Sunday, June 06, 2010
Four shadow MPC members vote for rate hike
Posted by David Smith at 09:00 AM
Category: Independently-submitted research

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by five votes to four to leave Bank Rate unchanged at ½% when the Bank of England’s rate setters announce their decision on Thursday 10th June. This narrow margin is the closest that the SMPC has come to advocating a rate rise for a long time. All four of the dissenters voted that Bank Rate should be raised by ½% to 1%.

There was no strong bias as to where rates should go in subsequent months, or whether Quantitative Easing (QE) needed to be re-activated. Some rate hawks believed that further rises beyond 1% would be necessary, although no-one was advocating a rapid return to the so called ‘neutral’ rate of 4½% to 5%. It was also believed that the authorities should be on standby to re-activate QE if the economy proved unexpectedly soggy.

There was widespread agreement among the members of the shadow committee that the fiscal situation inherited by the Conservative-Liberal coalition could not be sustained and risked placing unsupportable obligations on future generations – unless they chose to default at some stage. The 22nd June Budget and the autumn Comprehensive Spending Review would be crucial in setting out the fiscal parameters for the next half decade. Some members expressed concern that the UK was the wrong side of the Laffer curve, now that government spending was around 54% of the factor-cost measure of national output. One member presented a model simulation of the effects of raising Value Added Tax (VAT) to 20%.

This simulation suggested that such a move would leave government debt higher in ten year’s time, than leaving VAT unchanged, and that unemployment would be 231,000 higher and national output 1.3% lower with such a tax rise. It was suggested that the new Office for Budget Responsibility (OBR) should publish a series of such simulations using the HM Treasury model as a contribution to a more informed public debate.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold.
Bias: Towards ease, to help fiscal consolidation.

Since mid-2007 commercial banks’ claims on the private sector across the industrial world have been stagnant or falling. This was partly because of the closure of the wholesale inter-bank market, but is now increasingly because of the regulatory pressure for banks to raise their capital/asset ratios. Since claims on the private sector often represented over 90% of banks’ assets in mid-2007, the result has been stagnation or declines in the quantity of money broadly-defined, to include all bank deposits. The resulting squeeze on real money balances was powerful enough to cause the worst recession since the 1930s, particularly in the six months from September/October 2008.

The drop in interest rates to almost zero has mitigated the recession, with a fall in agents’ desired ratio of interest-bearing money to incomes deserving mention as well as the other beneficial effects on demand. Nevertheless, in both the USA and the Euro-zone broad money is now static at best, as it has of course been in Japan for almost twenty years. Indeed, in the Euro-zone structural flaws in the single currency arrangement have been made apparent by the post-2007 ending of the tendency for banks to grow their balance sheets exclusively by lending to the private sector. In theory, Euro-zone banks could continue to grow by acquiring claims on the state, but that is highly political, and begs many questions about the interaction between member states’ public finances and banking systems. Some of us were worried about these Euro-zone structural issues back in 1991 and 1992! Quantitative Easing (QE) type operations can restore a positive rate of money growth even if banks are losing claims on the private sector. So QE can stop any recession and I hope this is now consensus on the ‘Shadow’ and perhaps even on the actual Monetary Policy Committee (MPC). But it is not clear to me that economists in the USA, Europe and Japan understand the arguments here, an intellectual problem which reflects the wider neglect – apparently a global neglect – of traditional monetary economics in the current academic curriculum.

Strangely, given this difficult general background, the UK economy is doing quite well at present and the second quarter may even enjoy above-trend growth. Many industries are benefiting from the low pound, and over-indebted companies can get by with the very low interest rates. In operating terms (i.e., ignoring bad debts), the banks are profitable or very profitable. Also in the UK real money balances – measured properly – are now static or rising, rather than static or falling, and company money holdings and balance sheets are improving, if rather slowly. There is no need to change UK interest rates at present, while the immediate relatively good macro environment argues for no change in the Bank of England’s holdings of government paper (i.e., the stock of securities acquired by the QE operation). Strong action to reduce the budget deficit is essential on the grounds of fiscal solvency, while there is large body of evidence that this so-called ‘fiscal consolidation’ can be accompanied by above-trend growth. So my bias is for monetary policy to remain easy and so to ensure a benign macro setting for fiscal consolidation. The latest inflation numbers have been poor, but that reflects energy price movements rather than excess demand or some larger policy malaise.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate, maintain current £200bn of asset purchases.
Bias: Stand ready to reactivate QE in August to offset private sector de-leveraging.

The abrupt deceleration in money growth that started at the end of 2007 and in the early months of 2008 is now coming to an end and there are signs that monetary conditions may be stabilising. The monetary squeeze that precipitated the recession was dramatic. The magnitude of the monetary downturn has only been matched in recent times by the sharp slowdown of money growth in the wake of the Lawson bubble of the late 1980s, when M4 slowed from 18.4% year-on-year in January 1990 to 2.8% by April 1993. However on this occasion the downturn was more compressed in time: from peaks of 14.6% and 14.2% in 2006 and 2007 to 3.3% in April 2010 on the official M4 measure (though the official M4 data are distorted by the post-Lehman flight of funds from the capital markets to the banks that drove M4 up to 17.7% in February 2009). M4 data that exclude holdings of the financial sector show the steepest declines between the end of 2007 and the second half of 2009.

Whether monetary and credit growth can stabilise and accelerate over the next few quarters depends critically on whether private sector firms and households desire to repay debt, and in what quantities, and whether banks and other financial institutions are willing to start expanding their balance sheets (either by lending or by purchasing securities). Thanks to low interest rates the debt repayment process appears to be coming to an end in the household sector, but in the non-financial corporate sector bank loans are still being repaid. Thus total household borrowing (secured and unsecured) has been essentially unchanged since mid-2008, while bank borrowing by non-financial companies has declined 3.9% in the year to March 2010. For their part banks are still unwilling to expand their balance sheets. In combination this has translated into very slow rates of broad money growth of just 3.3% for both M4 and for M4 excluding balances held by OFCs in the years to April and March, respectively.

With money growth as low as 3%, and access to bank and non-bank credit still restricted, it is unlikely that the economy can resume a growth rate in line with its potential. This is no bad thing since households, businesses and financial companies had become over-leveraged, and they need to de-leverage by paying down debt, by raising capital, by restraining spending, and by raising savings. However, it does mean that economic growth will be constrained during this process.

The other major adjustment that must be made in the economy is to rein in the role of the state. Britain has had one of the largest increases in government spending as a fraction of GDP of any country in the OECD in the past decade as the ratio has risen from 36.6% of GDP in 2000 to 44% before the recession, and an estimated 53% in 2010. In addition, the public sector’s share of employment surged over the decade. While total workforce jobs increased from 28.4 million in 1997 to a peak of 31.66 million in 2008 Q2, an increase of 11.4% over the period, public sector employment increased from 6.55 million to almost 8.3 million, an increase of 26.7%. This has taken public sector employment from around 22.8% of the labour force in 1997-98 to 27% today.

The agreement between the Conservative-Liberal Democrat coalition partners to tackle the budget deficit as their first priority is to be welcomed - provided the solution is not simply tax increases. After all, the problem is not the deficit per se, but the extended period of excessive growth of government expenditure. Moreover, the creation of the Office of Budget Responsibility (OBR) by the coalition government should help to promote more impartial assessment and scrutiny of the public finances, and should also help to reduce the tendency of recent Chancellors to overestimate nominal GDP growth and tax revenues, and hence to allow expenditures to balloon.

In the meantime the Bank of England needs to continue to promote a recovery of the banking sector and the business and household sectors more generally by keeping interest rates low, while standing ready to step in with further asset purchases if further de-leveraging threatens to tighten monetary conditions once more.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold.
Bias: Unchanged Bank Rate and no extension of QE for the foreseeable future.

The first quarter UK GDP figure was, as expected, revised up to 0.3% reflecting the better March manufacturing output data. The increase in GDP was more than accounted for by the reduction in destocking. Elsewhere in the accounts private consumption spending (household and non-profit institutions) and net exports both fell (exports were disappointingly flat whilst imports increased), whereas fixed investment showed a surprising increase and general government spending also rose. Whilst this outcome for the first quarter is hardly a ringing endorsement of a robust recovery, business surveys suggest that conditions for the services and manufacturing sectors are continuing to improve. It must also be noted that January’s ‘big freeze’ dampened economic activity.

Consumer Price Index (CPI) inflation increased to 3.7% in April, well above the Bank’s 2% target and the previously targeted RPIX jumped to 5.4%, nearly 3% above its old 2½% target. Whilst the changes to the rate of Value Added Tax (VAT) partly explain above-target inflation, and the 11% inflation rate of the ‘transport’ component of the CPI (which includes the much reported increase in fuel prices) contributes to the higher aggregate rate, there are disquieting signs of other inflationary pressures picking up. How much of this can be accounted for by the depreciating currency and how much by companies in the UK supply chain fattening up their margins is difficult to say. But the concern must be whether these up-ticks in prices inflation will translate into higher inflation expectations and, crucially, upward pressure on wage settlements. The next Bank/Gfk NOP inflation survey is released in June. But a recent Citi/YouGov poll showed median expectations of inflation for the year ahead had jumped to 2.8% in April, the highest since October 2008. Earnings inflation (excluding bonuses) however remains subdued.

The coalition government has got off to a good start with the recently announced £6.2bn savings to the bloated, wasteful public sector for the current financial year. The notion, much trumpeted by the previous government ahead of the election, that these ‘Tory cuts’ (which represent less than 1% of total public spending) would derail the recovery was misleading in the extreme. But the cuts are just a start in getting a grip on the public finances. The Institute of Fiscal Studies estimates that they represent less than a tenth of the required ‘repair work’. All eyes will be on the 22nd June Budget for further information on the planned fiscal tightening and on this autumn’s Comprehensive Spending Review for departmental details for the fiscal years 2011/12 to 2013/14.

In the meantime, UK government debt is, ironically, in the happy position of being treated as a ‘safe haven’ from the raging Euro-storm. But such is the chaos in EU policy-making circles as they struggle to sustain the increasingly unsustainable Euro-zone. Turning to monetary policy, the higher inflation figures cannot be ignored. But I remain reasonably sanguine that inflationary pressures will remain contained without drastic monetary tightening in forthcoming months – especially in the context of the expected fiscal tightening. Bank Rate should be held at ½% and there should be no extension of QE for the foreseeable future.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%.
Bias: Increase QE by £50bn over the next quarter.

I do not believe that interest rate cuts provide material monetary stimulus all the way down to zero. For technical reasons I believe that a rate closer to 1.5% represents a true ‘zero’ for quantitative purposes. I also do not believe that it is necessary for interest rates to be lower than that when engaging in QE. Because of the extraordinary circumstances of late 2008 and early 2009, monetary authorities around the world decided to cut beyond standard notions of the minimum, so as to provide the market with signals at to their willingness to do all that was necessary to restore liquidity and confidence. Over the past few months we have had a window of opportunity to raise rates up to the normal minimum levels - somewhere in the 1.5% to 2% range. That window may soon shut, if events in the Euro-zone lead to further banking problems or other financial disruption. This could well be the last MPC meeting for some time at which it could be feasible to raise rates. The opportunity should be taken. That would then provide some modest scope to cut rates later in the year should such signals be necessary.

I am less convinced of the usefulness of raising rates as a signal of willingness to combat inflation. I do not accept the argument that this is necessary to preserve the credibility of the inflation target. The UK's inflation targeting framework already has almost no credibility - when was the last time a monetary policy decision in the UK was constrained by the need to keep CPI inflation between 1% and 3% whilst favouring the middle of that band? That framework was largely abandoned in early 2007, and the failure to raise the inflation target in 2008 led to such extreme and sustained violation of the target that credibility is gone. Inflation targeting is a framework in which annual targets are set. That is its purpose, and its annual nature is its key advantage over price-level targeting. If you are not going to raise the inflation target in years when you clearly do not hope to meet it (e.g. 2008) then you are not targeting the level you pretend to.

Furthermore, inflation will fall rapidly in due course. Underlying monetary pressures are deflationary still, and wage inflation is actually dangerously low. The risk of falling into outright wage deflation, with the result that households default on their mortgages imposing further problems on the banking sector, is still high. I also still anticipate at least one further quarter of modest contraction in GDP this year. There will be a significant rise in inflation, but that will come later, in 2012. The only measures we could take now to forestall the events of 2012 would be too dangerous in terms of the risk of deflation in the short term.

The above factors suggest that there is a case for further expansion in QE. That case is strengthened when one recognises the scale of the fiscal consolidation necessary in the UK over the next few years, probably a tightening of some £100bn. At the same time, in order to reduce the risk of failed gilt auctions if the sovereign debt crisis in the Euro-zone should spread further, there would again be some technical advantages in raising short-term interest rates. I therefore recommend that we raise interest rates by ½%, with a view to raising them again to 1½% if the opportunity arises, and at the same time expand QE by a further £50bn with a view to an eventual total of a further £200bn more QE.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold.
Bias: To raise.

So far the news from the UK’s unusual coalition has been good. The tackling of the massive deficit has taken pride of place, with both parties pledging to bring it under control in the lifetime of this Parliament. Growth could well halve the deficit anyway as revenues recover. Then when one considers that existing spending, if not increased, would fall by around 5% of GDP simply because of the growth in GDP, it becomes apparent that an expenditure freeze in real terms - difficult as even that is - will achieve much of the necessary reduction. Unfortunately, these calculations are inherently uncertain at present. The first issue is whether ‘potential GDP’ has fallen in line with actual GDP; past experience in oil and commodity crises suggests it probably has because available capacity is reduced by higher oil and commodity prices as uneconomic to operate. If so, growth in GDP will not include the ‘catch-up’ from lost productive potential. Over the next five years, average growth could be as little as 1.0%.

The second issue is the extent of revenue responsiveness. High salaries, profits and luxury consumption are very revenue rich. The collapse of revenues is due to the collapse of these elements. Their revival is likely to be slow in line with slow growth. The third issue is the extent to which services such as health and education have to be protected. Such ‘protection’ is undefined. These services are subject to demands that are in principle ‘infinite’, as being free at the point of delivery demand cannot be rationed by price and yet the ‘needs’ are huge and growing with both technology and social expectations. How far it will prove possible to restrain them in the interests of economy is quite unpredictable in a modern democracy. So fiscal policy is in uncharted waters; but the encouraging thing is that the coalition is so far agreed with little dissent on the priority of bringing down the deficit whatever it takes.

Against this background monetary policy faces difficult judgements. Credit growth has all but stopped. Equity prices have been falling in recent weeks, as the euro-zone crisis has intensified; so the equity market will seem less and less attractive as a source of finance. Inflation has been driven upwards by strong commodity prices. Central banks have lent massively against a variety of assets which sit unhappily on their balance sheets, reminding them that inflation could yet be unleashed were they to be used by banks for a massive rise in credit. Yet for all these difficulties, monetary policy since the Lehman crisis exploded has done well, braving the dangers of excessive lending with the consciousness of credit famine. As long as this famine continues, keeping interest rates close to zero and lending against wide collateral will remain the right thing to do, particularly with the fiscal retrenchment now spreading around the world.

With the environment still highly volatile, no threat of inflation visible, fiscal retrenchment starting, and credit growth on its back, I remain in favour of continued close-to-zero interest rates in the near term; the Bank should remain ready to resume QE if the economy threatens to lurch back into recession. However, my expectation is that the current nervousness will dissipate and that recovery will remain assured; thus I retain a bias to raise interest rates modestly over the next six months.

Comment by Peter Spencer
(University of York)
Vote: Hold.
Bias: Neutral.

Recent developments have seriously complicated the Sisyphean task facing macroeconomic policymakers. The monetary data remain in the doldrums. The official output figures now appear to be catching up with the strong survey indicators, at least for manufacturing, but the economy remains fundamentally weak. The usual engines of domestic demand are in neutral or reverse gear, forcing us to look for exports and investment to propel the recovery. Consumer spending was flat during the first quarter. The main driver of growth was stocks, while government spending and investment gave one final heave. Despite the persistent weakness of sterling, net exports were once again a drag on the economy.

The new coalition government has embarked boldly upon the task of deficit reduction, despite the pre-election reservations of its Lib-Dem members about early cuts. The scale of this task is clearly daunting. Furthermore, it is hard to envisage an economic background that is less helpful. The counterparts to the government deficit include a massive company surplus (of the order of 8% of GDP) which is likely to reduce only very slowly. Business spending is unlikely to pick up strongly while the economic situation remains uncertain and productive resources remain underutilised.

Households were willing and able to borrow and spend freely after the last recession, helping to propel the recovery and bring down the deficit, but are not in a position to contribute very much this time. We are unlikely to see any ‘Ricardian’ offset to government spending cuts. Indeed it would be hard to envisage a conjuncture that was less conducive to this outcome. Households are under pressure from the ‘globalisation of labour’, reflected in immigration, import competition and off-shoring, which affect the demand for skilled as well as unskilled labour. Before the credit crunch, UK households were able to resist these pressures and maintain the growth of spending by borrowing. They shot to the top of the G-7 borrowing league table between 2000 and 2007. Now of course it is a different story. Households that still have access to credit are weighed down with the debt of the previous decade.

The fall in the pound post-ERM meant that exports also helped the economy to recover while the government was retrenching. Yet European trade was growing rapidly then, spurred by the single market reforms. This time, our European markets have ground to a halt and the fiscal fissures opening up in the Euro-zone further reduce the chances of a successful export-led recovery. It will be hard for the coalition to achieve its stated objectives of deficit reduction and economic recovery against this background.

The problem facing monetary policy makers has now been complicated by the bounce-back in inflation. With CPI inflation remaining above the 3% threshold for a fourth consecutive month, the Governor of the Bank of England has written another letter of explanation. He argues that higher fuel prices, and the increase in VAT and the continued feed through of weak sterling are all combining to create upward pressure on inflation in the near term. He believes that the high margin of spare capacity will bear down on inflationary pressures in the second half of this year. I am inclined to that view myself but am beginning to have my doubts. Clearly, the exchange rate pass-through is proving to be more powerful than it was post-ERM. But is there something else at work?

In this situation I think monetary policy decisions must hang critically upon the labour market. If as I expect, the credibility of the inflation target continues to hold and wage settlements remain subdued then these inflationary pressures must eventually dissipate. Indeed, rising prices will further erode real incomes and spending, adding to the effect of government spending cuts. It will not be necessary to subdue inflation by tightening monetary policy in this case. However, if the financial markets or the public begin to question the credibility of the target and labour tries to resist the fall in living standards, then I would certainly vote to raise interest rates.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise by ½%.
Bias: Towards modest further increases in Bank Rate, but fiscal consolidation through spending cuts is the main priority.

Lady Thatcher once commented that the trouble with socialism is that sooner or later you run out of other people’s money to spend. That seems as fair a comment as any on the British fiscal experience of the past thirteen years. The internationally comparable statistics supplied by the Organisation for Economic Co-operation and Development (OECD) show that the share of general government expenditure in the market-price measure of UK GDP increased by 12.8 percentage points between 1997 and the part-forecast figure for this year and by no less than 16.8 percentage points after 2000 when ‘Prudence’ was done away with to make way for the hussy ‘Profligacy’. Despite the attempt of the previous Labour government to blame the fiscal crisis on irresponsible bankers, much of this rise had taken place before the global financial meltdown. Thus, the UK spending ratio was already 10.9 percentage points higher in 2008, when growth was still positive, than it had been in 2000, and it is wrong to regard the increased UK spending ratio as simply being an appropriate Keynesian response to the recession. The result is that Britain now has the fourth highest spending ratio of the twenty-eight OECD countries – it had been number twenty-two in 1997 and twenty-four in 2000 – and also the worst structural deficit. This is particularly apparent once it is understood that only the non-socialised private sector and foreign investors can absorb new government debt. Using OECD figures, the ratio of the cyclically-adjusted general government to non-socialised GDP in Britain will be the highest in the entire OECD area this year, at 21.2%, with the US coming in second highest at 15.9% and the OECD area as a whole having an imbalance of 6.6%. Back of the envelope calculations suggest that almost two-thirds of Britain’s structural deficit reflects Labour’s failure to control its costs and match the productivity improvement elsewhere in the economy.

The long-run effect of Mr Brown’s spending binge has probably been to slow the growth of UK productive potential to a Euro-sclerotic 1% to 1.5% each year. With government spending predicted to absorb 54% of the factor-cost measure of UK GDP this year, and real private domestic expenditure having fallen by 10.8% last year, the main need is to re-balance the economy by nurturing the private sector in the hope of generating a virtuous circle of increased activity, a faster growth of productive potential, and higher tax receipts from an unchanged tax structure or, even better, well crafted supply-side cuts. Now that the spending burden in Britain is over one half of GDP, the economy may be on the wrong side of the aggregate Laffer curve and any attempt by the Conservative-Liberal coalition to substantially tax their way out might easily lead to a worsened fiscal deficit as the private-sector tax base collapses and joblessness-related welfare costs rise.

To test whether this was the case a series of simulations were run on the Beacon Economic Forecasting (BEF) model to see which policy mix gave the best result over a ten-year horizon. The scenarios concerned incorporated policies such as a volume freeze on government expenditure, a rise in VAT to 20%, a £50bn public expenditure cut, and even a Greek-style scenario in which the government bond yield was fixed at 9.5% (the Greek figure at the time). Since there seems to be widespread political backing for a hike in VAT to 20%, it is worth emphasising that this simulation so damaged private activity that the government debt stock was higher in 2020 than if VAT had been left at 17.5%. Although the Budget deficit was 0.1 percentage points lower by 2020-21 with a 20% VAT, having been higher in the interim, this was at the cost of an extra 231,000 claimant count unemployed, a 1.3% reduction in national output, and a balance of payments deficit that was more adverse by 0.5% of GDP. The best buy amongst the scenarios considered was the £50bn spending cut simulation, followed up by across the board tax cuts a couple of years later, as the public finances started to improve. This aggressive spending consolidation maximised the virtuous circle effects and meant that extra private employment more than compensated for the loss of government jobs.

The second best buy was the ‘base run’ which essentially left the economy well alone and held the volume increase in government consumption spending at around 1¼%. This gradually floated the public finances off the rocks, and meant that the deficit was less than 3% of GDP by 2020-21. The worst ‘scenario’ on all measures of economic welfare was the one in which the government attempted to largely tax its way out. It would contribute to a more informed debate if the Office for Budget Responsibility (OBR) published comparable simulations using the HM Treasury model, which remains the OBR’s main forecasting tool.

An issue that may be discussed by future economic and political commentators is whether the Bank of England's quantitative easing programme allowed reckless government spending to continue without the usual adverse debt financing effects ahead of the May 2010 general election, buying enough seats for Labour to preclude a Conservative majority. This does not mean that QE was not justifiable on purely economic grounds – and the SMPC contained some of its earliest advocates – but rather that QE had unintended political-economy effects that benefitted the government of the day.

If inflation does not ease sharply over the next few months, the Bank could come under considerable criticism for its policies before the May election, especially as savers are presently losing one twentieth of the real purchasing power of their liquid assets each year. The acceleration in CPI inflation to 3.7% in April was bad enough but both the RPI and double-core RPI excluding all housing were up 5.3% on the year, and RPIX was up 5.4%, at a time when most liquid deposits are yielding 0.5% or less. The technical issue that underlies the Bank’s failure to anticipate higher inflation is to do with the relative power of the output gap as against the external value of sterling as influences on the UK price level. The Bank has effectively been betting that the domestic output gap is the dominant influence, rather than the exchange rate. However, it may be mistaken in so doing for the reasons set out in my May 2007 Economic Research Council publication Cracks in the Foundations?: A Review of the Role and Functions of the Bank of England After 10 years of Operational Independence (www.ercouncil.org). The Bank’s credibility as a politically independent inflation fighter is now on the line and an increase in Bank Rate to 1% should be its next action. Longer-term, it also needs to look hard at its forecasting model, particularly the relative power and speed of the output gap and exchange rate effects in its price relationships.

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

For the past six months, my vote has been for an immediate ½% increase in the Bank rate as an acknowledgement of the inflationary threat. This threat has matured, not receded, and now the OECD has broken official ranks to advocate a steep adjustment to UK interest rates (to 3½%) by the end of next year. The MPC appears to have misjudged the degree of inflationary pressures in the UK over the past two years and its forecast of inflation made a year ago was woefully inaccurate. Even if inflation outcomes were to abate in the coming year, the much-vaunted rise in the rate of VAT to 20% would add approximately 100 basis points to the CPI in the first year of its introduction. I would not rule out a 22% rate of VAT within 3 years.

At the heart of the UK inflation debate is a misunderstanding of the character of the global downturn triggered in mid-2007 in the US sub-prime mortgage context. Whereas the recession of 1990 to 1992 was induced by a dramatic tightening of UK policy to confront an overheating economy and property markets, the current slump was brought about by a rupture in the credit markets. The effect of monetary policies, here and elsewhere, had been to prolong the credit boom not to curtail it. Whereas the policy tightening in 1989-90 damaged the demand outlook and weakened domestic pricing power, the 2007 market-based tightening had its primary impact on supply capability and has strengthened the pricing power of the surviving companies. By virtue of the 25% depreciation of Sterling over the past three years, the UK economy has traded a better outlook for the real economy with a poorer one for inflation.

There has been a strange reluctance to acknowledge the bright prospects for real economic recovery this year. The normalisation of corporate expenditures is progressing apace in a host of countries around the world and the latest data for UK GDP in 2010 Q1 provides encouraging support for this thesis. UK corporate expenditures (investment and inventories) accounted for approximately 0.6 percentage points of improvement in Q1. There was no net contribution from consumption and a negative offset from trade, to yield a 0.3% estimate for GDP.

There are good reasons to expect this figure to be revised significantly upwards. The 2.3% monthly jump in manufacturing output and the revival of average earnings in February and March all support the proposition that a phase of rapid economic growth has begun. The strong medicine of emergency low interest rates has long ceased to be appropriate

An upward drift in inflationary expectations and investor concerns, evidenced by the outperformance of UK index linked bonds as compared to conventional bonds of matching maturities, will become progressively difficult and costly to address. UK bank depositors are becoming increasingly impatient with rock-bottom savings rates: the average rate of interest on time deposits rose to 0.75% for April. Banks and building societies are being forced to offer better rates to hold on to their deposit base. The whole structure of market rates is climbing higher. An increase in Bank Rate, initially to 1%, is more than justified by the UK inflationary outlook.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Raise by ½%.
Bias: To hold.

What a mess Britain’s monetary and fiscal policy is in! CPI inflation is nearly twice the Bank of England’s 2% target, and has been above target for the fourth month in succession, while the RPI is over twice the MPC’s original target level of 2.5%. Yet Bank Rate policy has ignored this, remaining at only ½%. The fiscal deficit is expected to be £163bn in 2010, or 11.6% of GDP, yet immediate cuts of £6bn are being greeted with horror despite only reducing the deficit by 3.7%, and being only 0.04% of GDP, well within the measurement error of GDP. Total government debt has almost doubled in the last three years and is projected to be above 80% of GDP.

Some simple calculations illustrate the order of magnitude of the options for eliminating the budget deficit. At one extreme of no growth, expenditures must be cut by 11.6% of GDP or roughly 24%. As in the last ten years tax revenues increased by approximately the same percentage as nominal GDP, at the other extreme of constant nominal expenditures, roughly a 30% growth in GDP is required to generate the necessary tax revenues. If output growth is 3% per annum then this would take just over nine years. As this is far too long, a mixture of expenditure cuts and higher taxes is required. For example, in order to eliminate the deficit in three years given a growth rate of 3%, government expenditures would need to be cut by 16%, still huge. George Osborne has suggested an 80:20 split between cutting expenditures and raising taxes. This implies an average tax rate increase of 2.4% of GDP and cut in expenditures of 10%. Such a tax increase would require a 9 pence in the pound rise in the average rate of income tax or a doubling in the rate of VAT. Ouch!

The UK is not alone in having an unsustainable fiscal stance. The US and several Euro-zone countries are in a similar position. With the exception of Greece, the UK’s situation is, however, the worst. The only advantage the UK has over Euro-zone countries is that it has an independent monetary policy and a flexible exchange rate. As the ECB targets average Euro-zone inflation, member countries, having given up their monetary and exchange rate policy instruments, must use fiscal policy to control both deviations of inflation from the Euro-zone average and their economic activity.

Why have monetary and fiscal policy in the UK been allowed to depart so far from what is sustainable? The answer is not palatable and has been couched in more socially acceptable terms, such as the need to maintain levels of employment. The real answer is so that the country can continue to spend more than it can afford. In the case of the public sector, it is so that expenditures can continue to exceed the public’s willingness to finance them with their taxes. In effect, we are financing our excess in public expenditures over revenues by steadily increasing our borrowing. This can only be at the expense of future private sector consumption by us and - not a morally comfortable position - future generations.

The justification for the current stance on monetary policy can no longer rest on saving the banks or providing them with the liquidity to lend. Nor can it be to stimulate demand in order to control inflation, as inflation is already too high. The dominant view at the Bank of England seems to be that the increase in inflation is temporary and that the low level of economic activity in the next year or two will bring inflation back to target. The increase in inflation has, however, been due, not to demand, but to supply-side factors (especially oil prices), tax increases and a falling exchange rate, induced by low interest rates and market concerns about government debt. Responding to supply-side inflationary pressures is trickier than to demand-side forces: whereas inflation rises due to positive demand and negative supply shocks, output rises due to the demand shock but falls due to the supply shock.

Normally, the correct response in these circumstances is to raise interest rates. This would cause an appreciation in the exchange rate and reduce the costs of imported oil. It would also reduce exports, which would slow economic recovery. The choice facing the Bank, therefore, is whether to give priority to controlling inflation in the short term, or to aid economic growth in the longer term. Given the Bank’s remit, it should raise interest rates. Just as the £6bn worth of fiscal cuts is little more than a signal to the markets that the UK intends to deal with its fiscal problems, a small interest rate rise would be a signal that the UK intends to continue to anchor inflation, and hence inflation expectations.

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.