Sunday, December 06, 2009
Hold Bank rate, says shadow MPC in 8-1 vote
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one to leave Bank Rate at ½% when the Bank of England’s rate setters meet on 10th December. The dissenting vote was to raise Bank Rate immediately to 1%, because of concern that underlying private sector inflation had accelerated to 3.9% in October, to reach its highest rate for fifteen years.

When asked to look further ahead, most SMPC members had a neutral bias where Bank Rate was concerned. This was largely because of the uncertainties involved. These meant that policy makers could only cautiously grope their way through the fog of events. In contrast, the dissenting SMPC member thought that Bank Rate would need to be raised again fairly promptly. Another had a bias to tighten if sterling weakened any further. This was partly because of concern that foreign investors would not be prepared to buy British government securities at their current low yields if they suffered further losses on the currency.

There was a divergence of views as to whether quantitative easing (QE) should be extended beyond February 2010. Some members of the shadow committee were keen to stick with QE until recovery was assured. However, others thought that QE should be terminated after February, because of the inflation risks involved.

One issue was that there seemed to be no accepted explanation of how QE was intended to work in theory. Some Bank officials have argued that its main aim is to support the financial markets, boost household wealth, and allow commercial companies to bypass the banking system. Other officials seem to see it a means of preventing a collapse in broad money of the sort that proved so catastrophic in the 1930s US Great Depression.

A number of SMPC members were concerned that current official proposals to force banks to hold more capital and liquidity would perversely reduce the supplies of credit and money as bankers re-organized their balance sheets.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold
Bias: Hold: QE should be varied to ensure that broad money growth stays positive

Central bankers and regulators interpreted the breakdown of the international inter-bank market from mid-2007 as being due to a lack of capital in the banking system and the consequent high levels of distrust between individual banks. Since the autumn of 2008, therefore, banks have been under pressure to raise their capital/asset ratios. Both the shrinkage of assets - which must be matched by a reduction in total liabilities - and the raising of capital (which reduces the ratio of deposit liabilities to total liabilities) destroy bank deposits. So the result of the regulatory pressure to force the banks to be better capitalised has been to lower the growth of the broad measure of money which is dominated by bank deposits. This process has now gone so far that, over recent months, the quantity of money has been flat or even falling in both the USA and the Euro-zone, which increases the risks of a downward debt-deflation spiral in 2010. By trying to make the banks safer, officialdom has paradoxically aggravated the deflationary dangers facing the leading economies and their banking systems.

The key individuals in the official institutions responsible for the capital-raising edicts of late 2008 and early 2009 either ignore or scorn the monetary theory of the determination of national income; the theory in which the quantity of bank deposits is so important. Examples of such key individuals include: Dominique Strauss-Kahn and Olivier Blanchard at the International Monetary Fund (IMF), Ben Bernanke at the US Federal Reserve and Timothy Geithner at the US Treasury, and practically any British Treasury or FSA official. A very large number of other economists – including probably a majority of the SMPC’s members – also scorn this theory and believe it to be irrelevant or wrong. But let us suppose that it is relevant and correct. Then it is clear that officialdom’s capital-raising edicts set in train a debt-deflation process. While the banks may have been genuinely short of capital in mid-2007, banks and their regulators are in constant contact, and regulators did not ring alarm bells about the subject in 2006 and 2007. Furthermore, 2009 has seen a surge in the value of the asset-backed paper that was supposed to be so ‘toxic’ in late 2008.

Moreover, as and when the process of bank de-leveraging is over, the cost of bank finance will be higher than it was in the years running up to mid-2007, if it is assumed that banks will seek the same return on capital. Logically, the equilibrium ratios of bank loans to national income will be lower. That does not necessarily imply that the quantity of money must shrink for a period and reduce equilibrium national income, because banks may acquire other assets. In fact, banks in the main countries are holding exceptionally large amounts of cash at present and their claims on government tend also to be rising. (The Bank of England’s quantitative easing programme has obviously had this effect.) However, my verdict is that – from an intellectual standpoint – policy-making is in chaos.

Bluntly, when the various panjandrums announced the capital-raising efforts in late 2008, they had no understanding of the wider implications of their actions. They had not for a moment thought about the repercussions of these actions on the quantity of money. Banks may or may not have had a serious capital problem but the focus of policy should have been to ensure that the quantity of money would continue to grow even as banks were sorting out their capital difficulties.

QE has rescued the UK economy from a debt-deflationary disaster, but I am far from persuaded that either ‘the main economies’ of the USA, the Euro-zone and Japan or the smaller British economy are out of the woods yet. Some help is on its way from the continued growth of money, credit and national income in the developing nations, including China. But Chinese M2 will grow more slowly in 2010 than in 2009, for example. In these circumstances, commentators who worry about an early and sustained rise in inflation need to have their heads examined. Bank Rate should be kept at ½% for many months yet, while the amount of QE should be varied – almost on month-by-month basis – to ensure that UK broad money growth stays positive. In terms of the structure of policy, it would be preferable that HM Treasury and the Debt Management Office (DMO) work with the Bank towards maintaining positive money growth, if necessary by suspending sales of long-dated debt so that the government has to finance its deficit from the banking system. More generally, my preference would be for the rapid reduction in the budget deficit, so that it is existing debt rather than new debt that is being monetised, but much Keynesian twaddle is going the rounds at present. Of course, the regulatory pressure on banks to raise capital/asset ratios has been fundamentally misplaced and should be wound down. A wider public debate is needed on the wisdom of the large increases in banks’ capital requirements that have been under way since the autumn of 2008.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold
Bias: To hold Bank Rate and further expand QE

The third quarter GDP data, now revised to a quarterly fall of 0.3%, were disappointingly weak and fell short of City expectations of a modest increase. One of the ‘explanations’ for the ONS figure being out of line with City expectations is that the Office for National Statistics (ONS) may significantly revise the GDP figure upwards and thus the City will be vindicated. But it would be unwise to rely on helpful ONS revisions to save the City’s face. A more plausible explanation is that forecasters partly rely on business surveys in order to make their forward estimates of GDP. And these surveys have intrinsic shortcomings. They are subjective and difficult to standardise over time. They do not provide direct and quantifiable estimates of changes in economic activity and their coverage is limited. Of course, the ONS data are imperfect but they are likely to be a better guide to economic developments than survey measures.

Given the ONS’s latest GDP data, Britain’s economic recovery seems far from firmly established. And even though growth should return in the next three to six months, it is unlikely to be robust given household indebtedness and the still fragile state of the banking system. And, of course, there surely has to be significant fiscal tightening in the pipeline. The Chancellor may even announce such measures in the Pre-Budget Report of 9th December.

Under these circumstances the authorities will be relying on monetary policy to continue to provide stimulus to the economy. Last month’s announcement of a further £25bn tranche of QE to take the total to £200bn was arguably less than expected. But the Bank can always extend QE next spring if it felt this was an appropriate policy action. And I would support this stance. Therefore, even though I would not recommend a further extension of QE at December’s meeting, my bias is towards further expansion. Bank Rate should stay at ½% - and should do so for a considerable time.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold and hold on QE
Bias: To hold until the second half of 2010

It seems to me that the issues at present fall into four categories: financial; recessionary; fiscal; and price level. Each will be taken in turn, starting with the financial. The situation in Dubai is a reminder that although (with the aid of in my view catastrophically misdirected support from governments) the prospects of UK banking sector firms - though not the market - are much brighter than they were a few months ago, it is by no means obvious that the sector is out of the woods. Estimates vary concerning the losses still to be crystallised, but they probably run into the hundreds of billions of pounds. The sector is in a race for survival, attempting to recapitalise through very high short-term trading profits being made as a result of extraordinarily low interest rates and high margins, in the hope that these high profits can materialise faster than the losses become manifest. That remains to be seen, and a new wave of sovereign debt crises could yet trigger further problems in a number of ways. It is possible to argue that this would suggest QE should be expanded in the short-term, so as to guarantee liquidity. However, this crisis is, at root, a problem of solvency associated both with past losses and reduced prospects of future profitability. Liquidity can, at most, provide a delay – and not a costless delay, for delay means denial, a failure to engage with problems swiftly and decisively, and larger losses in the end.

The UK is still in recession, at least officially. I am not inclined to share the certainty of many commentators that the Q3 figures are uniquely poor. However, it does seem plausible to me that, throughout 2009, GDP estimates have embodied assumptions about inflation/deflation that underestimated the degree of deflation in the economy, with the result that the figures in real terms will eventually be revised up, giving less recession, but more deflation. Two consequences would be (a) that deflationary risks are greater than has been thought; (b) that real wage rises are higher than thought. Be that as it may, I continue to expect that Q4 will show growth, and Q1 may do so also, but also that the economy will slip back into (mild) recession in mid-2010. This factor might again seem to provide a reason for QE to be extended. However, I don’t believe that this further phase of recession can be avoided, now, and neither do I consider it particularly desirable to attempt to do so. Indeed, I believe that it will be useful in encouraging consumers to deleverage more rapidly – which is highly necessary – and in restoring equilibrium in the prices of key assets such as housing. I would prefer to save my monetary ammunition in case it is needed to prevent the further slight slip I expect from turning into a darker extended depression or period of stagnation. However, I do not believe it will be necessary. The Bank of England now forecasts 4% growth for 2011. I consider that an under-estimate and expect the year 2011 to resemble the Heath-Barber Boom.

There needs to be a very sharp fiscal tightening, commencing next year, of the order of £100bn over a three to four year period (with further tightening to come – the structural deficit is estimated by the Treasury at £140bn; the total deficit will probably exceed £200bn this year (14% of GDP)). I do not consider it plausible that a deficit of 14% of GDP and public spending at above 50% of GDP - up from just 41% as recently as 2007/8 - is growth-promoting rather than growth-retarding. Provided that fiscal consolidation focuses overwhelmingly on spending cuts and can be accompanied by monetary easing, I believe that it will tend to encourage early recovery. This therefore suggests that available further monetary easing should be held back to accompany fiscal tightening. It would be better if fiscal tightening could commence immediately – perhaps even in the forthcoming Pre-Budget Report – and hence QE could continue. But I have no confidence or expectation of such fiscal tightening occurring.

The economy has now been in deflation for eight months – a fact that has received little attention in the press because of the fixation upon the policy rate of the consumer prices index (CPI) instead of the cost of living measure of the retail prices index (RPI). Deflation is with us, now, and the risks of further deflation are far from gone. Recent movements in monetary data are encouraging, but the wage data continue to deteriorate, down to just 1.2% in the year to September. I continue to urge that if nominal wage growth were to fall materially further, so that many people experienced nominal wage falls, there is a great risk that this would imply widespread prime defaulting on mortgages, and much further financial sector anguish, leading to severe monetary contraction. Deflation is the immediate concern. However, once strong economic growth commences at the back end of 2010, there will be inflation. This cannot be avoided without exacerbating the short-term dangers of deflation, and I believe policy-makers should simply accept that there will be inflation in 2011/2 on a scale the UK has not seen for at least twenty years, and perhaps thirty. That is not to say that RPI inflation in double digits will be desirable (a position urged by some commentators). It is that what we would have to do to avoid it would create such danger of worsening deflation, in a highly-leveraged economy in which high deflation would be disastrous, that we should not try. Aim off in the inflationary direction. That’s all there is to do. Overall, my judgement at this stage is that QE should be stalled until it can be combined with severe fiscal tightening commencing next year, and interest rates held, even though the expected consequence will be a money-fuelled inflationary boom in 2011/2.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Continue with QE at the present rate into 2010

The recovery is in progress across the world. Yet, the concern everywhere is whether it is robust enough to withstand the withdrawal of the massive government support measures, both fiscal and monetary, that have brought it about in response to the banking crisis of late 2008. The problem is that these measures have not revived credit growth in most economies. In the UK in particular, credit growth to firms is negative while that to households is negligible. But even though one can point to ambiguities in the official policy of the Treasury and the FSA, which may have encouraged this trend by accelerating the build-up of bank capital ratios, the truth is that the same behaviour is evident in the US and the Euro-zone where the regulatory attitudes have been overtly more permissive.

Meanwhile, other financial markets have seen renewed flows of intermediation, notably equities and corporate bonds - issues of both have increased sharply. So, savings have bypassed the banks, which have been unable to supply finance on attractive terms. The biggest concern about this pattern of intermediation is that it might leave small and medium-size (SME) firms starved of capital while big firms able to use the equity and bond markets enjoy plenty. However, this is to ignore the ingenuity of markets in exploiting opportunity - in this case, the re-intermediation of funds to SMEs via the large firm sector. A bit like ‘cash back’ from a supermarket, SMEs can get spare cash from their larger brethren. There is anecdotal evidence that such funds are available on the market.

Can there then be a credit-less recovery? It is an unusual idea, yet that seems to be what we are observing. Certainly, the market cost of capital has come down sharply in the past year for the average borrower. While that may be leaving some marginal borrowers out of the picture, it seems that for firms willing to try hard enough to find funds, find them they can. This still does not include first-time house buyers, for whom deposit requirements remain exacting. But this has not prevented a sharp bounce back in house prices over the second and third quarters - which has been no less than 7% on the Nationwide’s figures. As this housing recovery gets established, these buyers too will find the terms becoming easier.

It is likely that, as world recovery gathers pace oil, and other raw material prices will keep on rising. Already oil is around $80 a barrel. This has begun to show up in CPI figures which are getting closer to the 2% target. There is little doubt that this will give central banks some pause in the money creation programme. The ECB will probably be the first to tighten. The Bank of England and the US Federal Reserve will take longer, probably allowing inflation temporarily to go over the target, because of the special problems with the UK and US banking systems. The first part of the monetary easing programme to go will be money creation via the purchase of financial assets; interest rates will probably be raised later. At present, 2010 still looks like a year where interest rates will stay low, roughly where they now are, in the UK and US, but higher in the Euro-zone. However, this pattern will be highly sensitive to developments in the recovery.

The pattern of fiscal retraction will closely follow the path of interest rates. As these rise, the pressures to cut back public deficits will intensify because the interest cost of debt will start to bite. It is also possible that bond markets will tire of supporting governments that do not retrench sooner rather than later, so that long-term bond yields rise aggressively - also forcing retrenchment. As I have argued before, these fiscal and monetary developments are largely on automatic pilot under the inflation-targeting regime. Only if governments abandoned the target would this change; but there is no sign of that precisely because the inflation target was put there by popular demand in the face of past, highly unpopular, inflations. My views for the current monetary policy stance are: continue with QE at the present rate into 2010, with interest rates held at current levels. However, my bias is to tighten QE if as I expect the CPI rebounds on higher oil and raw material prices.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Neutral for both interest rates and QE

The most obvious effect of quantitative easing (QE) has been the rise in asset prices. The Bank of England has bought huge quantities of gilt-edged stock (British government bonds). The sellers have received money. Many investors, for example, life offices and pension funds, have reinvested the proceeds. The direct result has been a rise in the prices of the asset that they have bought. The ‘bears’, who had sold stock they did not own, have had to close, and asset-prices in general have risen. How large will be the stimulus to economic activity?

A rise in asset prices clearly stimulates economic activity. The increase in wealth encourages expenditure and confidence in financial markets spreads to the economy in general. History shows however that a rise in asset prices is a necessary but insufficient condition for economic recovery. In other words an economic recovery will not occur if asset-prices have not risen but the recovery may or may not occur if they have risen. The explanation is as follows. The supply and demand for money are rarely in line. If the supply of money exceeds the demand for money, as always happens before a recession ends, some of the surplus will be spent on goods and services and economic activity will increase. Some of the surplus will be spent on existing assets and asset-prices will rise. The rise in asset prices precedes the economic recovery because financial markets react more quickly than the real economy. If asset prices have not risen there will not be sufficient money to end the recession. If they have gone up, the amount of surplus money being spent on goods and services may, or may not, be sufficient to end the recession.

At the peak of a business cycle the demand for money from individual investors for savings purposes is usually higher than normal. The demand for bank deposits as a home for savings depends on how the rate of interest on bank deposits compares with the expected return on other investments, particularly on bonds and equities. At the peak of a business cycle short-term interest rates are usually higher than long-term ones and the income from a bank deposit is relatively high. Risk of loss is also relevant. Bank deposits have an advantage here too because perceived risk is high on bonds and stocks if markets are falling as they usually are at the peak of a cycle. The relative advantage of bank deposits is subsequently upset by either interest rates on bank deposits falling or the expected returns, allowing for risk, on bonds and equities rising. The latter usually comes first when investors judge that the bear markets are coming to an end. When the equilibrium has been upset, switching from bank deposits into risky assets during a typical cycle does not reduce bank deposits but merely transfers a bank deposit from the buyer to the seller of the asset. In normal times money is quite like the hot potato of the children’s game: one child can pass it to another but the group as a whole cannot get rid of it. Each time a bank deposit changes hands it is progressively more likely to be spent on goods and services. If the money stays in the system, the stimulus to economic activity continues.

QE has changed the timing of the bull markets in bonds and equities associated with a business cycle. It has been brought forward. The bull markets will end sooner than usual and with them the beneficial effects on economic activity. The next difference in the current cycle is that almost all of the money injected by the Bank of England was initially spent on assets and very little on goods and services. In the current cycle the amount of money being switched into risky assets has clearly been exceptional because interest rates on bank deposits are so low. An important difference is that much of the money has been invested in new issues by banks and in bonds issued by companies to repay bank loans. In both cases the money is destroyed and does not remain in the system. In the former case deposits fall and non-deposit liabilities rise on the liability side of the banking sector’s balance sheet, with no change in assets. In the latter case deposits fall on the liability side and loans fall on the asset side. In both cases the important continuing ‘hot-potato’ effect of money remaining in the system is absent.

The monetary data for September confirm that monetary ease has gathered little momentum. The rate of growth of M4X, which excludes transactions by quasi banks, was 1.9% during the last twelve months and has not risen as the annualised seasonally adjusted rate during the last three months has remained at 1.9%. The rate of growth of M4 holdings of household has however risen slightly from 2.5% to 3.9% and that of non-financial corporations has risen from 1.4% to 3.6%. The restructuring of balance sheets will undoubtedly be beneficial and assist economic recovery in due course. However, the monetary stimulus has not been gathering momentum. It will probably be wise to suspend further QE for the moment, whilst the effects of QE in the past are materialising. But a conclusion that more QE will not be needed in coming months is premature.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: Expand QE and take other radical measures

The third-quarter UK GDP figures revealed a fall of 0.3% on the quarter and 5.1% on the year. Surprisingly, stocks did not contribute to growth: it appears that this temporary boost may already have worn off. What was less of a surprise is that the car scrapping scheme appears to have boosted imports rather than domestic output. Net trade made a negative contribution to GDP growth in the third quarter. An increase in government spending was offset by flat consumer spending and the continued business retrenchment. Although these figures are at odds with the survey data for the same quarter, the performance of the economy over the last few months has been very disappointing.

Looking ahead to 2009 Q4, I still expect a positive GDP number as consumers bring forward planned purchases to avoid the increase in VAT on 1st January. However, this will exert a considerable drag on growth in the New Year, given that the overall effect of this effective price rise will be negative. At the same time, support from other short term factors such as the car scrapping scheme and the stamp duty holiday will wear off within a few months, and a bumpy and protracted recovery is in prospect.

The November Bank of England Inflation Report suggests that the growth rate will pick up quickly next year and reach 4% in 2011. However, I remain very sceptical and believe that more radical monetary policy measures should be considered in attempt to kick-start the economy. It seems clear that QE has boosted asset prices, but that there has not been the usual follow-through into spending. Cash has been injected into the wider economy, but has been used by companies and consumers to pay down debt rather than for spending. This gives a new twist to the old Keynesian idea of the liquidity trap.

It is hard to know what to do to get banks lending and people spending again. However, the minutes of the November Monetary Policy Committee (MPC) meeting reveal that the MPC discussed the possibility of reducing the rate of interest paid on commercial reserves held at the Bank. While they did not implement this policy, they saw this as an option if economic conditions did not improve. I think this should be implemented sooner rather than later. This might not stimulate lending but it would at least bring interest rates down by lowering the base of the structure. If zero did not do the job, I would consider a negative interest rate. The only problem that I can see is that a move to a negative interest rate on bank reserves would mean QE would turn into a tax on the banks, since they would find it difficult to pass this charge back to their customers. This would undermine the authorities’ attempts to recapitalise the banks and get them lending again. I have argued that the QE programme has allowed their best customers to run down their loan accounts, to the tune of perhaps £200 billion, effectively replacing them with these low interest bank balances at the Bank. Charging the banks for these holdings or even offering a zero interest rate would add insult to injury, especially since the aggregate amount is effectively set by the authorities.


Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold in December
Bias: To cautiously start tightening, especially if sterling weakens

A properly conducted monetary policy should have the stability of a tripod, with the setting of the official REPO rate, debt funding policy, and the regulation of the financial sector all being employed in a co-ordinated manner as part of one Central Bank toolbox. Unfortunately, the tri-partite dismemberment of the Bank of England in 1997, which resulted in the splitting off of its debt management responsibilities to the DMO and its regulatory responsibilities to the FSA, means that there is now a serious policy inconsistency between what should be the three main legs of monetary policy. It is needlessly cumbersome to have the DMO selling government debt on one day, only for the Bank of England to buy it back under QE the next. However, it is even more crazily inconsistent that the regulatory authorities are trying to get the commercial banks and building societies to hold more capital and reserves at a time when the need is to stop the broad money stock from imploding.

Fifty years ago, the economics text books of the day accepted that the reason banks held liquid assets was to protect against the worst-case scenario of a run on the bank. Once a bank run took place the whole point of liquid assets was that they could temporarily be run down to below their long-run prudent level, until the immediate crisis had passed. It was also accepted that the authorities should acquiesce in this behaviour and permit the reserve asset ratio be run down under these circumstances. It is discouraging that half a century later Britain’s financial regulators perversely appear to believe that they should be enforcing measures that can only lead to: a reduction in the size of the banking sector’s balance sheet; a smaller share of lending to the private sector within the reduced asset book; and less money supply, than if the regulators had left well alone.

Fortunately, Britain has a small open and trade-dependent economy and its national output moves more closely in line with the growth of the developed economies as a whole than it does with the policy levers controlled by the domestic authorities. The latest IFO World Economic Survey from the Munich based CES IFO group, published on 19th November, shows signs of a clear improvement in global sentiment, with a ‘V’ shaped rebound from the first quarter low point rapidly approaching (but not yet reaching) the 1993-2008 average from below. The IFO economic climate index for Asia is already above its long term average. However, business confidence in North America remains somewhat below, and in Western Europe well below, their long run averages.

Businessmen have suggested that one of their main problems has been that global supply chains collapsed after the Lehman bankruptcy because suppliers were no longer prepared to grant trade credit to each other. Since a typical consumer electronic good can have twenty or more suppliers in maybe half a dozen countries involved in its production, fear of default by a single counterparty – or their bankers – anywhere along this chain can cause the entire production process to jam up leaving suppliers and retailers with no choice but to ‘dash for cash’ by slashing inventories and employment and dumping stock at bargain basement prices.

While OECD broad money has not collapsed so far, the unmeasured ratio of international trade credit to broad money seems to have done so. This partly explains the limited leverage of conventional domestic monetary policy in the present crisis. Businessmen’s willingness to extend credit is likely to gradually return as general confidence is restored and experience reveals which of their counterparties are sound and unlikely to default. The subsequent recovery in intermediate demand as supply chains start cranking up again will initially appear as a rebound in inventories in the national accounts, and then in international trade, and private capital formation.

The problem facing the more mature western economies is that their supply sides are so sclerotic as a result of their high public spending and regulatory burdens that they will prove incapable of benefitting significantly from any global recovery. The US and Britain, in particular, have seen such large increases in their government spending ratios over the past decade that their sustainable growth rates have slowed down sharply. If this supply withdrawal is ignored, and central banks attempt to get back to the previous growth path, the outcome will be stagflation not recovery.

This policy error is now seen as having been one of the main causes of the stagflation in the US and Britain in the 1970s. There is a risk that both countries have repeated the policy error of the early 1970s that led to the catastrophic performance of the mid-1970s. A responsible policy of monetary stimulus has to be accompanied by measures to liberalise the supply side if it is not simply to end up letting the inflation genie out of the bottle. De-regulatory labour-market measures would not add to the Budget deficit and would be a useful first step. However, there will also have to be a reduction in the share of national output absorbed by the state. The 9th December Pre-Budget Report will clearly need to be closely scrutinised in this respect. The fiscal stabilisation literature strongly suggests that cutting public consumption expenditure from its present bloated level will not only reduce the fiscal deficit but also strengthen economic growth and employment.

Where does this leave the MPC? The answer is pulling policy levers that are probably no longer reliably connected to the wider economy and in many cases being tugged in an opposing direction by the regulators and fiscal authorities. The most likely scenario is that the British economy will be floated off the rocks by the rising tide of international recovery, but that domestic monetary policy will only marginally have helped the process and fiscal policy will have impeded it. Some MPC members appear to believe that the weaker pound will help the recovery. However, UK imports seem to be almost entirely insensitive to the exchange rate these days, and the price elasticity of demand for UK exports to be only around 0.4. The gains to exporters from a weaker currency also have to be offset against three drawbacks. First, the adverse movement in the terms of trade reduces national disposable income relative to GDP. Thus, in the year, to 2009 Q2 (the latest ONS figure available) Britain’s gross national disposable income at market prices fell by 8.1% when total GDP dropped by 5.5%. Second, and in a small-open economy like Britain’s, each 1% decline in sterling eventually comes through as a 1% hike in the price level, although this is usually a long-drawn out process. The 20½% drop in sterling over the past two years, and the 4% drop over the past year, represents a serious inflationary threat unless one believes that the overseas price level is likely to fall by a corresponding amount. Finally, overseas investors in British government securities will not be prepared to fund the fiscal deficit at anywhere near the present 3.6% on a ten year gilt, if they believe that they will take continuing foreign exchange losses. It is probably getting close to the point where Bank Rate should be raised in any case. I would certainly raise it if the sterling index, which was 80.1 (January 2005=100) on 27th November threatened to ease any further. The QE programme has now been extended to the end of February, but is really doing little more than offset the ‘crowding-out’ effects of the Budget deficit. The uncertainties are such that it makes sense to reserve judgement until nearer that date but a cessation of the programme would probably be appropriate. Finally, the politicians and the regulators must ensure that the perceived threat of a more onerous regime does not cause bankers to start re-trenching their balance sheets straight away in anticipation of future increases in capital and liquidity requirements. That really would produce a vicious second downwards leg to the recession.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%, persevere with QE
Bias: To Raise Bank Rate


Whereas the UK appears to be a laggard in the global economic rebound, it is becoming clear that the third quarter of 2009 showed a significant improvement in activity in a majority of Western countries. Asian economies had generally begun a recovery in the second quarter. Shipping container volumes scored their second successive quarter of double-digit percentage growth and annual growth rates should turn positive in the final quarter. Cargo rates for shipping and air freight have soared in recent weeks. Suppliers’ delivery times have lengthened in recent months, which is unusual for the early stages of a recovery. There is every indication that a powerful inventory rebuilding exercise is underway in the global goods economy.

In the additional national accounts detail released on 25 November, UK money GDP at market prices rose by 1% in Q3, led by a 3.2% gain in the gross operating surplus of corporations. The surprise in this data was the continued decline in business investment (down 3% on the quarter, 18% on the year) and the extension of the rapid depletion of inventories (another £3.6bn, making a total of £16.8bn or 4.8% of GDP) in the past four quarters. The timidity of the UK corporate sector looks to be seriously misplaced and the purchasing manager surveys suggest than an urgent normalisation of output schedules is underway. The October manufacturing Purchasing Managers Index (PMI) was at its best level for two years, and the new orders component index was even more impressive. Inventory change could rise to zero in Q4, propelling a sizeable increase in GDP. Notably, pricing pressures have also increased, reflecting the turn in energy prices.

In the monetary statistics, October brought the welcome news of a 1% monthly rise in M4 lending and a 1.8% increase in M4. The three-month annualised growth rates have recovered to more than 7% for M4 lending and to 11% for M4. In both cases, the three-month annualised growth rates now exceed the twelve-month growth rates, indicating that the latter are also poised to stabilise and grow. In short, the UK’s deflationary panic is over and the Bank of England’s MPC should not delay in taking action to remove the emergency setting of Bank Rate.

On a fundamental level, it is time for the pendulum to swing back from borrowers to savers. Mortgage borrowers have enjoyed a year of bonanza as their base tracker rates have tumbled from an average 7% in October 2008 to 3.9% in August and discounted two-year fixed rate mortgages, from 6% to 3.2%. Retail savers have suffered declines in Cash ISA rates from 4.4% to 0.4%; instant access accounts from 2.4% to 0.2% and notice accounts from 3% to 0.4%. While some embattled institutions are offering substantially better rates in order to attract deposits, the centre of gravity in the savings market is painfully low. If Bank Rate is left unchanged, the real rate on retail savings could be as low as minus 3% by next April.

Our familiar decomposition of the RPI reveals that private sector inflation of goods and services (excluding fuel and light) reached 3.9% in October, up from 0.3% in January, to record its highest inflation rate since 1994. There is a clear upward bias to UK consumer prices that will be painfully obvious to all once the extraordinarily favourable base comparisons of last summer disappear from the reckoning. Petrol and oil prices are already giving up their benefit to the RPI and CPI and soon fuel and light prices will follow suit. Another breach of the upper band of the official CPI inflation target, so quickly after the last (2008), will undermine what remains of the Bank’s policy credibility.

In conclusion, the gloomy mood of the past two years is beginning to lift, even if this is largely because of the significant forms of government support in place. This acute phase of the financial crisis is past and the opportunity should be taken to wean borrowers off the ultra-low interest rates that they have enjoyed in the past year. The option of extending and even strengthening the QE policy remains open should it be needed. But the era of very low interest rates and supercharged bank profits has overstayed. With equity and property prices rising, UK monetary policy cannot remain so accommodative. Otherwise, the Bank runs the risks of an escalation of gilt yields and another drop in the value of sterling, with extremely uncomfortable feedback effects on the public finances and domestic inflation.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: To hold Bank Rate but extend QE beyond February

High frequency data suggest that the UK economy will post positive growth in the final quarter of this year. The second estimates of the 2009 Q3 performance saw the initial fall of 0.4% moderated to one of 0.3%. Many argue that it will eventually be revised up to show positive growth, but that is moot at this time. Of much more significance is that the breakdown of the third-quarter data showed that net exports detracted from growth. Exports rose in the three months to September but imports were up even more. This is not good news for the pace of recovery in 2010, as it suggests that the currency is not weak enough to be supporting exports and/or the mix of UK exports is such that it is unable to benefit from the recovery taking place in world trade.

Either way, the end result is the same: there is little to prop up the economy in the absence of growth in domestic demand; and with consumer spending under pressure and an unsupportive fiscal picture looking ahead, recovery will be weak and muted at best. That is why it is so crucial that there is sufficient liquidity around to fund what growth impulses there are. Robust growth in money supply is therefore a prerequisite for any sustainable economic recovery. To that end, preliminary figures for October were encouraging, showing that broad money M4 rose by 1.8% in the month to stand 11% up on the year, down from 11.6% in the year to September.

It is true that Purchasing Managers Indices (PMI’s) are encouraging; retail sales look better, and industrial production is recovering from its lows, but it is also true that these may not last. Inflation is set to rise in the next few months, albeit temporarily, and hence will hit spending in the first half of 2010. Taxes are set to rise and some of the rise in industrial production may just be restocking after a bout of destocking. This is even more likely as there is not enough of a rise in exports to justify a sustained pick up in company output. Unemployment is set to rise further and both companies and households seem determined to repay debt and save more. In other words, the recovery may peter out if it is not sustained by continued low interest rates and abundant liquidity from the central bank and government.

As a result, it is too soon to say for sure that further QE is not required, and it is certainly too soon to even think of raising short term interest rates. Bank rate should therefore stay at ½%, and the decision on QE should be decided in February, when the current allocation is due to be exhausted. I have a bias to more QE, if required by a weakening economy after what is likely to be a return to positive growth in Q4 2009 after six quarters of decline.

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 nine votes are cast.