Sunday, April 04, 2010
IEA's shadow MPC votes 7-2 to hold Bank rate
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 seven votes to two to leave Bank Rate unchanged at its present ½% when the Bank of England’s rate setters meet on Thursday 8th April. The two dissenters both voted that Bank Rate should be raised to 1%, while recognising that any such rate change was unlikely so close to a general election.

There was a widespread agreement amongst the SMPC membership that the 24th March Budget had not made the fiscal backdrop to monetary policy significantly worse than it was already. However, there was more debate as to whether high government spending and the large fiscal deficit provided a useful support for private sector activity or, alternatively, was crowding out the non-socialised sector of the economy and exacerbating the recession. Some SMPC members thought that, in the absence of the detail provided by the urgently required Comprehensive Spending Review, the government’s commitment to enhanced spending discipline in the future was no more than an unrealisable paper promise.

There was also debate among the shadow committee as to whether Quantitative Easing (QE) should be resumed after the forthcoming election. Here, views were also mixed. Five members thought that the economy remained so weak that a resumption of QE probably would be required while two thought that the authorities should stand by to re-introduce QE, even if it was not needed immediately.

Two members of the shadow committee preferred to wait and see whether QE should be resumed or not. There was, however, a widespread acceptance that the uncertainties were such that the optimal course was to respond flexibly to events as they arose. The fact that this was a pre-election period made it difficult for the Bank of England to take any politically controversial steps until the election was out of the way and more was known about the post-electoral fiscal background.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate at ½% and maintain current £200bn QE target.
Bias: Be prepared to re-activate QE in May to offset private sector de-leveraging.

The process by which a bubble first inflates and then deflates is crucial to understanding what role monetary and fiscal policy must now play in the recovery of the British economy. Bubbles begin with the gearing up of balance sheets in the private sector, either in the household sector, in the non-financial corporate sector, or in the financial sector itself, or in some combination of these three. In the latest credit and housing bubble that burst in 2007 and 2008 it has been the household and financial sectors that took on most debt, whereas in the tech-bubble that peaked in 2000 it was the non-financial corporate sector that took on most debt.

In modern, democratic states that have an implicit or explicit commitment to maintain full employment, the bursting of the bubble in the private sector and the associated unwinding of leverage by the private sector is invariably countered by the leveraging up of the government’s balance sheet as the authorities step in to offset the decline in private sector spending with an increase in state spending. The problem is that this invariably occurs just as tax revenues collapse due to the recession, exacerbating the increase in the budget deficit and the national debt. The extent of the expansion of the government’s balance sheet via budget deficits and increases in the national debt, and the duration of that expansion will depend on the starting conditions. In the current instance of the unwinding of the UK’s 2001 to 2008 credit and housing bubble, leverage in both the household and financial sectors reached new records: the ratio of household debt to disposable income reached a new high of 173.6% in 2008 Q1 (up from 106.6% in 2000), while leverage in the financial sector – measured as total debt to GDP - reached 961% (up from 619% in 2002). These extreme starting conditions imply a steeper and longer increase in government indebtedness to compensate for the likely de-leveraging in the private sector.

However, eventually the government must also de-leverage. The key question is whether the government can do this pro-actively, or whether it must remain largely passive, responding to changes in the private sector’s balance sheets and spending. This is at the centre of political and economic debate in the UK today. A pro-active stance would imply taking measures to accelerate balance sheet repair in the private sector, rapidly reducing government spending, and perhaps also lowering taxes in order to encourage the maximum response from the private sector. A passive stance would call for the government to reduce its spending and borrowing only once the private sector’s balance sheets had been repaired sufficiently for household and business spending to resume a more normal rate of growth, and then to withdraw government spending or close the deficit pari passu with the recovery of activity in the private sector (and the recovery of government tax revenues).

The role of monetary policy in this process is conditional on the private sector’s appetite to borrow. In a modern economy money is created when private commercial banks grant credit to private agents, facilitated by the provision of reserve or high-powered money by the central bank. The problem in the UK today - and elsewhere in many developed, western economies - is that due to the prior over-leveraging of private sector balance sheets, there is almost no appetite to borrow (in aggregate), and hence monetary policy is unable to play its normal role of providing new credit and simultaneously expanding the stock of broad money in the economy. This is why broad money growth rates in the UK and across the developed world are currently all close to zero, and in some cases negative (e.g. Spain -2.5%, Ireland -4.4%). Until private sector balance sheets have been de-leveraged and the appetite to borrow has begun to return, it makes no sense for monetary policy to be tightened. On the contrary, monetary policy needs to keep short-term policy rates at the lowest possible levels that will assist private sector balance sheet repair. To prevent the de-leveraging process from causing a monetary contraction (as in the US in 1930 to 1933) it may be desirable for the Bank of England to continue with asset purchases under its QE scheme. However, the precise magnitude of the QE purchases is essentially a judgement call, not something that can be calculated in advance – it all depends how much households and financial institutions wish to de-gear their balance sheets.

In this context the decisions in the March 24th budget to insist on Royal Bank of Scotland and Lloyds/HBOS extending £94bn (gross) in new business loans ‘over the next year’ - nearly half to small- and medium-sized enterprises (SMEs) - and to set up a credit adjudication mechanism to assess banks’ lending decisions upon appeal are both ill-judged, and fly in the face of the evident desire of banks, businesses and households to de-leverage. Pressuring banks or their customers to gear up again prematurely will only accelerate the onset of the next financial crisis.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold.
Bias: Further expansion of QE and unchanged Bank Rate.

A recovery of sorts appears to be happening – even though a ‘double dip’ cannot be totally discounted. GDP for the fourth quarter of 2009 is now estimated to have been 0.4% higher than the previous quarter and a not dissimilar rate of increase may be expected for 2010 Q1. The annual inflation rate in the Consumer Price Index (CPI) spiked in January to 3.5%, broadly reflecting base effects caused by distortions twelve-months previously, but slipped back to 3.0% in February. Given the very weak earnings inflation figures, there seems to be little prospect of a ‘wage-price’ spiral developing and, as such, the fears of a significant pick-up in inflation seem to be overdone. Money supply growth remains weak and lending to households and businesses has also remained subdued, reflecting both demand and supply factors.

The growth outlook generally looks far from buoyant. The Budget GDP forecast of 1% to 1½% for 2010 looks reasonable but the marginally downwards revised growth figure of 3% to 3½% for 2011 still looks very optimistic. Fiscally, the 2010 Budget was a ‘do-little’ affair. It was mildly expansionary for financial year 2010-11 and very modestly contractionary for 2011-12 and 2012-13. The marginal downward revisions to the borrowing projections did nothing to distract attention from the truly awful state of the public finances. Further increases in gilt yields, and other market rates, can be expected. The trade figures do not seem to have benefited significantly from the weak pound yet – but with the recoveries in Britain’s main export markets still uncertain this is not surprising. There is no need for an imminent increase in Bank Rate or indeed for more QE at present. However, further QE should not be ruled out if the economic recovery appears to be stalling.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold.
Bias: To hold both Bank Rate and QE at their present levels.

It will be appropriate to have additional QE once we have a serious fiscal consolidation package in place, for fiscal consolidations are most likely to promote growth in the short-term if they can be combined with monetary expansions. However, as the Budget has not provided us with an adequate or early fiscal consolidation, we should hold off on additional QE for now. QE will presumably begin again one way or another shortly after the election as the pair of fiscal consolidation. That is either if: 1) the election result is decisive and empowers a serious consolidation; or 2) as a counter to a bond market panic if the election result is indecisive or unduly empowers those opposing serious consolidation.

In the meantime, evidence of a double-dip recession continues to mount, with the reversals in house prices and mortgage lending being another example. I am still inclined to expect that there was a modicum of growth in the first quarter with the double dip coming in the second and perhaps also third quarters of this year, before solid growth commences in 2010 Q4. Policymakers should not be panicked by this. Solid growth in 2011 at the sort of rate predicted by the Bank of England and Treasury is likely, but the result will probably be inflation.

One form panic should not take is that of over-reliance upon expectations concerning exports and then a precipitate downgrading of those expectations if the Euro-zone and US disappoint. All countries in the developed world cannot expect to have export-led recoveries at the same time. The key to growth in 2011 is more likely to be investment.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold.
Bias: Hold and extend QE by £50bn.

There is much loose talk about exit strategies, pausing QE and even raising interest rates. There were posters during the second world war that said ‘Loose talk sinks ships’. Loose talk of raising interest rates may not sink the economy but policy that follows such advice will certainly prolong the recession. It is fashionable to compare the current great recession with the Great Depression of the 1930s. There are indeed some similarities. The shape and depth of the recession matches that of 1930 to 1931. Interest rates fell to ½% by mid 1932 and remained there until 1938. Output reached its 1929 peak in 1934 and the real effective exchange rate had depreciated by 18% over the same period. Although world trade never recovered to what it was in 1929, exports had risen by 53% in the seven years to 1939. This was all done without the benefit of QE, which raises the question do we need QE at all? The answer is a most resounding yes. The fragility of the banking system and the level of indebtedness would have resulted in an even worse downturn than that of the 1930s if not for QE.

Clearly QE has not had the expected effect of stimulating domestic demand: business investment remains weak; household indebtedness continues to stifle consumer spending, and M4X grows at an annual rate of around 1%. But QE has influenced expectations. The sterling effective exchange rate, at 25% below its peak, has placed the export sector in a good position to exploit a recovery in the world economy. As in the 1930s, domestic demand will follow the external sector, not the other way round. The inflationary consequences of a weak sterling are overplayed. There remains considerable slack in the economy. QE should be resumed and increased to £250bn and interest rates be kept on hold.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold.
Bias: Hold and extend QE.

Now that economies virtually everywhere have been recovering for some months, the question is what to do post-crisis. For some, like Ireland, Iceland and Latvia, there is little option but severe and immediate public sector retrenchment. For most, however, there is a choice. On the fiscal side, this is between cuts (or tax rises) immediately or later and larger ones spread over a long period. On the monetary side, the decision is between the continued printing of money or the cessation and even reversal of QE. In fact, this is one of those periods when the ‘independence’ of central banks, that is their authority to set interest rates and decide on the extent of money printing, is a disadvantage for the economy, which needs at present careful coordination of monetary and fiscal policy.

In the UK it is obvious that there is no possibility of continuing with budget deficits of some 13% of GDP, which is the present prospect if no further action is taken. We cannot delude ourselves that rapid resumed growth will lead to a rapid return of the previous revenue streams. Growth in most forecasts, ours included, is projected as slow. In our view there is a good reason: the continuing shortage of oil and raw materials worldwide prevents rapid growth for the world as a whole. Since emerging market economies are continuing to grow rapidly, that pro tanto restricts the growth possibilities in countries such as the UK, the US and other developed countries. We are already seeing inflation spread into China and other emerging countries, forcing a tightening of policy. It seems likely that this tightening will be enough to restrain world growth to rates that will not push commodity prices much higher. So, even the fast-growing world economies are being forced to limit their growth ambitions. As for us, we are achieving recovery but hardly enthusiastic growth. All this will only change when innovation in raw material use has freed up net world supplies.

Fortunately, the flexibility of the UK labour market has restricted the jobs fallout. Unemployment has peaked below 8% (just over 5% on the benefit-claimant measure) as people have opted for wage freezes or cuts and shorter hours - so there is underemployment but not the disaster of double-digit unemployment rates. But this environment is one in which tax revenues will not recover much and in which the demands for public spending will continue. Time will tell how big the ‘structural deficit’ - that will emerge once the recovery is complete - may be. But policymakers cannot wait until this is better known. The need in the 24th March Budget was to produce a five-year public sector adjustment plan. Two things should have guided this plan: keeping taxes down and competitive, so that growth and innovation resumed, and restoring efficiency in public spending.

To begin with the latter, this government unleashed a massive surge in public spending from 2000, raising it by 8% of GDP before the crisis raised it by more again. Everyone knew that without reform and gradual increases, such money would be wasted; there was no practical way to spend such vast sums without raising wages and wasting money on speculative projects. Productivity in the public sector duly slumped and public sector remuneration including pensions has surged past the private sector where market forces suggest pay should be higher to reflect greater insecurity. To reduce public spending back to where it started in 2000 as a share of GDP (at around 36%) would require it to grow in real terms by about 16% less than real GDP over the next five years. Since total GDP growth over that period is likely to be about 10% that means that spending must be cut by about 1% a year in real terms. This is a feasible target. The Treasury under Gordon Brown became a brute instrument of spending increase. Oddly, this was somewhat against the protests of some departments worrying about wasteful effects. The Treasury was never traditionally like this - very much the opposite, a place from which wringing money was like getting blood from stones. It should be returned to its traditional function of restraint. Treasury control, old-style, is the best instrument for forcing departments to find the economies they privately know they can make.

Now, let us consider taxation. Already increased taxes, and stealth taxation in particular, had become the soft default option under this government. By the mid-2000s, the top marginal rate of tax including all imposts, whether on wages or consumption, had reached 60% (see my Agenda for Tax Reform’, Centre for Policy Studies (CPS), 2006), the average tax rate was 40% and the marginal tax rate on the average person 43%. Now that the explicit top rate of income tax has gone over 50%, the top rate has gone up to around 67%. So far, and for the average worker, not much has changed since the mid-2000s. However, further rises in tax rates from these levels are not an option and indeed they must be cut, for two reasons.

The first reason concerns the ‘Laffer Curve’ which computes the extra revenue raised for every rise in the marginal tax rate. This curve reaches a peak at some fairly moderate marginal tax rate because of the effect on effort and tax evasion. All informed observers, including the Institute of Fiscal Studies (IFS), which is generally in favour of higher taxes and redistribution, agree that the 50% new top tax rate will not increase revenue and will probably lower it for this reason.

The second reason concerns growth. Growth comes from the innovative activities of entrepreneurs, who are extremely sensitive to marginal tax rates because their activities are risky and any gains uncertain; the more these are taxed the less the expected return and if this drops below some threshold they will not bother at all. Estimates of the effects on growth of marginal tax rates are for obvious reasons uncertain; but the sort of effect that comes out of empirical studies is an elasticity of one third, i.e. for every 10% reduction in tax growth would rise by 3% (e.g. a reduction of the marginal tax rate from 40% to 36% would raise growth from 2.5% to 2.58%). This effect seems small but it accumulates into something large. So in short we need both to make the fiscal adjustment on the spending side by reviving old-style Treasury control and then quickly bring our tax system back into the land of reasonable incentives, following that up with reforms ‘flattening’ the marginal tax rates across the economy and income groups.

This fiscal adjustment, however gradually brought about, is going to be a fairly grim process and it will dampen growth further. It will require the efforts of the monetary authorities to support the economy through it, without pushing inflation over the target. At present bank credit is not expanding, whereas a growing economy requires bank credit growth usually of twice or more times the GDP growth rate. The Bank is keeping interest rates low but has suspended the printing of money through QE, even though bank credit growth has not responded. But it may well need to restart it. This is something we will need to watch. If, as seems likely, inflation falls back to well below the target and the economy falters under fiscal retrenchment, the Bank will need to take steps to get the broad money supply growing again. As I have noted before, other channels for money appear to be working in substitution - equity and corporate bonds issues have been substantial recently. So liquidity may turn out adequate even without credit growth revival. Therefore, and in the present circumstances, I recommend both keeping interest rates where they are and a return to QE unless credit growth revives or there is other evidence of adequate liquidity such as continued strength in equities and low yields on financial instruments such as corporate bonds.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold.
Bias: Neutral for Bank Rate; resume QE if collapse in monetary growth continues.

The latest available data for the US, the Euro Area and the UK indicate that the growth of broad money has collapsed. The Federal Reserve in the US stopped publishing figures for M3 broad money in February 2006 but, according to Lombard Street Research’s reconstructed series, US M3 actually declined by 1.9% during the year ending in February. What is worse, the annualised rate of decline was 3.8% in the last six month and 5.7% in the latest three months, which indicate that the fall was accelerating. In the Euro-zone, the comparable data were a fall of 0.4% during last year, a fall at the rate of 1.0% in the last six months but a rise at a rate of 0.8% in the last three months. In the UK, M4X rose by 0.6% over the past year, fell at an annual rate of 2.4% in the last six months and declined at an annual rate of 1.0% in the last three months. Fluctuations in monetary growth that last for six months or less can be ignored as insignificant but the collapse has lasted longer than this. The overall picture is beginning to become alarming.

People and firms that are short of money may cut back on expenditure on goods and services or sell assets. Because financial markets can react more quickly than the economy, the impact on asset prices usually occurs before that on economic activity, in which case a fall in asset prices is confirmation of the squeeze and a warning of the coming impact on activity. This is not likely to happen this time because professional investors have observed that the response to QE after it was announced in March 2009 was a rapid rise in assets prices. Currently, speculators are unlikely to sell assets because they will be afraid that a resumption of QE would catch them out. The conclusion is that the decision on whether or not to resume QE should be based on current data for the money supply.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1% and maintain QE pause.
Bias: Neutral but monetary policy will remain problematic without fiscal consolidation.

The 24th March Budget that was allegedly crafted by the spin-master Lord Mandelson, albeit delivered by Mr Darling, was designed to provide Labour with a plausible public relations narrative ahead of the election, without doing anything so crassly damaging that it provoked a run on the pound or a collapse in the government bond market. In this limited and purely factional aim it appears to have succeeded, leaving the outcome of the forthcoming general election surprisingly open. The fact that the Budget did not significantly worsen the pre-existing dire fiscal situation, or make it noticeably even less worthwhile for physical, human, and financial capital to remain in the UK, were its only saving graces. Some government borrowing undershoot compared to last year’s Pre-Budget Report predictions in 2009-10, when Public Sector Net Borrowing is now estimated to have been £166.5bn, has been a feature of the Beacon Economic Forecasting (BEF) model-based predictions for some time. However, the same projections also suggested that borrowing would rise to just over £200bn in fiscal 2010-11 and not reach a peak until 2012-13, before starting to ease, rather than the fall to £163.2bn in 2010-11 and £131bn in 2011-12 that the 2010 Budget documents predict. Two reasons why borrowing is likely to overshoot this year’s Budget forecasts are that: 1) economic growth is likely to be somewhat less this year than the Budget predicted and noticeably slower in 2011 and 2012; and 2) the implied official forecast that general government expenditure will account for 53¾% of the factor cost measure of GDP in 2009-10 and 54% in 2010-11 means that the non-socialised tax base is too small to supply the needed revenues. In 2010-11, for example, total current receipts are expected to be equivalent to 89½% of the residual element of factor-cost GDP after government spending has been subtracted. A third, and shorter-term factor, is that the prospect of the 50p higher tax band – which represents an effective rate of 56¼% once employers’ national insurance contributions are allowed for – and ill-founded rumours of a higher rate of capital gains tax encouraged wealthy individuals to declare income and gains in 2009-10 rather than 2010-11, leaving a corresponding gap in next year’s finances.

The really massive black hole at the heart of the Budget, however, was the absence of any detailed and credible plan to achieve its government spending targets, which assume that the volume of general government current expenditure will fall by 1.4% in 2011 and 2.1% in 2012, after having grown by 1.3% this year. Even more dramatic reductions are projected for general government gross fixed capital formation, where the 16.5% increase recorded in 2009 is predicted to be followed by a volume drop of 2.5% this year, 19% next year, and 8.5% in 2012. In the deliberate absence of the overdue Comprehensive Spending Review, setting out where these cuts will fall, these figures are as worthless as Bernie Madoff’s assurance that your money is safe with him. There has recently been a rather unworldly debate amongst academic economists as to whether it is better to commence fiscal retrenchment immediately or wait until the economy recovers. This ignores the two immense practical problems that face any attempt to rein in government spending. The first ‘Sir-Humphrey’ difficulty is that the vested interests concerned are so powerful that a government that tries for a £20bn spending reduction is lucky if it achieves a £2bn cut rather than an absolute increase. The second ‘oil-tanker’ problem is that it is very difficult to alter government spending in the short term, especially when a new government takes office part way through the fiscal year. The upshot is that if one wants, say, a £10bn reduction in two years’ time, the most effective tactic is probably to demand a £50bn cut immediately.

As it stands, the evidence that has been gleaned by applied economists by-and-large suggests that a properly designed and aggressive fiscal consolidation program that concentrates on reducing government current expenditure - but not raising taxes or cutting government investment - stabilises the budget position and leads to an unexpected surge in output and employment. It is extremely unfortunate that this substantial body of research has not found its way into the political debate, possibly because of the intellectual weakness of the opposition. The four main types of evidence concerned are: 1) cross-section studies using annual-averaged data for a sample of countries or sometimes regions; 2) the more modern panel data studies that utilise mixed cross section and time series data; 3) econometric equations using time series for one country, and simulations on macro-economic forecasting models; and 4) the evidence from the ‘fiscal stabilisation’ literature that has been published by international bodies such as the European Commission and the Organisation for Economic Co-operation and Development (OECD). On balance, this literature suggests that high government spending and borrowing levels seriously crowd out private economic activity and ‘real’ jobs, making the recession worse, not better. This directly contradicts the government’s assertion that its big-spending policies have somehow saved the economy, a claim that has never been backed with any form of empirical evidence.

It is unlikely that the Bank of England will want to change Bank Rate or re-instate QE so close to the general election that is likely to be held on 6th May. However, under normal circumstances a rise in Bank Rate to 1% would be desirable. In part, this is to convince speculators that shorting sterling is not a one way bet but also because the current ½% Bank Rate is still substantially below inflation. Fortunately, the annual increase in the ‘double-core’ retail price index (RPI) which excluded both mortgage rates and house prices eased from 4.9% in January to 4.4% in February, while the target CPI inflation rate eased from 3.5% to 3.0%. In the longer term, UK inflation will depend on the relative and currently divergent effects of the weak exchange rate and the large negative domestic output gap, in a situation where international inflation pressures are likely to remain subdued because of the spare capacity still available and the sluggish growth of OECD broad money. On balance, UK inflation looks as if it will be tending to undershoot its target late this year and in 2011 and 2012, but only if sterling remains reasonably stable from now on.

There is also a clear element of political risk where sterling assets are concerned. The foreign exchange markets are presently giving Britain the benefit of the doubt and assuming that the Conservatives will form the next government and prove as tough and capable as Lady Thatcher was in the 1980s. A Labour victory, a hung Parliament, or a minority Conservative government that ran scared of the public spending lobbies could all invoke a rush for the exits. However, Britain’s relatively sluggish broad money growth, if M4X is considered to be the appropriate measure, could help strengthen the currency in the very long run. Unless there is a serious and credible fiscal consolidation, however, the UK monetary authorities will be batting on an extremely sticky wicket for the foreseeable future. The Bank is also open to the charge that one of the unintended consequences of QE has been to allow the present government to run its feckless spending policies for longer than would have been possible otherwise, with the result that the Monetary Policy Committee (MPC) has bankrolled a cynical and unsustainable pre-election spending spree and hence meddled in the political process. On balance, the latest BEF predictions do not suggest that this charge will prove justifiable. However, the Bank’s reputation is now uncomfortably on the line and could suffer if inflation took off and/or sterling plummeted.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%; re-instate QE at £25bn per quarter.
Bias: To raise Bank Rate.

Last September, the UK economy embarked on a path of erratic improvement that should be expected to extend at least until the spring of 2011. There are grounds for believing that the expansion in the nominal economy will be quite vigorous this year, but the susceptibility to reversal will not easily be dispelled. Uncertainty over the outcome of the impending General Election has contributed materially to the hesitancy of the economy in recent months. Regardless of the outcome, the election of a new government constitutes the removal of this excuse. On the principle that the cancellation of a negative is a positive, the UK has a unique opportunity to develop a far more constructive mood in business and individual life and to project much greater confidence internationally. The potential for a near-term positive economic surprise is much greater than is popularly imagined.

The March 24th Budget confirmed that worst-case outcomes for tax receipts have not been validated by the data. The upward revision of VAT receipts by £2.8bn for the current fiscal year, relative to the November Pre-Budget Report, is a welcome sign that nominal expenditures are recovering. Retail sales values for February 2010 registered a 5.3% gain over a year earlier. In combination with brought-forward tax liabilities of financial sector companies and their employees, the outturn for public sector net borrowing has dropped to £166.5bn. Further improvement in the fiscal outlook can be expected as thousands of employees return to more usual weekly working hours after the extraordinary curtailments of the past year and the additional disruptions of a severe winter. This should result in lower public expenditure on entitlements to tax credits and benefits. In summary, irrespective of the policy measures, the budget deficit should be expected to fall faster than the consensus expects.

UK monetary policy remains mired in official doubts over the sustainability of the economic recovery. Fearful of relapse, the MPC is likely to remain much too accommodative this year. When, in February, ten-year gilt yields surged 25 basis points in a week, members of the MPC were queuing up to deny that the policy of quantitative easing had necessarily ceased. The February Inflation Report contained no new thinking concerning the inflationary threat and this leaves the UK as one of the most exposed developed nations to medium-term inflation risk. The weakness of sterling may well be reversed after the uncertainty of the election outcome is passed. However, a weak currency is a much greater liability to inflation control as a result of global credit and financial crisis. We continue to expect a much more serious pass-through of currency depreciation into UK consumer price inflation in 2010 and 2011, under the assumption of unchanged Bank Rate this year. However, sterling, like the UK economy itself, is not a basket case. The UK has a severely under-performing economy with the scope for substantial improvement. Weak sterling is our opportunity not our obituary. My vote is to reiterate a preference for a 1% Bank Rate, with the flexibility to extend the Asset Purchase Facility (QE) during the period of greatest pressure of primary gilt issuance.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: Hold Bank Rate at ½% and ease monetary conditions via QE.

It may appear on the surface that the economy is on an uninterrupted trajectory towards recovery following the rise of 0.4% in GDP in the final quarter of last year. However, such a view would be a mistake. True, alongside a rise in GDP there have been increases in manufacturing and services Purchasing Managers’ Indices (PMIs) to well above 50, the level that signifies growth in output. Even the monthly growth in money supply, which has been flat or negative, appears to have stabilised. Meanwhile, retail sales figures for February jumped by over 2% and financial markets, notably equities and bond markets, appear to be dealing remarkably well with the cessation of Bank of England purchases of gilts and other bonds. Indeed, the economic and financial market performance in the UK since that decision seems to have vindicated it, as the economy appears to be performing perfectly well without QE. On top of all of this, house prices remain stable, albeit no longer rising as quickly, and the rise in price inflation has meant that the APF decision, arguably, was taken at just the right time. And unemployment seems to be once again on a downward path, as shown by the sharp drop in February.

But a bias to ease monetary policy still is required, in my view, along with a Bank Rate of ½%. One reason is that the recovery is still very weak. A rise of 0.4% in GDP after a peak to trough fall of 6.3% is hardly stirring stuff. Moreover, the previous downward revision in GDP during 2009 was almost sufficient to offset the fourth quarter gain. With an annual fall in 2009 GDP of 4.9%, and assuming that trend growth in 2008 and 2009 would have been about 2¾% a year on official measures (I think that trend growth is probably around 2% to 2¼% at present), UK economic growth is presently likely to be 10% below its potential in 2010. Even assuming capacity scrapping of 3% or so would still leave a negative output gap of 7%. Since the labour market still appears flexible, the weaker pound should not translate into permanently higher domestic price inflation and so the bias of monetary policy should be to ease, until economic growth is at least looking like it will get back to trend, whatever that is now.

Yet another reason for concern is that recovery is very fragile. Take the 32,000 fall in claimant count unemployment for February; on closer examination the bad news was that employment fell. The fall in unemployment was entirely down to people leaving the labour force because they could not get work. Retail sales are another example; though there was rise in February of over 2% in the total including fuel, the January figures were revised down. It will now take a rise of more than 1.8% in volume retail sales in March just to prevent retail spending from lowering GDP in Q1. Such a rise seems unlikely, meaning that after a fall in the saving ratio in 2009 Q4, it may be rising once again in the first quarter of this year. A sign of this is that money supply is still not rising quickly enough to be consistent with sustained growth in GDP, as bank debt continues to be repaid by the UK private sector. For these reasons, and more, Bank Rate must be held and QE is very likely to be required. The 24th March Budget clearly showed that monetary policy may have to act as a counter-weight to what is likely to be a draconian spending round later in 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.