Sunday, January 03, 2010
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 the ½% originally set in March 2009 when the Bank of England’s rate setters next meet on 7th January.

The dissenter voted to raise Bank Rate to 1%, because the era of very low interest rates and supercharged bank profits had outstayed its welcome in his view. When asked to look further ahead, most SMPC members had no marked bias where Bank Rate was concerned. This was largely because of the uncertainties involved. In contrast, the dissenting SMPC member thought that the official discount rate would need to be raised again.

Another member thought that Bank Rate should probably be raised to 1% in February, when a new set of Inflation Report forecasts would be available to the monetary authorities.

The previous SMPC vote had been released before the 9th December Pre-Budget Report. Several members of the shadow committee used their January submissions to express disquiet about the fiscal backdrop to monetary policy. One member pointed out that the government’s intention to spend 53.2% of factor-cost GDP in 2009-10 and 53.6% in 2010-11 pushed the general government spending ratio to well above the 46½% recorded in the 1916-18 period, when World War I was at its peak.

It was hardly surprising that spending on this scale gave rise to unprecedented peacetime budget deficits and the economic and financial strains that traditionally epitomized wartime finance. Some SMPC members were concerned that current official proposals to force banks to hold more capital and liquidity would perversely reduce the supplies of money and credit. There was little to be gained from employing such a controversial technique as Quantitative Easing (QE) if the benefits were going to be nullified by negative regulatory shocks to the supply of broad money.

The SMPC is a group of independent economists who have met quarterly at the Institute of Economic Affairs (IEA) since July 1997. That it is the longest established such body in Britain and meets physically to discuss the issues involved distinguishes the SMPC from the similar exercises carried out by several publications. The current SMPC poll was ‘frozen’ on Wednesday 30th December 2009, although most submissions were received some days earlier, in part because of the Christmas holiday period.

The first SMPC gathering of 2010 will take place on Tuesday 19th January and its minutes will be published on Sunday 31st January 2010. The next two e-mail polls will appear on the Sundays of 28th February and 4th April.

Comment by Tim Congdon
(Founder Lombard Street Research)
Vote: Hold
Bias: Hold; QE should be varied to maintain positive broad money growth

The discussion of UK monetary policy is bedevilled by a verbal confusion. According to standard theory, the equilibrium level of national income is a function of the quantity of money, where the quantity of money consists of the currency circulation, plus bank deposits held by the domestic private sector. In practice money is dominated by bank deposits, and the phrases ‘the quantity of money’ and the quantity of bank deposits’ can be used interchangeably. It follows that an increase in bank deposits of, say, 10% implies an increase in equilibrium national income also of 10% (plus or minus a variety of factors, most of them minor). The evidence in support of this proposition is clear-cut in all economies at all times.

Since 1964, the ratio of non-financial-sector money to UK GDP has risen on average by about 1½% a year. The ratio of such money to national income has therefore doubled over the forty-five years. However, the increase in nominal national income was a compound 9% a year, meaning that money went up by ninety times and national income forty-five times. To repeat, the dominant effect of changes in the quantity of money is on the equilibrium levels of national income and expenditure. This effect is qualified by changes in the ratio of money to income, but over the medium and long the qualification is of limited significance.

The key proposition above – that national income depends on the quantity of money – says nothing about ‘bank lending to the private sector’. The relationship between money and national income holds regardless of whether bank lending is falling, contracting or going sideways. Indeed, bank assets could consist entirely of cash and government securities, and the relationship between money and national income would be maintained. Unfortunately, there is a complication. This is that – when banks make new loans to the private sector – they add extra deposits to their liabilities and so create new money. A large number of people – including, apparently, the chairman of the US Federal Reserve – go from here to believing that, when banks make new loans, ‘they increase spending in the economy’ and that ‘spending’ depends on ‘lending’.

This second claim – that spending depends on bank lending to the private sector - is the fallacy of ‘creditism’. It has nevertheless been given academic respectability by Bernanke and Blinder (1988), Benjamin Friedman’s articles in the late 1980s and early 1990s, and hundreds of subsequent papers about a so-called ‘credit channel’. It has also been parroted so often in the media that most financial journalists believe that the purpose of quantitative easing is ‘to increase the supply of money and hence boost bank lending to the private sector’. This is how the verbal confusion over ‘money’ and ‘credit’ has come to bedevil the current debate on monetary policy.

Why is the claim that ‘spending depends on lending’ a fallacy? It is in fact so wrong that it could be shot down from several analytical vantage points, as the following will show. Payments by means of money – which nowadays means almost exclusively payments across bank deposits – are a vast multiple of both national income and new bank lending to the private sector. Roughly speaking, in the UK today the value of payments is: (I). about fifty times the size of national income; and (II). a variable multiple of the increase in the stock of bank lending to the private sector, assuming that this stock is increasing. For example, in 2004 such lending was under £100bn and so was 1/600th of the value of payments, whereas in 2009 it was perhaps £30bn and was 3/8000th of that value.

A clear implication of (I) is that virtually all of the payments in an economy could be made if no new bank lending whatsoever took place. If this seems odd to creditists, they might ask themselves when they last took out a bank loan? Were they spending nothing in the months and years before that event? Did their spending suddenly surge by the amount of the loan afterwards? Let them just think for a minute or two about their own behaviour.

A further clear implication is that bank lending to the private sector can contract but people and companies will continue to spend, and national expenditure and income chug along without difficulty. If the UK banks had not lent £30bn in 2009, but instead seen their loan portfolios shrink by £30bn, the transactions directly affected would have been under 0.04% of all payments. (The effect of a drop in the stock of bank loans on the quantity of money is, however, a very important matter, because money is turned over many times and agents have a stable demand to hold it, but I anticipate.) Creditists might come back, and assert that bank lending should be compared with national income and expenditure (i.e. the totals of £1,500bn or so which are UK GDP), not with the total of payments. Well, they should again check facts. The overwhelming majority of payments from the deposits newly created by bank loans are to acquire existing assets, and have no direct and immediate impact on the Keynesian income-expenditure flow.

Bank loans to households are mostly to buy existing houses, not newly-built houses; bank loans to companies are largely for expansion by acquisition and hardly any lending to the financial sector is to finance goods and services. Furthermore, most agents do not have bank loans, if companies are excluded. Does that mean they don’t spend? Or that their spending doesn’t change unless they take out a bank loan? It is a simple exercise to show that – even in the corporate sector – there is no relationship between new bank lending and corporate spending, where Britain is concerned.

In short, the notion that spending depends on lending (i.e. creditism) is utter tosh. The correct theory is that the equilibrium level of national income depends on the quantity of money. If we could be confident that the quantity of money would grow in 2010, the macro outlook would be fine. The trouble is that various commentators and authorities, including key people in officialdom, have not understood basic monetary economics and think that ‘lending by itself’ is what matters. Given the prevailing intellectual muddles, it seems to me difficult to make a meaningful macro forecast for 2010. Bank lending to the private sector does not matter much by itself, but it matters enormously as an influence on the quantity of money. If the state’s financial transactions (i.e., those of the government and central bank) are assumed to have no effect on the quantity of money in 2010, my surmise is that bank lending to the private sector would contract by 5% to 10% and the quantity of money would fall by a similar percentage.

I would therefore expect a return of intense recession. However, there is a large budget deficit, which will be financed partly from the banks. In addition, the Bank of England has announced a programme of QE and given a semi-plausible account of how it believes QE to work. So QE remains in the policy-makers’ toolkit and the state’s financial transactions may add 5% to 10% to the quantity of money in 2010. With interest rates at virtually zero, balance sheets, asset prices and demand ought not to be disastrous. Even so, I am inclined to expect beneath-trend growth rather than above-trend growth in early 2010. Money trends in the USA, the Euro-zone and Japan are disturbingly weak, but the so-called ‘advanced world’ will probably pull in real money balances from Asia in the next few quarters. Asian banks etc. are mostly in fine fettle.

My policy prescription is to keep interest rates at near-zero levels and use the state’s ability to create money to ensure that money growth stays positive. That should go some way to neutralize the catastrophic effect of official regulatory pressures on the banks, which are obliging the banks to shrink their risk assets, their deposit liabilities, the quantity of money and the economy. If commentators believe that the Bank of England’s balance sheet has become unwieldy because of the QE exercise, the government itself should borrow directly from the banks and create money that way. I am of course opposed to excessive monetisation of the budget deficit; I support monetisation of the deficit only to the limited extent necessary to sustain money growth in the low single digits. My preferred course is strong action to reduce the budget deficit, combined with aggressive monetisation of the existing public debt.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold; maintain current £200bn QE target
Bias: To extend QE beyond February

The unorthodox monetary policy - Quantitative Easing - adopted by the Bank of England in March 2009 was successful in preventing the kind of multiple credit contraction and severe depression that the US experienced in 1931-33. The fact that real GDP in the UK was not showing clear signs of recovery by the third quarter of 2009 does not mean that the policy was a failure. Rather, the reason why monetary policy did not gain effective traction during 2009 - in the sense of ensuring a prompt recovery in real and nominal spending - is partly due to the standard lag-in-effect of monetary policy. But, more importantly, it is due to the continuing desire of households and financial firms to repair their balance sheets. After a bubble bursts and balance sheets are in need of repair, the tendency will be for growth and inflation to be lower than otherwise because debt repayment is inherently deflationary. The repayment of debt requires the debtor to write a cheque to his or her bank, while the bank cancels the loan. Both sides of the bank’s balance sheet decline. Money and bank credit in the economy are reduced. This slows growth and holds down inflation.

Evidence for the pervasiveness of this process can be seen in the very slow growth rates of money and credit - or in some cases absolute declines in credit – in the US, the Euro-zone and the UK, despite the fact that central bank interest rates in all these economies are close to zero. In other words, there is widespread debt repayment occurring, combined with an aversion on the part of households and firms to increasing their indebtedness, even if the cost of such debt is very low. During the process of balance sheet repair, the authorities can only respond in a reactive way. The fiscal authorities can replace private sector spending with government spending, but only at the cost of replacing private sector debt with public sector debt. The monetary authorities can engage in QE, substituting credit created by the central bank for credit created by the commercial banks, but only at the risk of rapid money growth when the private sector appetite for credit revives. In short, the ultimate driver of economic activity and spending is not the actions of the fiscal and monetary authorities, but the private sector’s income growth and the associated demand for credit, which in turn is dependent upon the state of its balance sheets.

Over the next few quarters QE must be calibrated to compensate for any further debt repayment and consequent credit shrinkage that will result from the process of household and financial sector balance sheet repair. Since UK households became significantly more indebted than their US or European counterparts during the credit bubble, it is natural that the repair process will take longer in the UK than elsewhere. Until that process is substantially completed, the Bank of England will need to continue with QE, and there will be little scope for rate hikes. However, once the balance sheet repair process is completed, QE will need to be withdrawn and rates will need to be raised – gradually - to levels that discourage the build-up of excessive indebtedness in the future.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold; no extension of QE
Bias: To further expansion and unchanged interest rates

The revised third quarter GDP figure, which now shows a quarterly fall of 0.2%, disappointed many City analysts who had convinced themselves on the basis of various business surveys that the UK economy had emerged from recession in that quarter. Of course, this figure may be revised again in due course – and possibly upwards - but a more likely explanation is that we have yet to see solid evidence of a return to growth. Indeed the real data so far available for the fourth quarter are disappointing. October’s services activity, some 75% of the economy, rose by an anaemic 0.1% in the month, October’s manufacturing output was flat and November’s retail sales slipped back after rising in October. In the meantime, inflationary pressures remain contained – despite the pick-up in November’s CPI, with more to come in January, and the undoubted pick-up in producer-price inflation. Earnings annual inflation was a meagre 1.5% in the three months to October.

The Pre-Budget Report was, as widely anticipated, mainly a political document with the general theme of soaking the rich. The Chancellor avoided any attempt to shore up the disastrous public sector finances, leaving this necessary but unwholesome task to his successor. Indeed, and despite the shocking state of the public finances, the Chancellor increased planned spending by around £15bn in total over the financial years 2011-12 and 2012-13 according to the Institute of Fiscal Studies, while recouping less than £9bn through new tax increases. It was another exercise in irresponsible procrastination. The Bank is well on its way to its targeted £200bn of QE asset purchases, over £190bn as at 17th December. Whilst I would not recommend a further extension of QE at January’s meeting, my bias is towards further expansion. The Bank Rate should stay at ½% - and should do so for a considerable time.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold; continue with QE for time being
Bias: Neutral

Worldwide recovery appears to have firmed up. Here in the UK the statistics have lagged behind the anecdotal signs of the same thing. No one believes in the peculiar decision by the Office for National Statistics (ONS) to call a revised GDP drop of 0.2% in the third quarter (now revised down from an initial estimate of 0.4%). We now have not merely surveys of purchasing managers but also employment, production and retail sales figures, all of which suggest that the economy levelled off in the third quarter and could have possibly also started expanding then, and was definitely expanding in the fourth.

The most troubling aspect of the recovery in western economies, including the UK, is the lack of credit growth to the non-bank private sector. However this has been accompanied by a general easing in monetary conditions as measured by other indicators, such as the rates of interest on corporate loans and bonds, and the cost of equity capital. So, it appears that the policy easing carried out by virtually all western central banks has succeeded in offsetting at least much of the effects of the credit crunch created by the banking crisis. Another feature has been the willingness of western governments to allow their budget balances to move into heavy deficit. The way to think of this is that governments will eventually have to pay off these deficits by either cutting spending services to the private sector or raising taxes on it. Hence these deficits are loans to the private sector to perform current services or avoid collecting current taxes; these loans will be paid off in the future. The government is effectively giving credit to the private sector that has dried up through the usual channels.

Some people would like to debate whether such government deficits are effective in supporting the economy; however, it should be obvious that, in a credit crunch, all credit provision is likely to be effective in offsetting the credit shortage. One can agree that in normal times deficit multipliers could well be low because rational consumers will work out that they must pay future taxes to pay for the deficits and hence they may well save in response, so offsetting the direct deficit stimulus. However, this argument is irrelevant in a credit crunch because the private sector is liquidity-constrained. So, monetary and fiscal policies have both been dominated by the need to provide a substitute for bank credit. They have done so and been rather effective in this. As long as the recovery does not raise inflation and require interest rates to rise, and money creation to be stopped and reversed, the government deficits have been costless because financed by money creation at zero interest rate therefore. The burning question is when is the turning point when ‘monetary exit’ must be started, turning these deficits into expensive processes that could violate sustainability conditions, and hence precipitating the necessity of fiscal exit also.

From the UK or US perspective, there is no real reason to rush to the exit. Both countries’ public debt to GDP ratios are quite low, in the region of 50% to 80% prospectively. There is no history of outright default, or of refusal to pay taxes. The main issue concerns the possibility of using inflation as a partial default tool. In the UK there has been a formal inflation target of 2% or so for seventeen years; in the US there is no formal target but a widespread assumption encouraged by the Federal Reserve that there effectively is one of the same order. Since debt has been issued over a long period on the assumption of such a target, the gain to the Treasury from a burst of inflation would be large; it would act like a windfall tax on bond investors. For example to reduce the debt/GDP ratio in the UK back to 40% from its current level of 56% would just require four years of inflation at 6%, only 4% over the target.

Tempting as this might sound, it is striking how little public interest there is in it. Inflation was highly unpopular in both countries when it was out of control in the 1970s and early 1980s; inflation targeting has proved politically successful for this reason. The reason seems to be that the operation of the ‘inflation tax’ is arbitrary and therefore seen as unfair. In particular, those who pay it are often the most vulnerable - for example, those with pensions invested in government bonds - while those with wealth and good advisors can usually avoid it. Ordinary taxation, however unpopular it may be, can be spread across the populace in a fair way, and so can normal ‘Treasury cuts’, which command wide respect as the only way of checking inevitable bureaucratic waste.

So what each of these governments needs to do is put in place a mechanism for the medium term that first brings down the deficit and then ensures that the debt to GDP ratio falls slowly with growth. Meanwhile, and for some time to come, there will be a need for monetary ease as the financial system is nursed back to health; this will keep the financing costs down. The growth rate of credit to the non-bank private sector remains exceedingly low; while other sources of liquidity have increased. However, it is still clear that liquidity is not generally available on competitive terms to many small firms and ordinary households. What has happened so far is that larger firms and wealthier households have benefited from low rates of interest while small firms and poorer households have found it difficult to gain access to finance at all. This is no basis for a modern economy to function well and recover confidently. Yet it is clear that restoring competitive finance when banks have been so damaged will take some time. There is no definite date when one can yet predict it will occur, what with the new capital required, the new procedures to be implemented, the paying-off of government to be done and so forth.

My conclusion is that quantitative easing has worked to partially offset the credit crunch and will continue to be needed as the banking system is rebuilt. Furthermore fiscal policy too will need to be supportive throughout the coming fiscal year, 2010/11- even though a process must be set in place to reduce the public deficit over the following five to ten years. The threat posed by the banking crisis was massive and has not gone away; and while it is premature to celebrate, the policy response has so far been effective. It needs to be continued. Therefore my vote on monetary policy is for unchanged interest rates and continued QE, its scale to be judged by measures of the general availability of liquidity on competitive terms.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold, expand QE
Bias: Neutral

A great deal of printer ink has been used up in explaining how quantitative easing works and how it has offset the negative impact of the credit crunch on domestic demand. The reality is that it is very difficult to evaluate the effect of QE. The theory is simple enough. The increase in liquidity from QE would manifest itself in an increase in the broad money supply and through a direct mechanism (the real balance effect) will stimulate domestic demand by encouraging consumer spending and drive the economy out of recession. An alternative view is that non-bank financial institutions will use excess cash balances to buy up assets such as stocks and commercial property driving up share prices and property prices. This ‘Keynes effect’ will stimulate domestic demand through an increase in investment spending. While share prices and property prices have reacted in the expected way, domestic demand has remained stubbornly muted. The reason is clear. Over-leveraged households are restoring net asset values by saving. Firms are using the buoyant stock market to restructure their balance sheets and not engage in investment. The banks have found that their good risk customers are repaying debt leaving their riskier customers to demand bank credit. The result is a higher risk premium, wider spreads and weak bank lending. All this has shown up in the third quarter results for GDP, which despite anecdotal evidence to the contrary, continue to highlight the weakness of the UK economy.

One glimmer of hope is the exchange rate. The evidence for the effectiveness of QE is in the near 25% depreciation of the sterling effective exchange rate (partly through a reversal of capital flows but also through an expectations effect). While net exports have yet to respond, signs of a recovery in global demand have begun to emerge and the UK is well disposed to exploit an upturn. An increase in external demand remains the best prospect for recovery. There is much we can learn from the experience of the inter-war period. The sterling real exchange rate depreciated by 18% between 1929 and 1934. Despite a subsequent appreciation, the real exchange rate in 1938 was 9% below its 1929 level. Exports which had fallen by 61% between January 1929 and September 1932 had risen 53% between September 1932 and December 1939. Of course exports never recovered their 1929 level and world trade did not go back to its 1920s levels, but the point is Britain fared better than many other economies with an annual rate of growth of industrial production higher than the average for advanced economies. Uncertainties concerning, budget deficits, taxation, interest rates and the election will hamper the recovery but sterling must be allowed to do its work. This means that quantitative easing must continue and the rate of interest should remain on hold for the time being.

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

The performance of the British economy continues to disappoint. The third quarter GDP headline figure is particularly disappointing - I had expected this to be revised up significantly after the revisions to the construction and business investment data. However, upward revisions to consumer spending and investment suggest that the economy is at least stabilising. The further draw-down of inventories means there is plenty of room for a turn in the stock cycle to support growth over the next few quarters. The big increase in the savings ratio since the beginning of this year is impressive. But it remains unclear whether this is voluntary or involuntary – the effect of much tighter credit markets. The monetary figures also continue to disappoint.

We remain the only G-20 country in recession but all indicators suggest that this will have finally come to an end in the fourth quarter of last year. I expect a positive GDP number as consumers bring forward planned purchases to avoid the increase in Value Added Tax on 1st January 2010. 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 thereafter is in prospect. The Bank of England and HM Treasury forecasts both suggest that the growth rate will pick up to 4% by the end of next year, but I remain very sceptical and believe that more radical monetary policy measures should be considered in attempt to kick-start the economy in 2010.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Raise Bank Rate to 1% in February 2010; extension of QE beyond February should be made dependent on fiscal consolidation

The figures provided in the December 2009 Pre-Budget Report can be manipulated to reveal that general government expenditure will rise from 49.2% of factor-cost UK GDP in 2008-09, to 53.2% in 2009-10, and 53.7% in 2010-11, compared with the April 2009 Budget forecasts of 48.7%, 52.7% and 53.6% for the three financial years, respectively. The general government spending ratios set out in the Pre-Budget Report have no peacetime precedent and significantly exceed the 46½% recorded in the three years 1916 to 1918 when the maximum effort was being put into fighting the First World War (see: How Should Britain’s Government Spending and Tax Burdens be Measured?, IEA Economic Affairs, Volume 29 No 4, December 2009).The Pre-Budget Report further predicted that the deficit on the general government’s current budget would be 10.4% of factor-cost GDP this year, and 10.7% in 2010-11. These are below the deficits recorded during the two world wars, when the current budget deficit peaked at around 28% of national output, but are also without peacetime precedent. While most commentators have emphasised the parallels between the present monetary situation and that of the US in the early 1930s, it is equally plausible that the British monetary authorities are now confronted with the problems traditionally associated with wartime finance.

Aggregate supply and the private-sector tax base are both reduced by the diversion of real resources to the military effort in a major war at the same time as increased government spending widens the budget deficit even further. Governments often endeavour to fund the war effort responsibly through the bond market in the early stages of military expansion. However, only the private sector and overseas residents have a demand for government debt. It is usually impossible for the much diminished private domestic sector to absorb debt issuance on the scale required – the PSNCR will correspond to 31.8% of the non-socialised element of factor cost GDP in 2009-10, according to the Pre-Budget Report, for example – while overseas residents will be reluctant to hold ever larger amounts of a foreign government’s bonds because of currency and/or default risk. The next stage is that wartime governments then start to borrow from the banking sector, perhaps by passing regulations obliging banks to hold a higher ratio of government debt in the asset side of their balance sheets, a process that inevitably crowds out the private sector from access to credit and is sometimes called forced funding. Finally, governments start to directly borrow from the central bank, what used to be known as resorting to the printing press. It is not until this latter stage is reached that inflation has the potential to take off, perhaps only after quite a long delay, and hyper-inflation has not inevitably been the outcome. Annual inflation during the 1914-18 war never got much beyond the mid-twenties in Britain, a performance similar to that observed in the 1970s, before the 1976 International Monetary Fund loan.

The problem that faces any independent analyst of the UK monetary outlook is that there is almost exact observational equivalence between the hypotheses that: (I) the Bank of England is doing the right things to offset the adverse macroeconomic consequences of the 2008 financial meltdown and has remained resolutely independent of the government in so doing; and (II) the Bank and the Financial Services Authority have been politically captured by the government and are now resorting to the stratagems and dodges of traditional wartime finance, in order to keep the government spending show on the road until after the general election, regardless of the longer term consequences. One cannot blame the typical overseas holder of British government securities, who has taken an 18.9% currency loss on sterling over the past two years, from tending towards hypothesis (II). More generally, if the average international bond yield is around 3½% and overseas investors expect to go on seeing currency losses of 10% per annum from holding sterling then it is hard to see why UK bond yields would not eventually settle in the mid teens, in theory. The foreign exchange and global bond markets may be holding their fire for the time being because they believe that an adequate fiscal consolidation programme will be implemented after the 2010 general election. The risk is that the prospect of a hung Parliament, or an excessively limp-wristed response by a future Conservative government, could lead overseas investors to rush for the exits.

The conclusion is that the UK has probably suffered a supply-side withdrawal caused by the rapid increase in the tax and spending burdens and the politically-motivated preference for raising hidden but extremely damaging taxes, such as employers’ National Insurance Contributions. The output-inflation trade off in Britain has probably deteriorated in recent years, and further monetary stimulus is more likely to emerge as inflation rather than enhanced private sector activity. The main hope is that increased global activity will float Britain’s small open economy off the rocks and that a more responsible fiscal approach will be implemented after the election. If this happens, I would expect UK economic growth to average just over 1½% this year, 2¾% in 2011, and 2¼% in 2012, before settling in the 1¾% to 2% range subsequently, compared with the fall of 4¾% in 2009. The annual increase in the ‘double-core’ retail price index – this measure excludes mortgage rates and house-price inflation - accelerated from 1.9% in September to 3.0% in November. There is likely to be a further acceleration to 4½% in the first half of 2010, before a deceleration commences in the third quarter. It is important that higher inflationary expectations do not get locked in as a consequence. A hike in Bank Rate to 1% is likely to be appropriate when the new Bank of England Inflation Report projections become available in February 2010, although this obviously depends on economic developments in the intervening period. It is also vital that the limited gains from QE are not wiped out by misguided regulatory interventions. Recent speeches by senior officials have been somewhat perturbing in this respect.

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

The release of revised third quarter national accounts data just before Christmas appears to confirm the suspicion of a lack of internal consistency evident in the earlier estimates for the same quarter. Real GDP is calculated as a compromise between the separate income-based, expenditure and output measures of whole economy activity and the output estimate is currently 0.9% below each of the others. This drags down the average estimate by 0.3%, or approximately £1bn per quarter. There is still room for revisions to bring up the third-quarter GDP growth estimate to flat or better. Indeed, it was disappointing that the upward revision to business investment, which is now estimated to be only 0.6% lower in the third quarter of last year than in the second quarter, and construction – this is now reported as making a 1.9% improvement in third quarter - was offset by a larger detraction from inventories than in the previous estimate.

Judging from the dynamics of visible trade in other countries, it seems probable that the UK inventory position stabilised in the closing quarter of last year, providing a much-needed lift to the final quarter’s outturn. Despite repeated denials by central bank officials, the global goods economy is recovering strongly, led by Asian trade. The UK’s participation in this ‘V-shaped’ recovery has been hesitant, but there is no reason to expect this sharp normalisation of business inventories to pass us by. A quarterly real GDP gain of close to 1% is expected in 2009 Q4, setting the platform for growth in the first half of 2010 of around 3% annualised.

It should be no surprise that this recovery, however technical in nature, has caught out the distribution and logistics sectors, and left them scrambling to meet seasonal demand. While the pricing power attached to a temporary misjudgement of improving demand conditions is unlikely to persist, rising world prices for energy and food will add to the momentum in retail prices that is already apparent. Despite some well-publicised price cuts by food retailers, UK food prices bottomed in September and the food inflation rate probably touched its low in November. Food carries a direct weight of 11.8% in the RPI, with catering adding a further 5%. The message is that the UK consumer faces considerable inflationary headwinds in 2010.

The November UK inflation data release registered another upside miss for the consensus. The untold story of 2009 has been the steady march of private sector inflation in the UK from 0.3% in January to 4.2% in November. Despite the gyrations of the headline RPI figure into negative territory, the deterioration in UK inflation performance has not gone unnoticed by international bond investors. From parity with 10-year Bund yields in mid-February 2009, the gilt premium has risen to more than 70 basis points. If there are hawks on the Monetary Policy Committee (MPC), they are keeping deathly quiet. Already behind the curve, few expect the MPC to embark on a rate increase before February, by which time the headline CPI inflation rate will probably exceed 3%. When union pay negotiators build their case in the next annual bargaining process, they will reflect upon a 2% to 3% fall in real earnings over the past year, with additional taxation to come. There may be trouble ahead.

As the public perceives an increased risk of higher inflation, the task of the MPC in restraining these expectations has already become significantly more difficult. The 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 available should it be necessary, but the era of very low interest rates and supercharged bank profits has overstayed its welcome. With equity and property prices reviving, UK monetary policy should not remain so accommodative. The lack of timely or proportionate public spending cuts in the Pre-Budget Report has undoubtedly added to the pressures on the UK sovereign debt market. The Bank risks a further escalation of gilt yields and another drop in the value of sterling, with extremely uncomfortable feedback effects on the public finances and domestic inflation. Bank Rate should already be at 1% with a move to 1½% under consideration.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold; maintain QE programme
Bias: To raise QE limit to £225bn in February 2010

Economic data in December suggest that the UK economy will have expanded by around ¼% to ½% in the fourth quarter of last year. This projection is based on figures for industrial production, retail sales, service sector activity and the various surveys of firms’ and households’ spending intentions. House price figures remain resilient, continuing to rise amidst recovery in equity and credit markets. Headline M4 broad money showed a rise in October and November. However, the improved economic picture in 2009 Q4 is still hard to reconcile with a strong sustained economic pick up at this stage, as the actual October underlying money supply data, i.e. excluding securitisation, showed a 5.3% annualised decline. Minutes of the December MPC meeting indicated that this is worrying the Committee as QE seems to be boosting financial markets (helping spreads to narrow, keeping down gilt yields, the equity risk premium and raising share prices) and hence lowering the cost of capital for firms but is not yet leading to faster growth in the quantity of money. Of course, it is not clear whether the economy would be recovering even now, without the boost to M4 broad money from QE. Part of why money supply growth is sluggish seems to be that households are paying off debt, mainly unsecured personal loans.

The final UK GDP data for the third quarter of 2009 highlighted a rising desire to save on the part of households, with a rise in the saving ratio to 8.6%, the highest since the recession of the early 1990s. Some of the rise in the saving ratio is due to a reduction in borrowing as much as to a rise in savings. However, the end result is the same, less consumer spending than otherwise and weaker economic growth. Indeed, data show that the UK was still in recession in 2009 Q3, with a quarterly fall in GDP of 0.2%, making national output 5.1% lower than in the same period of 2008. Another fact worth noting is that the UK is now the last of the G20 countries still to be in recession. The detail of the data in the third quarter also made for unpleasant reading. There was no help to GDP from net exports, and the volume of stock holdings fell by £4.6bn when measured in 2005 prices.

What this all means is that the recovery in the level of GDP from six quarters of consecutive falls may be slow and protracted. A further slide in sterling cannot be ruled out as part of the necessary ingredient for recovery to become sustainable and, indeed, may actually be necessary. Yet another is further expansion of QE, which may be necessary to maintain a low cost of borrowing in an environment where public policy is likely to be unsupportive to growth as 2010 matures. My view is therefore that with election uncertainty ahead, the re-imposition of VAT to 17.5% and an increased propensity to save amongst households, interest rates have to remain at ½% but further QE may also be required when the current £200bn allocation is spent by February 2010.

What is the SMPC?
The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.


SMPC membership
The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Roger Bootle (Deloitte and Capital Economics Ltd), Tim Congdon (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.