Sunday, October 04, 2009
Hold Bank rate and continue QE, says shadow MPC
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) unanimously voted to leave Bank Rate at ½% when the Bank of England’s rate setters meet on 8th October.

There was a widespread view that the present schedule of quantitative easing needed to be persisted with and extended beyond November, when new Inflation Report forecasts will be available. Looking further ahead, most members of the committee had a neutral bias. However, one thought that Bank Rate needed to be raised to 2% before the end of 2009.

Two further SMPC members suspected that monetary policy would need to be tightened before too long. However, another believed that Bank Rate should be held at ½% until the end of 2010. There was a strong undertone of ‘wait and see’ in the recommendations of all the members.

The SMPC poll was ‘frozen’ on Tuesday 29th September, although many submissions had arrived earlier. Most members of the shadow committee believed that the downwards momentum in the UK economy was ameliorating and that positive growth would be resumed in the third quarter and fourth quarters of this year.

However, there were also fears that there might be a relapse in the first half of 2010, because of the tax increases that have been announced but not yet implemented. There was further concern about the implications of the adverse fiscal background for monetary policy.

Some SMPC members thought that the urgently needed fiscal retrenchment would create a ‘hole in demand’ that would have to be offset by an expansionary monetary stance. However, there was a contrary view that the fiscal stabilization literature suggested that a reduction in the budget deficit brought about by reduced government consumption would be expansionary where output was concerned.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold; maintain current QE targets
Bias: Extend QE beyond £175bn after November

Since June the UK economy has begun to show signs of stabilisation, but that stability is hugely dependent on government-supported expenditures. Signs of a sustainable private sector recovery are still scarce. Unlike France and Germany the UK failed to show positive growth in 2009 Q2, with real GDP declining by -0.6% over the quarter, and dropping by 5.5% year-on-year.

The severity of the downturn was highlighted by business investment figures for the year to Q2 which declined by10.2% over the quarter and 21.8% year-on-year, the sharpest annual decline since records began over forty years ago. The stabilisation has been mostly based on government expenditure, some restocking, and an improvement in net exports. There has also been a continuing improvement on the production side of the economy as manufacturing orders and sales are restored following the Lehman-induced collapse in trade and industrial production last autumn and winter. The manufacturing Purchasing Managers Index (PMI) recovered to 50.2 in July but fell back to 49.7 in August, while the services index increased to 54.1 in August. An overall composite PMI is now consistent with growth of 1% to 2%.

However, consumer spending (down 3.6% in real terms over the year to the second quarter) remains vulnerable as unemployment has continued to rise, with the claimant count hitting 5.0% in August (or 7.9% on the International Labour Office (ILO) basis in July), and whole economy wage growth (excluding bonuses) slowing to 1.0% in July (compared with 3.7% a year ago). Household consumption has been helped by the government’s car-rebate scheme, which has just been extended and expanded.

Monthly house prices have also improved a little recently, but with mortgages granted rising only to 50,123 per month in July (compared with 120,000 at the peak in 2006-07) it seems unlikely that the upturn is anything more than a temporary respite. Over the year as a whole it is likely that the UK real GDP will contract by 4.3%, and CPI inflation will end the year below 2%, falling less than in other major economies due mainly to the weakness of sterling.

On the policy front the MPC kept interest rates at ½% in August and September, but increased the amount of Quantitative Easing (QE) by £50bn in August, to £175 billion by November. Following the G-20 meeting, proposals are likely to emerge soon requiring substantially higher levels of capital and liquidity for banks. Raising more capital and requiring banks to hold more gilts will almost certainly slow lending and balance sheet growth in the months ahead. Combined with recent data showing that UK consumers and businesses are now actively repaying debt and thereby contributing to a slowdown in money growth, it seems likely that the Bank will need to maintain QE for longer than market participants currently expect. The August data for M4x, which is still only the second set of monthly data, suggest that the annual growth rate is still in the 3% to 4% range, inadequate to support nominal GDP growth of 4% to 6%. QE will need to be extended, expanded and rates kept low after November.

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

Optimism about ‘green shoots’ appears to be mounting with even the Governor of the Bank of England proclaiming that there were signs that economic growth “had resumed” between July and September and, therefore, “the recession may be over”. And, as the Bank’s Minutes for the August meeting noted, M4, excluding the money holdings of institutions that intermediate between banks, had picked up slightly to 5.3% (on a three-month annualised basis) in July compared with 4% in June – an encouraging development. The Bank, however, continued to caution about the restricted supply of credit as the pressures on the banks to shrink their balances had continued to impose monetary restraint on the economy.

But the key factor now for macroeconomic policy is how to maintain some economic recovery into next year, given what now appears to be a political consensus that there will have to be severe fiscal tightening from 2010/11 onwards. The Treasury’s objective at the time of the Budget was to balance the cyclically-adjusted current budget by 2017/18. And the tax and spending measures announced and projected in the 2008 Pre-Budget Report and the 2009 Budget would deliver a fiscal tightening equal to 6.4% of national income by 2017/18 (over eight years including Fiscal Year 2010-11 when restraint is due to start) relative to the projections set out in the 2008 Budget.

Putting aside the issue of whether the public sector finances have deteriorated even faster than expected in the Budget, which they probably have, there is the matter of the wisdom of having so distant a target for balancing the budget. But if a less distant target is picked then the tightening will, of course, have to be even more stringent. According to my calculations, if a target of zero public borrowing by 2015/16 is chosen for illustrative purposes, another £70bn to £90bn of fiscal tightening would be required over the period 2010/11 to 2015/16.

Under these circumstances, there has to be the danger that the higher taxes and/or spending cuts will undermine the economy’s recovery – if not throwing it back into recession. But I take the view that the financial position is so dire that the most sensible objective would be to get the tightening over as quickly as possible and trust that the Bank of England could maintain overall spending power in the economy at a satisfactory level by keeping interest rates low, extending quantitative easing if necessary. The pound too will remain weak – thus aiding the all-too-necessary rebalancing of the economy from excess domestic expenditure and large current account deficits to a more sustainable domestic sector and a more balanced external sector. In the meantime I support the Bank’s policy of keeping interest rates very low and continuing with quantitative easing – up to the full £175bn, as announced in August, with a view to extending if considered appropriate.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate; extend QE at £25bn per quarter
Bias: Further extension in QE to be announced in November

Broad money growth continues to be quiescent; average earnings continue to grow at below 2%; unemployment is rising very rapidly and will accelerate further next year (indeed, disastrous productivity data suggests that there is a considerable backlog of unemployment implicit in the system). Banking sector losses on past loans continue to accumulate and future losses seem likely to dwarf those already declared. Thus, the deflation risk is far from gone, and no-one should be complacent on this point.

Of course, recent real economy data and financial market performance give some grounds for near-term optimism – say, over a three to six month timescale. I suspect that there will be positive GDP growth for Q3 and probably stronger growth in Q4. However, I believe that this is heavily attributable to a combination of policy response, inventory snap-back effects, and the weakness of the pound. These factors will not be repeated, and I continue to believe that GDP growth will turn negative again in the first half of next year, for one or probably two quarters, before more sustained recovery begins in the latter half of 2010 and into 2011.

There is an underlying desperate need for consumers to deleverage. I believe that the economy is in a race against time, which is not clearly being won at present. I was amongst the first to recommend quantitative easing, and I believe that it should be extended further. But we should pursue this policy without illusions. The core objective is to avoid deflation, but in doing so we will need to overshoot into inflation. I consider that inevitable and (although the inflation is not intrinsically desirable) appropriate because of the asymmetric risks involved – deflation of 5% would be much more dangerous to us, given our high indebtedness, than inflation of 10%.

But in due course policy will need to tighten considerably in order to prevent inflation spiralling entirely out of control. At that point (I suspect sometime in late 2011 or early 2012), consumers that have not adequately deleveraged in the interim may face considerable financial distress. Quantitative easing is buying the economy time to deleverage. But that deleveraging must be done. The attitude of many politicians appears to be that if consumers could just get back to consuming and borrowing more, all would be well. That is dangerous.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral on rates; persist with QE

Much ink is currently being spilt on the question of when governments and central banks should ‘exit’ from their policies of fiscal support and monetary ease. Some are suggesting that exit should be fairly soon, because otherwise inflation could become once again embedded in the economy. They argue that the pain of curing embedded inflation is far greater than any pain from prolonging the recession. The main problem with this view is the assumption it makes about the inflationary process. In effect it harks back to the view of Milton Friedman that the ‘lags are long and variable’ between policy and its effects.

Yet Milton Friedman’s ideas were apposite for a period when there was considerable confusion about both the aims of government policy and the workings of the economy. He adopted ‘adaptive expectations’ as his main assumption for the crucial process by which people formed their inflation expectations. This is a good model of learning. It does give rise to those long and variable lags, in the sense that policy shocks create long-lasting cycles in the economy and in inflation; these cycles are also hard to predict accurately, as the effects of sequences of policy shocks overlap each other in a way hard to disentangle.

However this approach does not apply to the new regimes of inflation targeting put in place since the onslaught on inflation in the 1980s. People now understand that government is committed to the control of inflation through monetary policies (with the discipline on fiscal policy that these in turn imply). Central banks have been in consequence given the job of running these policies with full political backing, backed in turn by a public opinion for which inflation remains a seriously unwanted threat. Finally, there is no learning any more about the inflation and policy process. That happened in the 1980s and once something is learnt it does not need to be re-learnt unless the current policy framework were to be jettisoned for some time - which is improbable because it is what both public opinion and politicians are committed to.

How does an economy work under these circumstances? Quite simply: people form their expectations with reference to those commitments (‘rationally’). In short they expect something like 2% inflation to be reverted to in due course. That this is so in the main western economies is obvious from both the inflation expectations implied by longer term interest rates and the short term ones implied by wage settlements. One may criticise inflation targeting for various shortcomings but one thing it has achieved rather clearly is this ‘anchoring’ of expectations for inflation. Provided it is clear that these policies are not going to
be abandoned, for the reasons given above, then people will continue to expect inflation to come back to 2% and this in turn will ensure that it does. Actual policies can even deviate in the short run quite a bit from their long run setting for this purpose, without upsetting the inflation process.

Applying this to the question of exit strategies, we can see that there is an automatic exit strategy built into monetary policy, in that as the economy recovers and inflation starts to pick up in response money will be tightened to ensure it comes back to target. While the amounts of debt taken on by the central bank are large, they can be sold off as easily as they were bought; and as they are they will tighten monetary conditions. Fiscal policy is not so constrained by automatic exit since it is not directly related to inflation. However, it is constrained by solvency in the context of monetary policy that cannot indefinitely be used to buy government debt. In the inflationary 1970s government budgets were widely financed by printing money (i.e. the central bank bought government bonds). This made it easy for governments to run deficits cheaply (without incurring interest on bonds to private sector holders) but it also caused high inflation. Once inflation is constrained by its target, the government must borrow in the private markets and so maintain its solvency or the borrowing will dry up.

We have begun to see what this means in practice from the changed tone of the UK public debate as people have seen the huge deficit to be financed. Plainly no government wishes to precipitate a sudden large cut in public spending or large rise in taxes when the economy’s recovery is fragile. But a gradual programme of tightening will be forced by solvency considerations. The next government will have to formulate a several-year plan that effectively brings the deficit down to the level at which the debt/GDP ratio is at least stabilised and then provide additionally for some downward pressure on it over a long period to ensure it drops back again to a healthy level.

So we can see that exit strategies are virtually spelt out by the policy context under inflation targeting. On the one hand there is plenty of scope in the short term to support the economy’s recovery; on the other once this is robust the pressures will develop to bring monetary and fiscal policy back into their normal mode. While a recovery is under way it is still vulnerable to fresh shocks and one of those would be premature exit, such as has occurred repeatedly in Japan during its long deflationary era since 1989. Hence I support the continuation and extension of the Bank’s asset purchase scheme for the time being, with no change in rates and no bias.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Neutral; QE should continue at the current rate or more

The aim of Quantitative Easing is to ensure that monetary growth is adequate. According to the latest monetary data, M4 excluding Intermediate Other Financial Corporations (M4x) has continued to grow too slowly. More precisely, in August it grew at an annual rate of 0.2% seasonally adjusted compared with 3.7% p.a. in the second quarter of 2009 and 3.3% in the year ending in the second quarter.

M4 holdings of households, however, grew at annual rate of 7% in August, which was the fastest monthly rate of growth since June 2008. Overall, there is insufficient new data to alter last month’s conclusion. Quantitative Easing should continue at least at the current level.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Neutral for the next month or so; adverse fiscal backdrop could require monetary tightening

This is an uncomfortable time to be commenting on UK monetary policy because it is difficult to do more than advocate more of the same, at least for the next few months. If economists are to add value under these circumstances it can only be through questioning some of the implicit assumptions under which the current policy debate is conducted. One such assumption is that monetary policy, fiscal policy and supply-side considerations can all be allocated to separate boxes and that the feedbacks between them can be ignored. However, the reason that QE is widely feared as a step on the road to the ‘Mugabeisation’ of the British economy is that there is observational equivalence between: 1) the monetary-policy hypothesis that the MPC is doing the right thing in adopting QE because the alternative is a collapse in broad money, debt deflation, and a downward spiral in activity; and 2) the political-economy hypothesis that the Bank is supinely doing the bidding of the present government and irresponsibly trying to maximise activity ahead of a 2010 election, regardless of the longer-term consequences. Expansionary open-market operations (QE) could be safely used in the 1920s because the commitment to a balanced budget and the fixed parity implied by the gold standard meant that there was no inflation threat, while the public debt being bought and sold had been generated by the historic accident of the Great War, not current fiscal profligacy. It is not only the fiscal background that breaks these 1920s conditions in present day Britain but also the Bank’s insouciant attitude to the downwards movement in sterling, whose effective exchange rate on 28th September was 13.1% down on the year and 23.4% lower than two years’ previously. This might appear to be more consistent with the second, political-economy, hypothesis than the first.

The second implicit assumption that should be challenged is that pruning public spending and government borrowing will inevitably create a hole in demand that needs to be counter-balanced by a laxer monetary policy. This seems to ignore the extensive literature on fiscal stabilisation and the distinction between Type 1 and Type 2 stabilisation packages. There is evidence from numerous international case studies that Type 1 packages – which do not raise taxes, do not cut government investment but do rein in government consumption and welfare payments to the population of working age – are followed by an officially unanticipated burst of output growth and a substantial improvement in the public finances. In contrast, the politically more attractive Type 2 stabilisation packages – which rely on attempting to raise taxes and cutting government investment but allow current spending and welfare payments to grow unchecked - almost inevitably lead to an unexpected reduction in activity and a noticeable deterioration in the budget deficit. The fiscal measures being implemented by the present British government clearly represent a Type 2 package, with the government committed to large cut in investment and an increase in the viciously job-destroying National Insurance tax but a 4.7% increase in the volume of current expenditure in calendar 2009.

The third implicit assumption that needs to be questioned is the view that the current global recession has a simple mono-causal explanation in the form of the banking crisis that commenced in the late summer of 2007. The international literature on the sources of economic growth suggests that the 11.8 percentage point hike in the share of British government expenditure in GDP between 1997 and 2009 would be expected to slow the growth rate of UK real GDP per head by some 1.5 percentage points, while the 6.2 percentage points rise in the US over the same period would be expected to have a growth-retarding effect of around 0.8 percentage points. The Euro-zone has seen a more modest 1 percentage point hike in its socialisation ratio over this period, while in Germany there has been a reduction of 0.7 percentage points. This may help explain why GDP in Germany expanded in 2009 Q2 while UK national output fell by a revised 0.6%. Supply-side theory suggests that a reduction in the sustainable rate of economic growth would lead to sharp falls in the levels of property prices, equities and private investment - because the net present value of the expected future returns on these assets has been cut in line with the reduced prospect for economic growth. There is evidence that financial crashes are followed by long periods of disappointing growth. But it is also probable that a slowdown in the potential rate of growth caused by excessive government spending and ill-thought out regulations helped bring about the financial crash initially. In addition, the populist measures politicians introduce in the aftermath of a financial crisis seem guaranteed to have an adverse impact on future productive potential, the recent proposals by the Group of Twenty (G-20) leading industrial countries being a classic example of the genre.

One explanation of how the problem of stagflation became so acute in the 1970s is that the global monetary authorities failed to realise that there had been a slowdown in the growth of productive potential, wrongly assumed that there was a demand shortfall rather than a supply withdrawal, and attempted to get the economy back onto its old growth path by pursuing inappropriately expansionary policies. There is a significant risk that this policy error is now being repeated in both the US and Britain. The maintenance of current easy monetary conditions in the UK should be made conditional on the rapid implementation of a Type 1 fiscal retrenchment package. If this is not politically feasible, the MPC cannot afford to let sterling weaken further if it wants the financial markets to consider it to be serious about its commitment to low inflation and should be thinking of a modest normalisation of rates sooner rather than later.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold; persevere with QE
Bias: To increase Bank Rate before the end of the year

Provisional data for the third quarter national accounts are expected to show a resumption of nominal and real economic growth. The restoration of nominal GDP appears to have become an implicit objective of the Bank of England. This rebound in nominal and real GDP is being driven primarily by the corporate sector, whose net cash flow has improved beyond recognition since a year ago. The rebuilding (or even stabilisation) of inventories and work in progress will have a markedly positive effect on sequential GDP. Capital expenditure projects that were shelved last year may be revived in the final quarter of 2009. The monthly figures for job loss may surprise positively.

Most of this improvement will be invisible to the consumer, whose disposable income is under severe pressure and will remain so. Here, it is the extravagant financial support provided by the government that is the mitigating factor, and the level of this support is set to diminish next year as budgetary disciplines bear down. In the UK, the household saving rate has begun to revive but the gross national saving rate has plunged to a sixty-year low of 12% under the weight of public sector dis-saving. In order to persuade non-residents to hold more gilt-edged securities, it may be necessary for sterling to revisit its year-lows and possibly new lows in the coming months.

The dilemma for the MPC, now with a dual mandate that sets financial stability on a par with inflation control, concerns the process for signalling alarm over the inflation outlook. UK CPI inflation is already higher than in most other large industrialised economies and unfavourable base comparisons will carry headline inflation above 3% by the New Year. In August, private sector inflation, excluding fuel and light, rose to its highest rate since 1998. It is clear that the policy of QE continues to enjoy the support of a majority of MPC members and is likely to be extended well into 2010. The only recourse left to the committee is to begin to raise Bank Rate from ½% towards a more realistic level of around 2%.

It is my understanding that the beneficiaries of ½% Bank Rate are few and far between. Transactions activity in the interbank market remains subdued and most banks are willing to pay well over 2% to attract retail deposits. Apart from damaging bank profits marginally, there would be little to lose from a Bank Rate increase and much to gain in terms of policy credibility and the perceptions of sterling.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold
Bias: Neutral in near term; tighten in longer term

Economic growth is slowly picking up but inflation is still low and is likely to remain below target in the near future. The immediate danger for monetary policy is that the asset purchase scheme is fuelling the current stock market recovery and that the recovery does not reflect economic fundamentals. The Bank must be careful not to encourage investors to return to the market solely on the basis that the market is rising, whatever the reason. As a consequence, I vote for holding interest rates at their present level. My bias is still towards neutral in the near term but for an increase in the longer term.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Hold rates through 2010 and extend QE in November

UK economic indicators are suggesting that, after lagging the recovery in the rest of the world somewhat, the UK, along with the US, will achieve positive growth in the third and fourth quarters of this year. On top of this, financial markets have staged a strong comeback from their March lows. The FTSE is up by over 40%, credit spreads have narrowed, inter-bank rates are back to where they were in 2008 and bond markets are showing remarkably low and stable yields despite the recovery signs in the economy. The need to absorb the official debt issuance required to fund the expansion in public spending seems not to be causing digestive problems for the markets currently. But can it last? The answer is that we do not know. The first test will be when the monetary and fiscal authorities begin to withdraw the extraordinary measures put in place to inject liquidity into a range of agents in the financial markets.

Before that point is reached, however, the authorities must make sure that the economy is on a solid enough footing to withstand the inevitable rise in short and long term interest rates and a tightening of credit conditions as liquidity provision from the public sector is curtailed. Yes, some economic data look good at the moment; manufacturing output is recovering; retail sales are still going up; the services Purchasing Managers Index (PMI) is above 50, and therefore indicates expansion; surveys of the residential housing market show that prices are rising modestly and the Investment Property Databank (IPD) figures showed a rise in commercial capital values took place in August.

But there are doubts about the sustainability of some of these trends, with unemployment rising, the recovery in the residential property market may not be maintained as arrears and defaults are likely to rise further. Is the recovery in manufacturing output down to restocking after massive destocking and so it will it last and how much of the recovery in financial markets is due to the virtually free money that is still flooding from the public sector?

Borrowing trends suggest that, big picture, households and companies are still busy repaying debt. The growth in the money supply excluding the deposits of Other Financial Corporations suggests that there simply is not enough monetary expansion to support a sustained a return to vigorous economic growth. The headwinds in the first half of 2010 will be very strong, with higher taxes due, some from a return to 17½% VAT, and further increases in unemployment. At the same time, there are likely to be increased bankruptcies from households and businesses. This suggests that monetary policy should stay loose until is clear that the uncertainties in the first half of 2010 will not undermine the nascent signs of recovery being seen at present. If this risk is as high as seems likely, further QE will be required to maintain the recovery in financial markets and allow business confidence and balance sheet restructuring to progress further. Bank Rate in such an environment can stay low through most, if not all, of 2010 as ample spare capacity means that the upside risk of inflation remains very low. My vote is to maintain Bank rate at ½% and extend QE in November.

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 (International Monetary Research Ltd.), 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 exactly nine votes are always cast.