Sunday, February 28, 2010
Shadow MPC votes 6-3 to hold rates
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 six votes to three to leave Bank Rate unchanged at its present ½% on Thursday 4th March. The three dissenters, in contrast, all voted to raise Bank Rate to 1%.

This reflected their concern that the adverse fiscal background had damaged the economy’s supply side so extensively that it left the monetary authority facing a helplessly malign output/inflation trade off. Both SMPC hawks and doves agreed that the recent UK output data had been disappointingly weak and that there was a serious risk of a renewed downturn in activity. The disagreement was whether this was primarily a demand-side problem, perhaps associated with the slow growth of M4X broad money, or a supply-side malaise caused by the 16.8 percentage point rise in the government spending ratio since 2000 and the mass of new regulations that has been introduced.

There was also debate among the shadow committee as to whether Quantitative Easing (QE) should be resumed, now that the initially intended £200bn schedule had been completed in February. Here, views were mixed. Some ‘holds’ were happy to maintain the QE pause for the foreseeable future, while others thought that the authorities should be prepared to re-introduce QE at any moment, particularly if the growth of M4X remained sluggish.

One advocate of a 1% Bank Rate also wanted to re-instate QE of £25bn per quarter, while another hawk was prepared to wait and see, and a third wanted some rolling back of the £200bn already committed. There was a general agreement that the uncertainties about the future course of the economy were such that strongly entrenched views were inappropriate. The fact that this was a pre-election period also rendered fiscal and monetary policy making problematic. This was because the time horizon of senior politicians was now less than the lag between cause and effect when policy settings were altered.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold.
Bias: Hold for the time being. Use funding policy to sustain money growth.

The current flare-up in inflation is temporary and reflects the large rise in energy prices in the last six to nine months - as Saudi Arabia has re-asserted its control of the oil price in an improving international environment – together with the continued follow-through effects from the pound’s devaluation in late 2008. Money growth remains disappointingly weak, although Quantitative Easing (QE) added probably about 10% to the January 2010 level of M4. Until money creation by means of banks credit to the private sector shows definite signs of reviving (and it does not at present), policy-makers must err on the side of ease in their interest rate decisions. Keep base rate at ½% for the time being.

I have two main policy recommendations on the structure of policy-making. The aim must be to ensure that the quantity of money continues to grow despite the pressures from regulators, asset price weakness and so on. First, suppose that the contraction in banks’ risk assets has a few years still to run. Then the state – either the government or the central bank (or both working together) – must conduct its own financial transactions so that increases in its borrowings from the banking system sustain banks’ balance sheet totals and replace their reduced claims on the private sector. The UK’s QE experiment is an example of what can be done. However, the deliberate monetisation of public debt by the government (i.e. with the initiative being taken in the Treasury) should also be considered. The 1985 full funding rule is apparently still causing trouble.

Secondly, decisions about financial regulation and the management of the public debt have monetary effects. Financial regulation and debt management therefore need to be integrated with monetary policy decision-making. Because of the necessary interdependence of these aspects of public policy, the notion of ‘central-bank independence’ can be over-interpreted. Central banks must work with finance ministries and regulatory agencies on public debt management and banking regulation, just as finance ministries and regulatory agencies must work with central banks on the monetary consequences of public debt management and banking regulation.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Prepare to resume QE to offset private sector de-leveraging.

The risk markets – including equities, commodities, and high yield/commodity linked currencies – have all suffered a significant sell-off since the start of 2010. The apparent triggers for the sell-off have included: (1) the measures threatened by the Obama administration against the banks; (2) the tightening measures in China that threaten to curtail credit growth in the one region where money and credit has been buoyant, and (3) the rising sovereign risk problems of the peripheral Euro-zone economies. All of these are plausible reasons for the sell-off, but are no more than superficial explanations.

There are deeper reasons for the current malaise. In particular, just as the start of the credit crisis in August 2007 was triggered by a prior period of six months of near zero growth in money and credit, so the current sell-off comes after an extended period of pronounced weakness in both money and credit both within and outside the banking system. The mini-inflation surge evident in Consumer Price Index (CPI) movements around the world is highly misleading in this context. The underlying prices trend is very weak once the commodity-related and tax factors are removed.

In the US, M2 broad money growth has slowed abruptly since September 2009, falling from an annual 10.5% in January 2009 to 6% in November and just 1.9% by mid-January 2010. At the same time, bank credit has declined continuously since October 2008 and on a year-on-year basis since September 2009. It would be unprecedented if such low rates of money and credit growth could co-exist with rising rates of inflation for any sustained length of time. It is more likely that the current inflation episode - which is based on a statistical echo of the weakness of commodities and other items in late 2008 and early 2009 - will fade away within three to six months, to be replaced by substantially lower inflation rates, or even some risk of deflation.

In the Euro-zone, money and credit growth has also been exceptionally weak, with M3 declining by 0.6% in December, while loans to households and non-financial corporations fell by 0.2%. These negative growth rates are without precedent in the Euro-zone or its predecessor economies. They imply severe weakness in spending and the risk of widespread deflation if continued. Japanese broad money (defined as M2 plus Certificates of Deposit) increased by a yearly 3.1% in December, while bank lending declined by 1.2%. The clearest evidence of risk aversion is the banks’ vigorous purchases of securities, such as Japanese Government Bonds. In September, these increased by 32.1% year-on-year and in December they were still increasing at 19.3%. While Japan has occasionally experienced more risk-averse behaviour by the banks in the past decade, these numbers clearly show another shift towards caution.

Finally, money and bank credit in the UK continue to show only very weak growth. The latest data for M4 show a sharp slowdown to a 5.3% increase year-on-year, while money held by households and non-financial companies (M4X) continues to drift along at 1% to 2% p.a. As in Japan, de-leveraging by the private sector is more than counter-balancing the attempts by the authorities to expand money and credit via QE. Again, this is in no way compatible with any sustained acceleration of inflation, irrespective of what happens to sterling. Against this backdrop, the authorities should prepare for a decidedly weak recovery and the risk of deflation in 2011.

Outside the banking system, the shrinkage - or very weak growth - of credit continues. The balance sheets of the main organisations that financed the credit and housing bubble during the last decade - the investment banks and the shadow banks - continue to contract. Based on US data for the third quarter of 2009, the combined balance-sheet total for broker dealers and shadow banks exceeds M2 broad money so these magnitudes are not trivial. In particular, two specific forms of non-bank credit that were aggressively employed during the credit bubble - commercial paper and repurchase agreements - have continued to decline.

Commercial paper has contracted by 51% since it peaked at $2.2 trillion in July 2007, declining to $1.09 trillion at the end of January. This decline has occurred despite the US Federal Reserve’s overt support for the commercial paper market in the wake of the Reserve Primary Fund ‘breaking the buck’ and triggering a run on other money market funds in September 2008. Repurchase agreements were (and are) a key source of funding for investment banks. At their peak, just before the credit bubble burst, outstanding repurchases were running at $5.4 trillion, a figure that has now declined to $2.4 trillion. None of these funding operations shows any sign of resurgence. The conclusion is that the international credit squeeze continues, even if interest rates are very low.

At the end of 2008, commodity prices - including oil, petrol and other elements of the US, UK and Euro-zone CPIs - plunged steeply, and UK VAT was cut from 17.5% to 15%. With the end of the post-Lehman panic, commodity prices bounced back after March 2009, prompting a smaller bounce-back in consumer prices. It is this bounce-back that has been reflected in the recent rise in year-on-year CPI figures around the developed world. However, this rebound will soon terminate as oil and other commodity prices stabilise or decline again, and the more heavily weighted components such as housing and services come to dominate the trend in the CPI. The housing component of the US CPI peaked in July 2008 and has been on a downward trend subsequently. The money and credit trends discussed above suggest that commodity prices are likely to weaken in the months ahead. Consequently, the recent year-on-year jump in the CPI will rapidly evaporate, leaving the trend inflation rate far below the Monetary Policy Committee’s (MPC’s) target.

The legacy of over-indebtedness from the credit and housing bubble will result in a prolonged period of balance sheet repair that is incompatible with any strong bounce-back in real GDP, or consumer or business spending in the leading developed economies. The latest UK and US GDP data for 2009 Q4 confirm this view. In the UK case, GDP growth was just 0.1% in the fourth quarter according to the preliminary figures. In the US, the advance 5.7% annualised rate for 2009 Q4 was mainly due to a reduced inventory rundown, while domestic final sales growth (excluding inventory changes) slowed to 1.7% in the fourth quarter from 2.2% in the third. Without money or credit expansion, the growth of spending or economic activity will depend primarily on income growth which is likely to be weak in 2010. There is no case for a rise in interest rates or an end to QE any time soon.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold.
Bias: To maintain QE pause for now.

The British economy appears to be heading for a double dip recession, mirroring the pattern across much of Europe. I expect this second dip to be a mild and fairly short-lived affair - perhaps a couple of quarters of contractions of less than half a point of GDP. Unemployment is likely to rise considerably, as labour hoarding schemes are surrendered once businesses and workers realise that recovery will not be rapid.

Inflation is above target at the time of writing, which makes policy management difficult, but on a year-to eighteen-month perspective the real threat is deflation. Monetary and lending growth are both weak. Perhaps most dangerously, total employee compensation is down well over 5% from its peak and has been shrinking further during the latter half of 2009 - and this despite unemployment not rising much, reflecting widespread private sector wage freezes and cuts. Households have been struggling through because their other income (e.g. benefits) has risen and their costs (e.g. mortgages) have fallen. These cost reductions cannot be sustained indefinitely, and without nominal wage growth the risk of widespread defaulting on debts driving further financial sector problems will lie continuously just beyond the horizon.

After the election, there will be a ferocious fiscal tightening, unprecedented for nearly a century. Such fiscal consolidations are least damaging to growth if they can be combined with monetary loosening. There will be a need for further QE to commence perhaps later on this year and perhaps to be sustained through 2011 (at least). This will eventually drive a significant spike in inflation. That is not desirable, but the deflationary alternative - falling nominal wages; failing banks; sovereign default - is much worse. Policy should aim to deliver mainly upside inflation risk and very low deflation risk. So, QE will return, but not yet.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold.
Bias: Neutral for Bank rate; stand ready to resume QE.

With the MPC deciding to pause, the initial program of QE has ended. A second program will most probably be needed. What are the lessons from the first valid for the second? I was one of the early advocates of QE. I was alarmed by the collapse in monetary growth, more precisely in M4X (M4 less intermediate OFCs) and, in particular, by the actual fall in the deposits of non-financial corporations in 2008. The primary aim of QE was to boost these monetary aggregates. The principle mechanism was to inject money directly into the economy, by-passing the banking system, as described by Mervyn King in his BBC interview of 5th March 2009. Some argued that the aim was to boost bank reserves, in the expectation that this would lead to banks increasing lending. I argued that reliance should not be placed on this for two reasons. First, it was unlikely to be successful; whilst a horse can be lead to a trough, it cannot be made to drink. Second, the focus should be on monetary growth and not on bank lending. One of the reasons for this is that money is normally quite like the hot potato of the children’s game. Whereas one person can pass it to another the group as a whole cannot get rid of it. Money normally stays in the system and has a continuing effect whereas bank lending has a one-off effect.

In the event, much of the money injected by QE was got rid of. When the Bank of England bought gilt-edged stock, the sellers of the stock received £200bn. A substantial amount of this was spent on new issues by banks, which destroyed the money. Some was spent subscribing to new issues of corporate bonds, the money being destroyed when the corporations issuing the bonds repaid bank loans. Other money may have gone abroad or have been switched into foreign currencies. None of these was the main aim of QE but all were desirable. As far as the first two are concerned, banks and non-financial corporations needed to strengthen their balance sheets. The third may have been one of the reasons why sterling fell, which was desirable because it will in due course stimulate the economy by boosting exports and import substitution. These are successes of QE and not failures.

The more worrying impact of QE was the way in which the money has been spent on assets rather than on goods and services. Normally, money staying in the system percolates after a while through from the one to the other. Little if any of the percolation has happened. The main impact has so far been on asset prices. Some economists have argued that the rise since March has been ‘almost miraculous’. On the contrary it has been more or less precisely in accordance with the liquidity theory of asset prices. What did these economists expect the people who sold gilts to the Bank to do with the money? Was reinvestment not anticipated? Did they not realise that this would raise asset prices? In the event the bears had to run for cover, which raised prices further. The demand for money as a medium for holding savings then fell as perceived risk of loss on equities, etc., fell as the bear market changed to a bull market.

The main direct beneficiaries of QE are the holders of assets, including banks. Banks profits have rebounded. It is particularly galling to see bankers being paid bonuses resulting not from their own expertise and efforts but because of QE financed by tax payers. This leads to the thought that tax payers would have enjoyed the profits if the Bank had bought equities rather than gilts. As it is, the Bank’s program of £200bn purchases of gilts has driven up gilts prices and there is an obvious danger that the Bank will make a loss when it disposes of the medium and long-dated stock it has bought under QE. Another criticism of QE is that a second round might lead to a bubble in asset prices. This danger is in the future rather than current because UK asset prices are at present probably fully-valued rather than over-valued. Asset prices are likely to fall in the coming months not because they are over-valued but because of a general lack of liquidity resulting from the collapse in monetary growth in both the US and European Union; sluggish growth in the UK, and reduced surplus savings from China as the authorities there tighten policy. A second leg of the UK recession appears likely and the first sign of this is likely to be a fall in asset prices, with financial markets reacting, as usual, more quickly than the real economy. Perceived risk of loss is then likely to rise again. Put another way, the current level of asset prices is not firmly based on an increase in the supply of money but on a fall in the demand for money that could suddenly reverse.

Overall QE has played a vital role in arresting the collapse in asset prices and stopping a serious recession from turning into a depression. The gain vastly exceeds the costs. The authorities should pay close attention to the behaviour of asset prices in the coming months. If there is a substantial fall exceptional circumstances will warrant exceptional measures. The Bank should stand ready to purchase equities, employing several fund managers rather than choosing the investments itself.

Comment by Peter Spencer
(University of York)
Vote: Hold.
Bias: To resume the QE programme.

The economy remains very weak. The fourth-quarter GDP headline figure was disappointing, although this is likely to be revised up in line with more recent output data. With CPI inflation back in letter-writing territory at 3.5% in January, there have been concerns that the UK is in for a period of stagflation. The key theme of the minutes from the January MPC meeting was uncertainty, and in particular the wide spectrum of risks to inflation. However, I believe that the inflation risks are overdone and that with fiscal policy tightening, economic growth should remain the focus of monetary policy. I think that it was probably a mistake to suspend the QE programme and would be inclined to resume asset purchases at an early stage.

I do not share the view that inflation is resurgent. The increase in CPI inflation over the last two months is largely due to VAT and base effects arising from falling petrol prices last year. These upward pressures are short-term in nature. Significantly, RPIY - which excludes indirect taxes like VAT - showed a big decline in January. This suggests that underlying price pressures are weakening. Wage pressures remain very subdued and the weak recovery will leave a large overhang of spare capacity bearing down on inflation. I expect the CPI to fall back below target by the end of the year.

The monetary figures are still extremely depressed and with the QE programme abeyant I expect them to remain so. Banks and their borrowers remain very risk averse. Money and credit growth are unlikely to return to normal until banks rebuild their balance sheets, and with revenues being siphoned off into bonuses as they recover, this could take the best part of the decade. In the meantime, the customer funding gap remains as large as ever, despite the increase in personal savings. Moreover, the banks will have to use increases in private sector deposits to repay the funds raised through the Special Liquidity Scheme (SLS) by 2012 and under the Credit Guarantee Scheme (CGS) by 2014. These obligations amount to about £300bn and are in addition to the large outstanding loans to overseas banks.

Against this bleak fiscal and monetary background I would have continued to buy assets under the Asset Protection Scheme (APS). Fortunately, the MPC has left the door open for further asset purchases. I think the downside risks to the economy make it likely that these will resume later in the year.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate by ½% and maintain QE pause.
Bias: Wait and see; fiscal consolidation necessary to maintain monetary credibility.

The normal practice when writing text books or designing student courses in economics is to put monetary policy, public finance, regulation, and the determinants of aggregate supply into separate and self-contained compartments and not to bother about the feedbacks between the four. However, the economy is a holistic organism. The potential self-reinforcing feedbacks between these policy areas can have more significant consequences than what is happening within each one, especially when mutually inconsistent policies are being pursued by the authorities concerned. The high degree of specialisation in modern economics and the fact that macroeconomic model building has fallen out of favour mean that it is now unusual for economists to take a necessarily rough-and-ready top down view of the system as a whole, rather than concentrating in Pre-Raphaelite fashion on the microscopic details of a small canvas. There is now a serious policy inconsistency between the regulators’ desire to impose restrictions on the banks - restrictions that will inevitably lead to cut backs in the supplies of money and credit - and the simultaneous use of QE to prop up broad money. No threat of new financial regulation until the economy recovers and no QE either would be a more sensible option. At present, it looks as if the Bank of England’s initiatives to stimulate the economy will be nullified by the actions of officials elsewhere.

The same consideration applies to fiscal policy. One reason for attacking Gordon Brown’s post-2000 spending blow out is that the trade-offs facing the central bank deteriorate sharply as the share of government expenditure in national output increases beyond its optimal level of 35%, or so – the sort of numbers seen in Australia, Switzerland and London and South-Eastern England. One reason is that monetary policy can only operate on the private sector and ever coarser proportionate adjustments have to be forced onto it as the private sector takes a diminishing share of GDP. Another is that managing disinflation in the labour market without generating mass unemployment becomes more difficult as welfare benefits and relatively high wages in government employment provide a floor below which nominal private earnings cannot fall, even if this is necessary to equilibrate the labour market. This is a particular issue in some of the cheaper and less productive areas of the country, where central and local government are the dominant employers. A third reason is that the growth of aggregate supply tends to slow down as the share of public spending in national output increases, meaning that more of any given monetary stimulus appears as inflation and less as higher activity. Finally, large budget deficits both lead to funding problems and can undermine the credibility of the monetary authority as well as the fiscal one, including in the foreign exchange markets.

Recent UK economic indicators suggest that a decade’s worth of fiscal incontinence has now led to a permanent structural deterioration in the economy’s supply side and its ability to generate real private sector jobs. The acceleration in annual CPI inflation from 2.9% in December to 3.5% in January has been much commented on. Less attention has been paid to the fact that the double-core Retail Price Index, which excludes both mortgage interest payments and implied house prices and is the most consistently defined historic inflation measure, accelerated from 4.1% to 4.9%. The UK’s trade deficit on goods and services also deteriorated from £8.1bn to £9.5bn between the third and fourth quarters, when the deficit was the largest since the third quarter of 2008. This provides another indicator that the UK has an unhealthy balance between aggregate demand and aggregate supply, even at present low levels of activity. Total GDP is a somewhat misleading measure of economic activity, now that more than one half of national output is in the government sector, particularly as imports and welfare benefits act as important swing factors to offset movements in private sector activity. During the first three quarters of last year, Britain’s real GDP fell by 5.4% but real private domestic expenditure – defined as non-welfare financed consumption, private investment and stock building – plummeted by no less than 11.7%. The unexpected 0.4% drop in M4X in December, took the annual growth rate down to a mere 1.1%, according to the Bank’s calculation, and caused a ¼% reduction in the previous Beacon Economic Forecasting prediction for the average UK growth rate this year, which now stands at 1.1%, followed by 2.7% next year and 2.8% in 2012. With the annual growth of broad money in the OECD area also slowing progressively from 8.2% in the first quarter of last year to 6.9% in the second quarter, 5.7% in the third and 3.6% in the final quarter, global monetary aggregates are clearly not behaving as central bankers desire.

The US$64,000 question is what the Bank of England should do under these circumstances where the costs of any policy error are likely to be far higher than they would be in an economy with a lower government spending burden and a more responsible fiscal stance – Britain has the largest structural Budget deficit in the entire OECD area. The Bank was right to pause with QE, presumably until after the General Election, while leaving open the option of reviving it if activity takes a turn for the worse. The main regret is that Bank Rate was not raised to 1% at the same time. In practice, Bank Rate is now likely to remain on hold until after the election. However, it would enhance the MPC’s reputation for political neutrality if it went up by ½% in March and this is my recommendation. (Editorial note: David B Smith has recently written an empirical paper Money Still Matters – the Implications of M4X for Quantitative Easing, which examines the links between QE and broad money in more detail. This will shortly be downloadable from

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Raise Bank Rate by ½%.
Bias: Hold/achieve 1% Bank Rate. QE should not be resumed and should start being reversed soon.

The dilemma facing monetary policy is getting worse. The Bank’s original justification for a ½% interest rate was that the economy needed to be stimulated in order that inflation would be high enough to meet its 2% target. This helped increase the demand for private-sector loans but the banks were unwilling to lend. QE was begun in order to provide the banks with the necessary liquidity to provide the additional demand for loans, but instead the banks used this liquidity almost entirely to rebuild their balance sheets. Even the government-‘owned’ banks like the Royal Bank of Scotland group, when faced with two conflicting government instructions – to rebuild their balance sheets and to increase lending – decided on the former. Thus, both conventional and unconventional monetary policy failed. To add to these woes, inflation has now exceeded the permitted upper limit, mainly due to supply factors. Given the Bank’s remit is to control inflation, the case for continuing a loose monetary policy is now threadbare.

The government is concerned about output and employment and so, despite entering the recession with an unsustainably loose fiscal policy, it has allowed the fiscal deficit and national debt to reach unprecedented heights. Given that the government shows no intention to do anything about this, it must continue to hope that the Bank does not tighten monetary policy, especially as it would increase the cost of servicing national debt and worsen the fiscal deficit if the Bank raised interest rates.

So the dilemma for the Bank is whether to keep strictly to its remit by tightening monetary policy (and giving up QE), or to ignore its remit (and the evidence on the lack of success of QE) and support the other objectives of the government.

According to the Bank of England Act of 1997, which gave independence to the Bank, it should only support the other objectives of the government subject to achieving its inflation remit. The implication is clear: the Bank should tighten monetary policy. I would therefore support an interest rate of 1% and a start to winding down QE with a view to restoring nominal interest rates to a more sustainable long-run level. This implies that it becomes even more urgent to get to grips with the fiscal deficit. None of this would be palatable to a government shortly to seek re-election. This is the price for the government not acting much sooner. What is more important: the economy or getting the government re-elected?

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ½%; reinstate QE at £25bn per quarter.
Bias: To raise Bank Rate.

The first release of GDP at current prices for the final quarter of 2009 should confirm that a recovery of nominal spending and income has been underway since the spring of last year. Using timely, but incomplete, data there is every reason to believe this to be true. The value of manufacturing output rose 4.7% between January and December last year, with 5.5% predicted for the annual gain to January 2010. Retail sales value (excluding automotive fuel) rose by 3.7% in the year to January, up from a low of minus 1.9% last May. For non-store retailing, the annual growth was 17.8%. There is an abundance of evidence that the UK’s deflationary panic is over. Extremely slack settings of monetary and fiscal policy, in combination with an accumulation of sterling weakness since mid-2007, are indeed delivering a robust nominal recovery.

If there are grounds for disappointment in the response of the UK economy, these rest with the weak initial estimates of real growth and the contrasting strength of the inflation readings. The reaction of the Bank of England in the latest Inflation Report has been to disregard these inflationary tendencies as temporary and self-correcting, while reiterating their expectation of a phase of rapid real GDP growth. Our analysis suggests that this is a mistaken comprehension of the situation, with the inflation risks skewed heavily to the upside. Abstracting from the rollercoaster effects in the annual inflation data, the compound rate of inflation over the previous two years has risen from 1.5% last April to 1.9% for the headline retail price index; from 2.8% last April to 3.5% for the old inflation target, RPIX; and from 1.4% last January to 3.1% for our composite private sector good and services (ex-fuel and light) measure.

The MPC’s decision to suspend the Asset Purchase Facility in February cannot be rationally construed as a counter-inflation response. Rather, its suspension should be interpreted as a warning to the Treasury that the Bank does not stand ready to finance indefinite laxity in the public finances. However, this is an odd decision to take three months before the likely date of a general election. The chances of forcing additional fiscal tightening during an election campaign must be regarded as slim in the extreme. Consequently, the suspension of QE has been greeted with dismay in the gilt-edged market with UK benchmark yields rising by 25 basis points in the week to 19th February, much more than any in other government bond market, bar Greece. A neutral course of action in February would have been the extension of QE at its prevailing rate of £25bn per quarter. The increase in gilt yields is considered to include an inflation uncertainty premium that relates to the future financing of the UK’s budget deficit.

A much clearer and consistent policy action would have been to raise Bank Rate to 1% from its longstanding ½% rate. This would warn borrowers that the emergency rate settings were no longer appropriate. Even at a 2% Bank Rate, UK real interest rates would be negative this year, on average. If the Bank wishes to defend its inflation target and assert influence over inflation expectations, then a rise in Bank Rate is the only sensible approach. The transmission from different amounts of asset purchase to the inflation objective is far too vague to constitute a coherent policy response. Finally, the renewed weakness of the broad monetary aggregates is a reminder that the rehabilitation of normal banking activity is still some way off. Eagerness and ability to repay bank loans by corporations and financial institutions is likely to weigh upon the aggregate data for a few months to come, but steady M4 growth of 5% to 10% per annum should resume later in the year. Slowing monetary growth should not be viewed as a distress signal in these extraordinary circumstances.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: Ease further via an extra £50bn of QE, taking stock to £250bn

My arguments for a continued ½% Bank Rate and bias for further monetary easing via further QE are straightforward. The UK economy barely grew at all in 2009 Q4, when it expanded by just 0.1%. This figure compares with the 5.7% annualised growth reported in the US and 1.1% in Japan, which we are led to believe has more serious problems than the UK. Although the UK's fourth-quarter growth rate is similar to that of the Euro-zone in the same period, it ignores the fact that the Euro-zone has already had two quarters of positive economic growth prior to the fourth quarter slowdown to just a 0.1% expansion. Indeed, this slowdown in Euro-zone growth itself is a cause for concern for UK growth prospects, as it implies that net exports will be even less likely to offset the weakness of domestic demand.

In this context, a weak sterling exchange rate might not be enough to boost exports, as the Continent is the destination for over 50% of UK exports. Moreover, UK firms seem to be raising export prices in line with the fall in the value of the pound, perhaps in order to benefit from a lower currency by allowing profit margins to improve at a time when domestic margins are being squeezed by weak domestic demand. The implication in the February Inflation Report is that GDP growth will be revised up to 0.7% for 2009 Q4 in due course, with a projection of 3% growth by the end of 2010 and a similar rate during 2011, the upper end of independent forecasts. However, the likelihood of significant upward revisions to fourth quarter UK GDP at the current time seems unlikely, based on the data that is currently available. Unemployment is starting to rise again, with the January 2010 increase (along with revisions to preceding numbers) alone reversing the falls recorded in the final quarter of last year. The volume of retail sales also fell by 1.8% in January. Money supply growth is dropping. And whilst manufacturing output is no longer falling, the level of output remains very depressed.

This is precisely why price inflation seems unlikely to be a serious concern in the medium term - although it is clear that UK price inflation is higher than in similar developed economies, perhaps due to a weaker exchange rate. Wage inflation is still flat, up 0.8% in the three months to December at an annual rate. There is plentiful spare capacity in the economy, even though some of the lost output may never be brought back on stream. With fiscal tightening yet to take effect, and overseas growth weakening in our biggest export market, the UK economy faces a stiff challenge in the quarters ahead. For all of these reasons, UK economic growth will likely be very modest this year in the context of the fall last year, so in my view justifying further monetary easing. Otherwise, the inflation target will be significantly undershot in the medium term, with higher unemployment and more lost output than necessary.

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.