Sunday, May 31, 2009
IEA's shadow MPC warns of re-entry risks from quantitative easing
Posted by David Smith at 08:15 AM
Category: Independently-submitted research

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) unanimously voted to leave UK Bank Rate at ½% when the Bank of England’s rate setters meet on 4th June.

The unanimous SMPC vote reflected the belief that there was little case for a rate increase in the near future – despite signs that the lower turning point of the international and domestic business cycles may not be too far off - combined with the view that ½% was close to the effective lower limit where Bank Rate was concerned.

The SMPC had been an early advocate of quantitative easing (QE) and there was a general belief among its members that QE was the ‘least-bad’ option available under current circumstances. Some members of the IEA’s shadow committee thought that the scale of QE would need to be stepped up. Others thought that the current thrust of monetary policy was about right for the time being.

The SMPC also welcomed the Bank of England’s belated publication of a back run of quarterly statistics for ‘core’ M4 broad money, excluding the deposits of other financial corporations, and the Bank’s accompanying announcement that it would resume publication of the table showing the links between public borrowing, funding policy, bank credit and broad money in early June, having previously suspended publication last autumn.

This information was vitally important, given that QE was essentially an attempt to boost ‘core’ M4 using open market operations in the hope that the links between money and activity would then prove tight enough for this to stimulate demand. However, there was concern about the longer-term consequences of present policies. A particular worry was whether it was possible to make a smooth re-entry from QE without provoking either a renewed downturn or losing control of inflation.

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

Since the announcement of quantitative easing (QE) in early March, UK business surveys have improved sharply and the stock market has advanced over 30%. The increase in claimant-count unemployment – 136,600 in February – dropped to 57,100 in April. The UK is likely to be the first of the traditional industrial economies out of the current recession. (Chinese growth merely paused in late 2008 and seems again to be running at a rate which in most countries would be regarded as full-scale boom.)

Given the timing, it could be suggested that quantitative easing was the decisive step that checked the recession. However, the attribution of the turn-round solely to quantitative easing is implausible in certain respects. In my February 2009 Council for the Study of Financial Innovation (CSFI) pamphlet, How to Stop the Recession, I argued that – even if an increase in the quantity of money (M4) were initially concentrated in the financial sector – it would quickly move into corporate hands and ease the cash strains in the business sector. The high volume of corporate fund raising in recent weeks may reflect this pattern at work.

Unfortunately (for me), this view is difficult to reconcile with the virtual stagnation of M4 in both March and April. The trouble may be that the M4 numbers have been distorted since at least mid-2007 by deposits held by intermediate OFCs. Until we have the breakdown of the money numbers by sectors (on 2nd June), we cannot be confident what was happening in April, but I suspect that M4 excluding intermediate OFCs rose strongly. A key number to monitor will be M4 held by non-financial corporations (i.e., companies, not financial institutions or households). I will be surprised if this did not rise in April by at least 2% (i.e., at an annualised rate of almost 30%). If companies had three to six months in which their money holdings climbed at an annualised rate of 25% or more, the recession would be over. My guess is that QE is in fact already leading to a dramatic amelioration in company balance sheets of the desired kind, but we will be able to check – properly and with some degree of confidence – only when we have the data in the autumn.

Obviously, I agree with the general thrust of monetary policy at present. So I am in favour of ‘no change’ in either interest rates or the scale of QE. As I show in my PowerPoint presentation (Editorial Note: this can be obtained from timcongdon@btinternet.com) official policy towards banks’ acquisition of claims on the public sector changed dramatically in early 2009. The apparent stagnation of M4 in March and April may be disappointing, but – if the banks had not been acquiring claims on the public sector on such a large scale – the quantity of money would have been falling. QE and/or under-funding was the right course to take.

But a whole mass of issues remain for debate. How are the authorities to be persuaded that their focus on bank lending to the private sector - Bernanke-an “creditism”, as I call it in a forthcoming piece for Standpoint (Editorial Note: this can be obtained from timcongdon@btinternet.com) - is misguided? Are the Bank and the Debt Management Office (DMO) now cooperating in this vital area of public policy or do they continue to operate autonomously? What happens to gilt yields when – as is surely inevitable sooner or later – loan demand revives and the authorities will need to start selling gilts to non-banks again to combat inflation? For the moment, while the recession is still with us, the official programme to raise M4 growth by QE is correct.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: Prepare to extend QE beyond £150bn after July

Despite sharp declines in quarterly real GDP in 2008 Q4 (-1.6%) and 2009 Q1
(-1.9%), there have been a number of bullish signals from the British economy recently. First, the stock market has recovered strongly since the lows of early March, led by banks and other financials, as well as cyclical and commodity-related shares. In the money and capital markets, London Inter-Bank Offered Rates (LIBOR) have eased, and non-financial companies have been able to raise impressive amounts of funds, mainly through corporate bond issues. The ISM measures of manufacturing and non-manufacturing have slowed their rate of decline, and other survey data have been improving. Retail sales volumes, recently revised downwards in recognition of past overestimation by National Statistics, have been reasonably buoyant, rising 2.6% in April from April 2008. In addition, gilt yields have risen.

While signals from the housing sector remain mixed, though preponderantly pointing to continued weakness, and capital expenditure by the business sector has been extremely weak, the rapid deterioration seen in 2008 Q4 and 2009 Q1 appears to have ended. Private sector wages are slowing abruptly, and unemployment seems likely to continue rising, but at a lower rate from here onwards. The economy at last seems to be finding a trough. Can a recovery be predicted? In my view that depends firstly on the monetary measures taken and their consequences for the banking system, and much less on the government’s fiscal spending plans (where the multipliers are small and early positive gains are likely to be undermined by subsequent negative effects). It also depends, secondly, on the health of the balance sheets of the private sector in the economy.

Leaving aside the recapitalisation of the banks, one of the most important developments from a macro-economic standpoint has been the continued growth of bank balance sheets since the collapse of the inter-bank markets in September-October 2007. This is in large part due to central bank lending and purchases of securities, including (since March) QE. Although the Bank switched to a fully activist role only from September 2008, if these measures had not been taken, commercial bank balance sheets would probably still be declining, money growth would be negative, and the economy would still be in a downward spiral.

In terms of the monetary data it is too early to see much improvement yet. Total M4 is heavily distorted on the high side by the deposits of intermediate OFCs (other financial corporations) which undermine M4’s value as a meaningful indicator for the real economy, while adjusted M4 (which excludes intermediate OFC holdings) has slowed from 10% in 2007 to about 3% recently – far too slow. Nevertheless, according to the Bank’s May Inflation Report “four-quarter growth in M4 excluding intermediate OFCs ticked up to 3.9% in Q1, from 3.5% in Q4”. Moreover, one key change on UK banks’ balance sheets between June 2008 and March 2009 has been a sharp increase in sterling investments (including gilts) of £172 billion (+65.6%), more than compensating for the absolute decline in lending to households and non-financial companies of £66 billion (-4.4%). In other words, although bank lending to households and businesses is still falling, bank credit to the non-financial sector as a whole is rising – a necessary precondition for a recovery in adjusted M4 growth and hence a recovery in nominal GDP growth.

Even though QE might seem to be gaining traction, a major problem in ensuring its transmission to a recovery and stable growth of adjusted M4 could occur if the rate of decline in bank lending to the private sector offsets the increase in bank holdings of securities and other investments. This could yet happen if the household and corporate sector balance sheets are so impaired that these two sectors continue to contract their balance sheets, reducing their borrowing (as happened in Japan under QE). Fortunately, this does not seem likely for the non-financial corporate sector - where, as mentioned, corporate bond issuance has already been active - but it is quite possible for the household sector. For this reason it will almost certainly be necessary for the Bank of England to extend QE beyond the £150 billion (or 7.4% of M4) that it is authorised to complete by July.

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

The Governor of the Bank of England was quite right to warn that there may be problems with the sustainability of the recovery, when introducing the May Inflation Report recently. Green shoots spotters beware! Such warnings, along with some remarkably benign inflation projections, suggested that the Bank will be running a very loose monetary policy for the foreseeable future. And the minutes of the May MPC meeting indicated that the MPC thought the risk of doing too little to stimulate the economy was greater than the risk of doing too much. There were also indications that the £150bn (£125bn committed so far) quantitative easing sum could be increased “should the economic conditions warrant it.”

At the moment the QE train is happily charging down the track full steam ahead. But it becomes increasingly clear that the unwinding QE could prove very problematic indeed – especially as there will be a glut of gilts to sell in forthcoming years because of the parlous state of the public finances. The Bank’s Deputy Governor Charles Bean’s recent comment that “it is not necessary to unwind the asset purchases before raising Bank Rate” may suggest that the Bank will be sitting on the gilts purchases for a considerable period of time and tighten monetary policy, when deemed appropriate, with higher interest rates rather than selling off the gilts. We shall see. In the meantime I support the Bank’s policy of keeping interest rates very low and continuing with quantitative easing.

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

On the real economy side, the picture of a three- to six-month stimulus-induced temporary reprieve from 2009 Q4 to 2010 Q1 seems ever more likely. Further recession through the latter half of 2010 and into early 2011 seems almost equally assured. House price falls continue unabated. Financial markets have stabilised, but only in the sense of a patient described as ‘critical but stable’. The threat of wage deflation is now acute. Average weekly wages fell an incredible 6% in the year to February, and overall employee compensation fell 1.1% in the first three months of 2009. The nightmare scenario of heavily indebted households facing nominal wage falls now seems upon us. If matters do not turn around on the wages front as a matter of urgency, we could yet see widespread prime defaulting on a scale to dwarf the subprime issue.

Quantitative easing is continuing apace - our last weapon to try to limit nominal wage falls and the defaulting they would herald. The scale is enormous, and must surely result in high inflation down the line. I find it implausible that quantitative easing could be extracted so precisely that deflation can be safely averted without inflation spiking upwards. I would now consider it a success if deflation does not go beyond 5% and if there is only one year of 10% plus inflation on exit. Neither of these is assured. We must also worry about the implications of the policy measures required to get inflation down from 10% - will the economy be ready, by 2012 or 2013, to tolerate the high interest rates that might be required? Can we escape with only a mild tightening-induced recession in 2013?

Public expenditure is totally out of control, and must be brought under control as a matter of extreme urgency. Spending on current levels must have a material impact on the UK's long-term growth rate, and might undermine confidence amongst international lenders in the UK's creditworthiness. Politicians must understand that it is the spending itself, not merely the debt or even the deficit (serious though the deficit is), that is the real issue. This cannot be solved by tax rises or by hopes of future growth. The spending nettle must be seized, and seized urgently.

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

While the press conference by the Bank of England for its May Inflation Report was typically cautious, the Bank is fortunately sticking to the policy of injecting money into the economy on a large scale to maintain the pressure for recovery. All the evidence from episodes like the 1930s Great Depression and Japan’s ‘lost decade’ is that policies to remedy the situation were abandoned too early and caused ‘double dips’. So in this key respect the Bank is doing what it should. Meanwhile, the world economy is looking up decisively.

This is most obvious in the Far East where stock markets are now well up (in China more than 50% up) on the end of 2008, as the evidence has poured in of: firstly, the end of the stock run-off that caused the collapse in world trade and manufacturing at the end of 2008; and, second, of the effectiveness of the huge programmes of support from governments in that region. In the earlier Asian Crisis, these countries found they had insufficient reserves to counteract the pull-out of money from their economies. As a result, they drew the lesson that they should build up huge reserves to counteract these shocks in future. These reserves have used them effectively in this western crisis.

The last six months have seen the most dramatic monetary easing of the post-war period. This has been accompanied by: firstly, direct credit provision by the taxpayer on an unprecedented scale, in the form of support to banks’ balance sheets of various sorts; and, second, the emergence of huge budget deficits triggered by automatic stabilizers plus ‘fiscal packages’ where the stabilizers are small, as in the US. Effectively these deficits are a way the taxpayer provides direct credit to households and firms in the downturn. In the long term, of course, these firms and households still have to pay the same amount to the taxpayer; but they would not be able to raise the finance to keep going without big cuts in their own spending in the downturn. Thus, the availability of this credit from the government is vital - that credit aspect has been the key contribution of fiscal action, not the conventional ‘stimulus’ which may not be much.

So overall we have had a massive creation of money and credit by the taxpayer. This is beginning to have an effect in easing the economic downturn. According to our models, the lag before the full effects of monetary easing kick in is around two to three quarters. That is more or less what we are now observing. Some people argue that it will all be different this time because the balance sheets of key players have been so badly hit. But this argument makes no sense if what motivates people and firms is opportunities and the costs of exploiting them. Clearly soon after the Lehman bankruptcy the costs of credit rose very sharply, with many unable to access it at all. But this has now changed markedly under the impact of the massive easing described above. Rates for most households and firms are well down on September 2008. Thus the average spender can now exploit opportunities at a much lower interest cost. Also as the situation eases risks themselves get lower for such exploitation.

A particular element in the current situation has been the dramatic inventory cutbacks generated by the credit crunch; firms unable to get credit reduced their working capital hugely in the final quarter of 2008. But this is a self-limiting process; at some point inventories cannot be cut further. Also with credit costs falling inventories will be rebuilt. When inventories fall - for example, by one month’s output - that implies that production falls by a third in that quarter (one month’s output cut from the normal three months of output). Something like this seems to have prompted the huge falls in manufacturing output and trade we saw in the fourth quarter of 2008. This is now being reversed, even though its impact is bound to be partially offset by other cuts in spending as the recession bites. Hence the prospects for 2009 are for a steadying of output from the second quarter after sharp falls since the Lehman disaster. There should be a modest revival in demand towards the end of 2009 which should make 2010 a better year.

This means that policy is, at last, proving successful in getting the crisis under control. It is now necessary for the Bank to ‘make sure’ by keeping policy steady in its easy phase, with low interest rates and continued monetary injection (‘quantitative easing’). In my view the lags are short enough for the Bank to be able to extract liquidity from the system rapidly once the situation has firmly stabilized in a moderate recovery pattern. In turn inflation can be headed off quite effectively because the lags from that to inflation are fairly short.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: To expand QE programme further

At its May meeting, the MPC voted unanimously both to keep interest rates at ½% and to increase the QE programme to £125bn, but it recognised the potential need for further stimulus. The MPC mulled over the option of increasing the QE programme to £150bn – the initial upper limit set by the Chancellor – but came to the conclusion that “as the precise amount that would ultimately be required was so uncertain, there was no pressing need for the larger extension at this meeting”. All MPC members agreed that the asset purchase programme should be extended this month rather than next given the view that the economic recovery was likely to be slow and that ultimately more money would be required to bring inflation back to the 2% target over the medium term. However, the Committee acknowledged that a considerable amount of monetary stimulus had already been applied and that “there was a risk that the Committee would not be able to identify early enough when it should be withdrawn”.

This stimulus will seriously complicate policymaking during the recovery phase. On the one hand, a premature reversal could result in a ‘W- shaped’ recovery or even a Japanese-style relapse. Alternatively, if the reversal comes too late, we risk a ‘V-shaped’ recovery in output that mirrors the steep descent, followed by a serious overshoot in inflation. There are clear signs that the financial markets are stabilising and that the economy has passed the inflexion point, at which falls in output and house prices begin to moderate. However, in my view, the risks of not giving the economy sufficient stimulus still outweigh that of giving it too much and I support the MPC’s decision to step up the programme this month. Interest rates should remain on hold until clear evidence of a recovery emerges.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Hold for next few months but prepare to start tightening this autumn

British monetary policy seems to have settled remarkably quickly into the grooves of a ½% Bank Rate and QE. As a result, the main monetary development since last month has been statistical, not a policy initiative. In particular, the Bank of England issued a News Release Recent Developments in Statistics on 25th May that contained two important announcements. The first was that that the Credit Counterparts Table A3.2 - which shows the relationship between the budget deficit, funding policy, bank lending and the expansion in broad money - will be reinstated in the forthcoming 2nd June edition of the Bank’s Monetary and Financial Statistics report. This is a welcome development that SMPC members have requested ever since Table A3.2 was discontinued last autumn. The re-instated figures will make it easier for independent commentators – and, one might suspect, an increasingly nervous International Monetary Fund (IMF) – to monitor the effectiveness of the QE programme and ensure that it does not de-generate into crude inflationary finance.

The second major statistical development was the Bank’s simultaneous publication of an article Measures of M4 and M4 Lending Excluding Intermediate Other Financial Corporations - this now seems to be the main intermediate target of the QE programme - and its release of a back run of quarterly data for the new monetary aggregate back to 1997 Q4. This series can be downloaded from the Bank of England’s data bank using the code RPQB53Q.The new data is seasonally-adjusted but it is calculated as a residual by subtracting ‘Other’ Intermediate OFC (OIOFC) deposits from the established M4 money definition. Unfortunately, this means that the quarterly figures are of lower statistical quality than the more established Bank data series. In addition, monthly statistics will not be available until 1st September 2009, and annual growth rates on a monthly basis not until September 2010.

Nevertheless, the quarterly data was sufficiently adequate to enable some preliminary analysis. The first stage was to compare the year-on-year growth rates of the two series, something that the Bank has been doing in its Inflation Reports. This shows that the annual growth rates in the two series were reasonably close from 1998 to late 2003. However, they then started to diverge in 2004 while the extent of the divergence became increasingly marked from 2007 onwards, producing a classic ‘Jaws’ effect. The annual increase in total M4 was 17.8% in 2009 Q1, compared with the 2.5% reported for M4 excluding OIOFC deposits. The next stage was to calculate the ratio of the new M4 definition to the old one. This showed that in 1997 Q4 the new M4 definition was 98.5% of its forerunner, but that this ratio had fallen to 76.6% by the first quarter of this year. The difference in 1997 Q4 might be because the Bank have subtracted OIOFC deposits from a different M4 measure to the latest break-adjusted figures in their data bank. Alternatively, it could reflect a pre-existing OIOFC distortion. The subsequent divergence between the two M4 series has important implications for anyone attempting to model the behaviour of broad money and its links with the real economy in an Error Correction Framework in which the long-run relationships eventually catch up on trend. The final stage in the preliminary analysis was to splice the new M4 series onto its predecessor before 1997 Q4, deflate the result by the double-core Retail Price Index – i.e. RPI less mortgage rates and house price depreciation – compare it with the annual growth of real GDP and see how the current downturn compared with previous recessions. The result showed strong similarities with the abrupt deceleration in real broad money and the weakness of real GDP observed in the recession of the early 1990s. This is clearly not the case with headline M4, where the annual price-deflated increase was 14.2% in 2009 Q1 compared with minus 0.7% using the new broad money series (Editorial Note: the charts can be obtained on request from xxxbeaconxxx@btinternet.com).

In addition to the graphical evidence, there are a number of statistical tests that can theoretically be applied to see whether OIOFC deposits should be excluded from M4 - either, in total or in part - using demand-for-money equations and other relationships. This subject will be returned to in future. However, a quick and dirty methodology was to replace the old M4 series with the new ex. OIOFC deposits series in the input stream into the Beacon Economic Forecasting (BEF) macroeconomic model. The BEF forecasting model incorporates a wide range of feedbacks from money to the real economy as well as vice versa. The BEF model was last re-estimated in the autumn of 2008 and it has been badly over-forecasting national output in recent quarters. What we did was a highly dubious procedure from the viewpoint of econometric purity. However, given that the data runs used for estimation typically go back to the mid 1960s and the worst distortions are to some extent post the estimation period, it seemed worth a try. The results of this exercise were spectacular with a 1.4 percentage points greater fall in national output being projected for this year, and 1.6 percentage points coming off the growth forecast for 2010.The tracking performance of other areas of the model, including the exchange rate and broad money itself, also seemed to be improved by the substitution of M4 less OIOFC deposits for total M4. This made it possible to run the model with far fewer residual adjustments than previously.

With hindsight, it is clear that our forecasting record has been badly corrupted by our reliance on the Bank of England’s published break-adjusted M4 series in recent years. However, statistical models have to run on data. There is little that one can do if the figures supplied by the UK statistical authorities are not fit for purpose. As the US economist Professor Kenneth Boulding humorously commented forty years ago in the August 1969 National Westminster Bank Review:

‘We must have a good definition of Money’
For if we do not, then what have we got,
But a Quantity Theory of no-one knows what,
And this would be almost too true to be funny’.

Essentially, QE represents an attempt to shore up M4 ex. OIOFC deposits using Open Market Operations, in the hope that the links between broad money and activity are sufficiently tight for this to stimulate real demand. The new M4 definition appears to be superior to its more inclusive predecessor but it has taken far too long for the data to appear in the public domain. Much statistical research will now have to be done in the Bank and elsewhere to test each link in the chain of logic that justifies Britain’s present monetary approach.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: To increase Bank Rate to 2% before the end of the year

The key events of the past month have been the extravagant borrowing projections contained in the UK Budget and the early announcement of an extension to the Bank of England’s Asset Purchase Facility (APF). While some would place the 1.9% reported decline in UK GDP for the first quarter as the most important development, I do not. Appearing only two days after the delivery of the UK Budget, a variety of economic and political commentators rushed to declare that the Budget’s economic projections were instantly outdated. Indeed, the Bank of England, in its May Inflation Report, expects GDP to fall by around 4% this year. There are sound reasons to suppose that the consensus has overreacted to the sharpness of the decline in 2009 Q1. In particular, the contribution of de-stocking was extremely significant in the first quarter as was also the case in the US national accounts. In the past couple of months, there is evidence that the global trade slump is in the process of a spirited recovery, consistent with that of a stabilising trauma patient.

Continuing the theme expressed in previous commentaries, the UK banking system remains a python attempting to digest a pig. The porcine in question is the replacement finance for hundreds of billions of pounds of assets in the Other Financial Corporations sector. Specifically, the mortgage securitisation and other fixed income vehicles that had previously been funded using the international money markets and by the issue of debt securities to foreigners, often in other currencies. The expanded QE programme should permit a gradual relaxation of lending capacity constraints with respect to the real economy sectors (businesses and households) as the rehabilitation of disintermediated financial structures moves towards completion. To reiterate, the banks have been preoccupied with the indigestion in the financial sector for the past twenty-one months. The pressing nature of this problem - maturing finance - has superseded their responsibilities towards the real economy, even the financing of seasonal inventory patterns. This has been a key trigger for the trauma in the goods economy. The worrying decline in lending to PNFCs in recent months is partially mitigated, for large companies, by improving capital market trends. The early expansion in the QE programme, to £125bn, is a positive step and should be followed by a further extension within the next three months.

Striking new evidence has emerged that deflationary pressures are abating rapidly in the UK. Despite the alarming profile of nominal GDP deceleration, a more careful examination of the data allows a different interpretation. First, the detailed analysis of GDP in the first quarter reveals a staggering £6bn of de-stocking, an amount larger than the quarterly decline in GDP. As in other developed countries with large current account deficits, the rate of domestic production plus imports dropped well below the prevailing pace of domestic consumption in 2009 Q1. The uncertainty over the outlook for final demand and the inability to finance excessive inventory levels compelled businesses to embark on a programme of emergency liquidation. Consistent with this narrative, the reformulated official retail sales data contain dramatic V-shapes for the implicit deflators. Thus, what appeared to be an economy in deflationary freefall a few brief months ago is revealed instead as a trauma patient whose vital signs are stabilising. The Office for National Statistics (ONS) has retracted its previous insistence on a stronger profile for retail volumes at the expense of prices.

My favourite decomposition of the retail price index is the third significant piece of evidence. Forces entirely beyond the control of domestic businesses – interest rates, house prices, oil prices, sterling, VAT rates and excise duties – have combined to deliver a temporary and perverse contribution of minus 4.7% annual inflation. Prices set in competitive UK markets have risen by 2.4% over the year to April, if fuel and light are included, and 1.7% if these items are excluded. Gas and electricity prices fell materially in April as a delayed response to the decline in input fuel prices since last summer, but the inflation rates of other private sector goods and services rose to compensate. This occurred despite the abatement in food price inflation to 8.6%. The underlying pricing climate is rebounding towards an inflationary outcome. Once the extraordinary concurrence of lower oil prices, house prices, interest rates and indirect taxes is eclipsed by monetary and fiscal realities, there is scope for UK RPI inflation to hit 4% to 5% by mid- to late-2010.

If the Bank of England’s MPC is taking the inflation target seriously, then the reign of 0.5% Bank Rate should be extremely brief. By the end of September, it should be clear that the deflationary emergency is over and that Bank Rate can be restored safely to around 2%. My vote is to hold interest rates at ½%, but to plot a course for a return to 2% by December, in conjunction with a further supplement to QE in three months’ time.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Bias to ease via QE

UK interest rates have been cut aggressively in the last six months but, as they operate with a lag, this has done little to prevent GDP in 2009 Q1 from falling by 1.9% and the level from being 4.1% lower than in the same period of 2008. Although there are increasing signs that the worst of the fall in GDP may be over for now, there is no indication of a recovery in the economy, merely of a slower pace of decline. But the latter seems enough to lead to talk of the ‘green shoots’ of economic recovery.

To some extent, the Bank of England’s May Inflation Report tended to argue against this view by referring to the UK economic recovery being likely to be long and protracted once it gets underway. However, this has not prevented the equity and commodity markets from showing a stronger profile in recent weeks. This may have been helped by government efforts to inject liquidity into financial markets, with some of this finding its way into commodity, foreign exchange and equity markets. However, actual money supply figures for the UK in April showed only a modest rise in M4, of 0.1%, with a decline in the year over year rate from over 18% in the month before to just over 17%. This monthly pace, an annualised 1.2%, is clearly not consistent with sustainable economic recovery, especially since there were signs in the detail of the data of a renewed slowdown in lending to households and companies.

All in all, this implies that the Bank of England was right in asking for access to a further £50bn of the already sanctioned £150bn of funds to purchase gilts and bonds, taking their planned spending to £125bn. Moreover, the wording from the minutes taken of the May MPC meeting makes it clear that there is likely to be a request for the remaining £25bn but also for additional funds. This would seem prudent given that signs from the PMI data and the Confederation of British Industry (CBI) surveys suggesting that manufacturing cutbacks in stock levels and production have been sufficient do not yet mean that firms are about to lift output levels.

Already weak export orders have taken a further hit from the recent rise in sterling from its lows and the rise in volume retail sales is being offset by reductions in household services and consumer durables spending. This means that monetary policy should still lean towards easing, via QE, especially as the price and wage inflation data are falling into line with the sort of rates consistent with the large negative output gap that has opened up in the UK and elsewhere in the world economy.

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.