and Hong Kong as well as in Europe and America.

Regarding real economic activity, he noted that leading indicators were still very weak and expected the annualised decline in US GDP in 2009 Q1 to be 5%. Meanwhile, the plunge in Asian exports appears to be stabilising, following recent annual declines of between 20% and 50%. He suggested that Chinese exports may weaken further given their downstream position in Asia’s supply chain. He presented some forecasts for growth and inflation in 2009, noting the likelihood of some stability in the second half of the year but not a genuine economic recovery.

The UK background
Following the same line of argument as for the international economy, John Greenwood identified the acceleration in UK private sector debt from 2003 as the source of the current difficulties. Prominent in the evolution of UK credit expansion were financial corporations whose debt to GDP ratio had risen from little more than 600% of GDP in 2002 to over 937% on the latest data. He drew attention to the re-intermediation of borrowing by the ‘other-financial’ sector which had distorted the pattern of bank lending and deposits. He believed that headline measures of broad money growth were misleading and preferred the adjusted M4 data provided by the Bank of England. Lending to households and non-financial companies registered a 2% annual growth on the latest figures. There was every possibility that adjusted lending growth could go negative. This would be typical in the aftermath of an asset bubble burst.

The expansion of the Bank of England’s balance sheet had been very rapid in the second half of last year and had recently begun to expand again. However, the new policy of Quantitative Easing (QE) is barely visible in the statistics having only begun a few weeks ago. In the broader banking system, unsecured personal borrowing had begun to compensate for mortgage unavailability last year, but had receded sharply in recent months. John Greenwood noted the rise in the UK personal saving rate to 4.8% of disposable income and rationalised this as part of the necessary adjustment in household balance sheets. The rise in the saving rate represents a headwind for personal consumption.

John Greenwood presented a selection of output and fixed investment indicators to demonstrate the weakness of current activity and investment intentions. He observed that the annual growth rate of employment had fallen to minus 1% and private sector average earnings had slipped to a 1.4% annual rate. Inflation expectations as represented by breakeven rates calculated from the index-linked market had moderated to around 1% although the March Consumer Price Index (CPI) continued to show 2.9% inflation.

Why Quantitative Easing may not work
John Greenwood presented a sequence of charts relating to the Japanese experience of corporate sector deleverage and balance sheet recession from the late 1990s. He showed that the desire to repay debt by households and firms had a stultifying effect on the policy of QE. Through the period in which QE operated, March 2001 to March 2006, the size of Japanese bank balance sheets was broadly constant but their composition had changed. Banks acquired government securities in roughly the same quantities as they shed loans. Between December 1998 and December 2007, Japanese banks eliminated ¥100trn of credit to the private sector and added ¥107trn of credit to the government. At the same time, broad money - defined as M2 plus Certificates of Deposit (CDs) - had not accelerated at all, growing at only 1% or 2% per annum. John concluded that the policy of QE had been largely ineffective in ending the deflationary episode.

Debate over Quantitative Easing

Patrick Minford contested the conclusions drawn from John’s analysis of the major economies. His objection was that incentives still matter, even in a time of severe economic weakness. He argued that economic agents would take advantage of new opportunities, including low interest rates. He anticipated a big inventory correction after the slump in trade flows, notably in China. More broadly, he contended that the immovable object of the credit crunch had been met by the irresistible force of aggressive policy response, particularly after the collapse of Lehman last September. He argued that prices in the global economy had become much more flexible and that the supply response would be dynamic.

Andrew Lilico suggested that QE had been a success in Japan in that it had prevented deflation. He was interested to know how Japan had calibrated its policy of QE and what lessons could be learnt for the UK. John Greenwood replied that current account balances at the Bank of Japan had been the chosen instrument rising from ¥5trn to ¥35trn. He added that, although governments do not want to see the accumulation of bank reserves, when they see banks increasing their lending to the private sector they must necessarily withdraw the quantitative easing. In addition to buying JGB’s, the Bank of Japan had purchased short-term funding bills known as Tegata. When QE was ended, the “bill mountain” of Tegata was allowed to mature, effectively withdrawing ¥17trn from the QE programme within the space of three months.

Trevor Williams opined that even £150bn of QE will not be enough. He argued that the banks’ ‘funding gap’ would swallow up the existing target for QE. Philip Booth commented that the Bank of England had ignored money for so long that it was ill-equipped to operate a policy of QE whilst providing markets with the confidence that it would know when to end the process in order that the inflation target was hit. Trevor Williams argued that the impact of QE in lowering gilt yields would be offset by the increasing size of the fiscal deficit.

Philip Booth argued that there were important differences between the current situation and Japan in the 1990s. Firstly, Japan’s economy had big structural problems in the 1990s, e.g. its insurance industry. Secondly, the saving rate in Japan was at a much higher level than currently in the US or UK. He viewed the sharp depreciation of Sterling as an equilibrating factor in the UK experience.

Roger Bootle drew a contrast between the text book and the practical versions of QE. He noted that in the text book version the policy of QE seemed irresistible because it was limitless in scale. However, in practice, there is an official reluctance to use QE because a fear of subsequent chaos restrains the scale of operations. Roger Bootle considered it a second order question, as to which assets should be bought in the market. He reckons that balance sheet size is more important than composition.

Trevor Williams raised the issue of whether the private sector would buy back the impaired assets that have been taken on by the Bank of England’s balance sheets. There had been some reluctance on the part of the Bank of England to crystallise a loss. Roger Bootle considered that there was no real difference between a government-financed bailout and a loss on the central bank balance sheet.

Andrew Lilico recognised that the lagged defects of QE gave rise to an inflationary concern. He advocated the use of a price level target rather than an inflation target, arguing that a price level target removes the uncertainty over the speed of policy withdrawal. Roger Bootle commented that there were other ways of controlling liquidity and that the authorities could force banks to buy short-term debt. David B. Smith highlighted the use of mandatory reserve asset ratios as a means of limiting the inflationary risks of QE. He added that the Financial Services Authority (FSA) had already advocated a 6% to 10% liquidity ratio for the banks on prudential grounds. This would also serve to soak up shorter-term government debt as a side effect, however.

Roger Bootle was concerned that the Bank of England (BoE) did not have a credible plan regarding the withdrawal of QE. He stressed the need for the Bank to offer a convincing strategy for the policy. Philip Booth bemoaned the fact that there has not been enough sound analysis of monetary developments and worried that the policy of QE was disconnected from the inflation target. The Sunday Times observer, David H Smith, commented that the BoE expects to lose money on QE, but has been indemnified by the Treasury. This raises an issue regarding the independence of the central bank. It implies that the Bank is operating QE only with the permission of the Treasury.

David B Smith reminded the committee of the covert institutional power struggle between the BoE and the Treasury that had existed ever since the nationalisation of the Bank in 1946. Recent events had brought the Bank back under the Treasury’s heel after its eleven year period of temporary freedom. The historic record from 1694 onwards suggested that a HM Treasury controlled Bank always pursued more inflationary policies than an independent one.

The Chairman then asked each member to make a vote on the monetary policy response, apart from Patrick Minford who had voted earlier. In addition, Ruth Lea had to vote in absentia, since she was inadvertently delayed on her way to the meeting and had not been physically present. 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. On 26th April, Peter Warburton slightly modified the transcript of his 21st April vote, to incorporate his comments on the 2009 Budget.

Comment by Philip Booth
(Cass Business School)
Vote: Hold
Bias: To rein in QE

Philip Booth stated that either the BoE or the Treasury should publish a strategic document, analogous to the Medium Term Financial Strategy of the 1980s. The purpose of this document would be to connect the policy of QE to the existing inflation targets. It would set out the basis for QE and the expectation for the policy. Philip Booth further expressed his desire to see a tightening of fiscal policies alongside QE. Also, he favoured a return to the use of RPIX as the target inflation measure.

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

John Greenwood reminded the meeting that in Japan, the QE program grew to approach 30% of GDP at its peak, implying that the scale of operations in the UK would need to be increased substantially. He warned that the prolonged fiscal expansion in Japan, which carried the public sector debt from 50% to 180% in GDP, had no lasting effect on domestic recovery. He thought that the lesson to be learnt was to tighten fiscal policy and especially to reduce government expenditure. UK banks should be required to hold a higher proportion of gilts in their portfolios.

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

The economy may or may not be showing the first green shoots of recovery. At best, there is tentative evidence that the rate of decline may slow in the second quarter of this year compared with the first. And credit conditions may be easing, not least of all those relating to secured lending for the housing market. But the economy remains mired in deep recession. Given the parlous state of the public finances, for which the Government must be held at least partly accountable, not that they appear capable of admitting to this, there is absolutely no room for fiscal easing.

So monetary policy has to be relied on to give all the help it can to the economy. Under these circumstances, interest rates should be left where they are and QE should continue – though we might well ask why the Debt Management Office does not just issue gilts directly to the Bank of England. QE appears to be under-funding by any other name. Of course the Bank needs to start to explain its exit strategy. We need far more transparency on economic policy in general.

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

Andrew Lilico reiterated the need for a clearer exit strategy from QE. He believed that the size of the QE program is sufficient for the time being but should be reviewed in the year ahead. He reckons that the inflation target has lost credibility and prefers a shift to a price level target for the duration of QE, recognising that QE has the constrained ambition of avoiding deflation. A price level target would allow more tolerance of inflation as the policy of QE was withdrawn. Andrew was extremely concerned by the projected rapid increase in the share of public expenditure in GDP and its implications for the growth of potential output in the medium term.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral

Patrick Minford voted to pursue the policy of QE in order to make sure that the deflationary tide had been turned but said policy makers should be ready to start ‘reversing engines’ within the coming year. In the meantime, he argued that QE should be given explicit objectives in the form of target reductions in spreads between Bank Rate and market rates. These spreads reflect ‘disequilibrium risk’ due to the credit/liquidity famine; the role of QE is to ease this famine. Hence the point that the objective of QE can be translated into reductions in these spreads- contrary to a widespread view (even found in Bank comments) that the spreads represent an appropriate ‘re-pricing of risk’. For example, Patrick Minford said that he would like to see a halving of the London Inter-Bank Offered Rate (LIBOR) spread - currently around 100 basis points - and a reduction, say, of 100 basis points on the spread of corporate bond rates over equivalent gilts.

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

David B Smith strongly supported Philip and Roger’s call for a published medium term strategy for the use of QE and its withdrawal and hoped that such a document would be published alongside the next day’s Budget. He also called for better monetary statistics and the revival of the table showing the links between government borrowing, funding policy, credit expansion, and the change in the broad money supply.

He added that the essential point about QE was that it was an attempt to boost the stock of broad money in the hope that this would lead to increased activity. However, published M4 was up 18.6% on the year in February, and a provisional 17.6% higher in March, and clearly did not need to be increased further. Instead, official attention was apparently concentrated on M4 less the deposits held by so-called ‘other’ financial corporations (OFCs). This measure appears to have risen by around 2.8% in the year to February. For the Bank not to publish a break-adjusted back run and the latest monthly figures for this underlying monetary series was as ludicrous as having an inflation target, but not telling anyone what the target was, in his view. He was also not convinced that 100% of OFC deposits should be taken out of M4. This was an empirically testable issue.

On the basis of his own published research on this subject in the 1970s, he could think of four or five ways in which the hypothesis that 100% of OFC deposits should be excluded from M4 could be tested econometrically if consistent back runs of the data were in the public domain. He was surprised that the Bank had not published such research itself. It would be taking huge risks with inflation if the ‘true’ rate of broad monetary growth was closer to the headline 18.6% than the adjusted 2.8%.

David B Smith added that he agreed with Peter Warburton’s concern about the wider fiscal background (see: below). The extensive international literature on fiscal stabilisation policy strongly indicated that it would be impossible for any government to tax its way out of the looming fiscal crisis facing the UK, now that spending and taxes were such a large share of GDP. Any attempt to raise taxes from where we are now was likely to cause a collapse in aggregate supply and worsened Budget deficits, not smaller ones. This meant that genuine government spending cuts - or decades of stasis - were the only available options.

He was also concerned that Britain’s large budget deficits were stifling the private economy for ‘crowding-out’ and Ricardian-equivalence reasons. He believed that the supply-side implications of the present unsustainable level of public spending had been ignored by the Treasury in their estimate of future potential growth. The essential point about QE is that it represented a retrospective monetisation of past budget deficits. Simply, underfunding a proportion of the current massive budget deficit would probably have been sufficient, although it might have taken effect slightly later.

David B Smith added that there still seemed to be considerable uncertainty as to how much QE was needed in order to produce a given increase in M4 broad money. By chance, he had examined this issue in his May 2007 ERC monograph Cracks in the Foundations: A Review of the Role and Functions of the Bank of England After Ten Years of Operational Independence (; see page 13) using the long-run steady states of the statistical relationships incorporated in his Beacon Economic Forecasting macroeconomic model. The arithmetic, based on the current model, went as follows. Firstly, a 1 percentage point cut in the twenty-year gilt yield was associated with an 8.1% increase in M4 ceteris paribus.

Second, net gilt re-purchases from the non-bank private sector of 1% of non-oil GDP seemed to cut the twenty-year yield by 18¼ basis points. Putting the two figures together implies that an arbitrary 5% boost to M4 would require a 62 basis points drop in the twenty-year gilt yield, equivalent to net gilt repurchases of 3.4% of non-oil GDP or just over £42bn in cash terms.

This suggested that the official plan to repurchase up to £75bn of public debt should add around 8.9% to M4 in the fullness of time. However, there are lags involved. In addition, it would require a continued stream of debt re-purchases to maintain broad money at its higher level. Once debt re-purchases ceased, the money supply should eventually return to its previous level, ceteris paribus, using this demand for money approach. This suggested that the re-entry problem might just take care of itself in theory. In practice, however, these effects were likely to be swamped by the need to finance the huge stream of deficits expected to be announced in the next day’s Budget. These would, in turn, lead to a severe interest-rate crowding out of private activity, especially long-term capital investment, and an atrophying of aggregate supply.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: To tighten before year end

Peter Warburton, taking a cue from Mervyn King, who ventured the opinion that it would be inappropriate for the fiscal stance to be loosened in the 2009 Budget, thought it necessary to include a judgment about fiscal policy. There is never a good time to limit public spending in the face of an enduring crisis. However, given that the Treasury has conceded that the UK budget deficit is primarily structural in character, there can be no better time to address overspending than the present. The fiscal projections presented on 22nd April pose a significant threat to sovereign credit worthiness. Irrespective of a formal downgrading of the UK’s AAA credit rating there is a risk that the costs of debt service will spiral upwards and render the task of fiscal stabilisation impossible.

It would have been much better to cut back government expenditure now, by around £30bn, in order to set the public finances on a more credible path to stability. At the same time, the scope and scale of QE should be expanded aggressively until deflationary fears have been overtaken by inflationary ones. Peter Warburton shared the concern of other SMPC members that the withdrawal of QE will be problematic. Nevertheless, given how high are the stakes, this policy combination is preferable.

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

Trevor Williams said that, while there was clearly little scope for interest rates to be lowered, it was still technically possible to use money market operations to force rates a little lower, as in the US. However, it would be much more important to step up the scale of QE and broaden the range of instruments purchased from the market. It would be necessary to bolster the credibility of QE, particularly in respect of the manner in which it would be withdrawn. Trevor Williams expressed the view that, as gilt issuance was revised higher in line with the fiscal deficit, the program of gilt repurchases should be expanded accordingly.

Policy response
1. On a unanimous vote, the shadow committee voted to hold Bank Rate at its current ½% with seven out of nine members having no immediate bias. This was partly because most members thought that ½% was the practical floor for Bank Rate. However, Trevor Williams believed that it was technically possible to lower Bank Rate further and had a bias to ease. In contrast, Peter Warburton wanted to raise the official REPO rate before the year end.

2. The SMPC expressed a strong preference for the continuation of QE as the main monetary tool in the immediate future. However, there was agreement that this was a potentially dangerous policy if not followed prudently. There was a widespread support for Roger Bootle’s view that the authorities should publish an explicit exit strategy, akin to the early 1980s Medium Term Financial Strategy.

3. There was also some support for Andrew Lilico’s argument that the QE approach would be more credible if a price level target was adopted, so inflation overshoots and undershoots were not just treated as bygones. Philip Booth also suggested that credibility would be improved by a return to the old RPIX target measure. Earlier comments about the inadequacy of the Bank of England’s published statistics were also re-iterated. It is impossible for independent observers to be confident that QE is more than just a crude resort to inflationary finance without better data.

4. The SMPC gathering was held the evening before the 22nd April UK Budget. Several SMPC members were deeply concerned about the implications of the fiscal stance for funding policy and the supply-side of the British economy before the 2009 Budget measures were announced. These concerns have been exacerbated by the Budget measures themselves, according to a subsequent poll of SMPC members.

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), 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.