Sunday, July 04, 2010
Shadow MPC votes 7-2 for rate hold
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 seven votes to two to leave Bank Rate unchanged at ½% when the Bank of England’s rate setters announce their next rate decision on Thursday 8th July. The two dissenters both voted that Bank Rate should be raised 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. This was largely because of the uncertainties involved.

Two particular unknowns were: firstly, the extent to which the problems in the Euro-zone would impinge on the British economy and the government’s funding costs; and, second, the extent to which over-enthusiastic financial regulation at either the G-20 or domestic levels might cause an implosion of money and credit as commercial banks were forced to re-engineer their balance sheets.

The SMPC contains several well-known fiscal commentators, as well as representing a concentration of monetary expertise. A widespread reaction to the 22nd June Budget was that it represented a set of harsh but necessary measures overall, without which the government’s credit rating might have collapsed.

Members of the committee had some specific reservations about the Budget measures, however. One was that the ‘front-end loading’ of the tax increases and the ‘rear-end loading’ of the spending cuts was misguided from a macroeconomic perspective. It also asked people to take it on trust that spending discipline would be delivered, despite the appalling fiscal record and false political reassurances of recent years.

There was further concern that the increased VAT would exacerbate inflation expectations, reduce output and employment and worsen the public finances, because of its adverse second-round effects. More generally, it was feared that Britain may be on the wrong side of the Laffer curve now that government spending accounts for 53.3% of factor-cost GDP.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold.
Bias: Wait and see.

There is not much to add to my comments last month, except in two areas. First, as after the 1981 budget – and also, indeed, the fiscal retrenchment in 1977 which followed the 1976 International Monetary Fund (IMF) Letter of Intent - numerous economists of Keynesian lineage are claiming that the proposed reductions in the cyclically-adjusted budget deficit will cause a return to recession. This is rubbish. The sequel to the 1981 budget and the notorious letter to The Times from the 364 economists protesting against it should have permanently discredited naive Keynesianism in the UK. Furthermore, the experience of many countries in the last thirty years is that changes in the cyclically-adjusted budget balance have no clear relationship with the strength of economic growth.

Countless examples can be cited of reductions in the cyclically-adjusted budget balance – due to so-called ‘fiscal consolidation’ – being accompanied by above-trend growth. The American Keynesians – Krugman, Stiglitz and Summers – along with the main writers on the op-ed page of the Financial Times are among those who have yet to wake up to the evidence. They are to blame for the USA’s disastrous plunge into fiscal unsustainability and deserve to be heavily criticised.

Secondly, the Euro-zone is now an utter shambles, with the ‘no bailout clause’ effectively abandoned and a high risk that Germany will decide to leave. At any rate, for the moment the European Central Bank (ECB) seems to have decided to imitate the Bank of England’s Quantitative Easing (QE) operations in 2009, if in a much diluted and chaotic form. (The ECB is targeting Greek government bonds, in particular, for purchase!) The result may be a return to a positive rate of money growth in the Euro-zone in the next few months and some easing of wider balance sheet strains. Against this background, I continue to advocate a low, but positive rate of broad money growth in the UK, with both the short-term interest rate and debt management policy (i.e. QE, as people now call it) calibrated with that end in view. It is very encouraging that budgetary policy is now being geared to medium-term fiscal solvency. That is excellent.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold.
Bias: Unchanged interest rates and no extension of QE at present – but do not rule it out.

George Osborne is to be congratulated on his budget. It was a game-changer which marks a return to fiscal control after the uncontrolled profligacy of Gordon Brown. By the end of the Parliament the current structural deficit should be all but wiped out. And government borrowing as a share of GDP is projected to fall from around 10% in the current financial year to just over 1% by 2015/16. A significant part of this projected turn-around in the public finances will be an extra £40bn a year of belt tightening by 2014/15, over and above the Labour Government’s proposals to cut the deficit.

It cannot be emphasised enough that interest rates would have risen, borrowing would have become more expensive and growth would have been undermined, if Osborne had not taken these decisions. And this assumes there would not have been a major crisis of confidence in Britain’s sovereign debt. The issue facing the country is not so much a matter of whether belt-tightening will wreck the recovery, leading to escalating unemployment and a ‘double dip’, as some claim. The issue is whether our huge, unsustainable public sector deficits would have wrecked confidence in British sovereign debt. The grim, and increasingly disturbing, situation in countries like Greece, Spain and Portugal, with the horrendous implications for Europe’s banks, surely focuses minds on this score.

There will be an initial ‘hit’ on economic growth of the deficit-cutting. The Office for Budget Responsibility (OBR) has downgraded its forecasts accordingly, especially for next year. But thereafter, growth picks up and is expected to record quite respectable annual growth rates of 2¾% to nearly 3%. I do not expect the fiscal tightening to lead to a ‘double-dip’ recession, provided monetary policy is kept very accommodative. The deficit cuts announced in the Budget were, of course, necessary in their own right. But there is a silver lining to the spending reductions. As the public sector shrinks as a proportion of GDP, the more productive and dynamic private sector, no longer ‘crowded out’ by an expanding state, should expand to fill the gap left by the shrinking state. The notion that cuts in public spending mean irretrievable and irreplaceable reductions in output and employment, as critics of this Budget are claiming, could not be further from the truth.

Economies with small public sectors grow faster than those with large public sectors, other things being equal. This is a message that cannot be repeated often enough. In addition, we must hope that greater spending discipline in the public sector improves its productivity performance which has been dire. Given the scale of the fiscal tightening ahead I vote for no change to the Bank Rate and keeping further quantitative easing in mind if required.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate; extend QE – initially aiming for around £30bn this quarter.
Bias: To hold.

Nominal wage growth in the UK has stabilised a little recently, at around the 2% level excluding bonuses, having threatened to drop below 1% only a few months ago, and including bonuses had returned to a healthy 4% plus level in March and April. This suggests that the imminent threat of nominal wage deflation driving defaults has receded a little. Furthermore, M4X growth appears to have picked up a little in the data published on 29th June. However, international monetary developments in the US and the Euro-zone suggest significant deflationary pressures, also, and could yet provoke a modest double-dip recession in the latter half of 2010.

A particularly negative development for sustained monetary growth (a sine qua non for sustained recovery) is the G-20 agreement that there should be a large increase in capital requirements. The final numbers will only be determined later this year, but it appears clear already that the intention of policymakers is that future capital buffers should be adequate for all firms to survive the sort of scenario that arose in late 2008. That is rather like requiring that San Francisco maintain, at all times, a reserve of fire engines adequate to deal with the ‘Great Quake’. The inefficiency implied by such a requirement is manifestly absurd.

Past research indicates that huge increases in capital requirements will result in banks contracting their balance sheets in approximately equal proportion to the increase in their capital holdings. Thus, for example, if capital holdings are extended from their previous 8% to, say, 15% (compared with the current typical values of approximately 10% prevailing in the industry), that would imply a contraction in risk-weighted balance sheets of around one fifth and an increase in capital holdings of about one fifth (since 12/80 = 15%). Forcing banks to contract their balance sheets by around 20% from 2012 onwards, even if there is a period of transition, at a time when the international financial sector is at constant risk of collapse, would surely rank as amongst the most perverse regulatory decisions of all time.

Although some firms doubtless did have inadequate capital at the time, the regulatory problem in 2008 was not predominantly one of inadequate capital. It was mainly one of grossly inadequate resolution mechanisms and moderately inadequate liquidity guarantee schemes and requirements, combined with monetary policy framework flaws and various regulatory mechanisms that tended to systematically coordinate the circumstances under which firms failed both nationally and internationally. The policy of huge increases in capital requirements indicates that policymakers have failed totally to understand what went wrong and stubbornly refused to comprehend the role and nature of policy failures in the crisis.

This absurd regulatory policy, against a dangerously deflationary monetary backdrop, makes the conducts of monetary and fiscal policy extremely awkward. The new Coalition government in the UK has rightly proposed a massive discretionary fiscal tightening, in real terms exceeding £100bn out to the fiscal year 2014/15, including around £75bn of spending cuts. This is about the right aggregate and, if delivered, the spending cuts would reduce the role of the state to a very welcome 40% of GDP.

However, there are two problematic elements. It very much remains to be seen whether the departmental spending cuts promised can be delivered, given that the nonsensical NHS ring-fence will imply cuts of 25% to 33% in other departments. Failure to deliver would damage fiscal credibility severely. And to add to this, the budget chose to front-load the tax rises whilst having a smoother path for spending rises. I would have preferred a smoother path overall, with the spending cuts frontloaded and the tax rises back-loaded. The danger of the profile chosen is that the VAT rise will bite in early 2011, just following a potential quarter or two of contraction in the third and fourth quarters of 2010.

It is easy to understand why this approach was politically attractive - by raising more tax than required early, the government could create scope for tax cuts approaching the next Election. But the effect may be to negate much of the potentially positive growth impact of early spending cuts. I had previously hoped that a significant fiscal consolidation might promote growth, even in the short term. But by raising so much tax early, I now fear that the Emergency Budget itself might generate a quarter or two of contraction (though, of course, it is plausible that any such contraction would have been worse without the tax rises, if there had been a UK sovereign debt crisis).

Now, I did believe that 2011 would be a boom year - indeed, an excessive boom year. So perhaps some relative contraction in 2011 would not be unwelcome in that sense. But that excessive boom was serving an important purpose - allowing households, through rapid nominal wage growth, to erode their debts significantly ahead of the large interest rises that will inevitably have to come later (probably in 2012). The danger of damping that boom is that households may find it more difficult to escape their debts, and so it might become necessary to hold off until later with the large interest rate rises - potentially meaning that the scale of inflation on exit becomes greater. I would have favoured additional QE to offset the effects of the fiscal contraction even under my favoured consolidation profile. Front-loading the tax rises, against a backdrop of near-insane increases in bank capital requirements, only strengthens the case. It's time for more QE. In the end, probably a lot more.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold.
Bias: Neutral on Bank Rate, QE should be kept on standby.

The environment for monetary policy has suddenly become considerably more hostile. World recovery is proceeding. However, there is crisis in the Euro-zone - with serious difficulties surfacing for the Euro-zone banks - the US housing market is back in disarray following the end of the first-time home buyer’s tax credit, and Far Eastern countries are tightening monetary policy. Finally we have had a new budget from the coalition government that represents a sharp tightening of fiscal policy. The budget and related announcements are positive news on the whole but contain unfortunate elements on regulation particularly that will further tighten the situation.

Nevertheless, the emergency budget could have been much worse. The heavy lifting is being done by a rise in Value Added Tax (VAT) bringing in £13bn. On the spending side, the cuts are achieved by freezing public sector pay; indexing state benefits to the Consumer Price Index (CPI) rather than the faster-rising Retail Price Index (RPI), and freezing child benefits. State pensions will be indexed to the higher of wages or the CPI but the pension age will be raised to sixty-six fairly soon. The disappointment is on the tax side where compromises with the worst aspects of the Lib-Democrats are apparent.

Capital Gains Tax goes up to 28% for top earners - a mistake. The 50% top tax rate and associated rise in the top marginal rate on pensions have been left alone. There is a levy on banks bringing in £2bn, which is defensible, just, at this level. Even so, it needs to be remembered that taxpayers generally make money out of bailouts, because they get assets at knock-down prices and are able to hold them until times are better. Then there are the cuts in corporation taxes on both large and big firms which are to be welcomed. But there is no clear logic here, no sense that the tax system is to be remoulded to give incentives for entrepreneurs, inward investors and indeed home investors.

The main question that most people will be asking is whether the fiscal arithmetic will come off and the deficit contract as planned to 1.1% of GDP by 2015/16. The answer depends entirely on growth. Contrary to most people’s comments, cutting spending as planned is not really that difficult. Much of it will involve simply freezing programmes in real terms and also cutting pay in real terms which the announced freeze on pay will do. Probably some programmes can actually be cut without much trouble given the considerable decline in public sector productivity during the last decade - in other words, value for money in the public sector has never been worse.

The main issue is whether GDP will grow at the forecast 2% to 3% in the next few years. If it does, then revenues will recover substantially. Already, in fact, the PSBR figures have come in some £10bn below the original projections and that seems to be because the original growth figures for 2010 were too low. There are good reasons for thinking growth of this order will occur. The world economy is recovering rapidly, led by the East - China, India and East Asia. These countries are achieving extremely rapid rates of productivity growth by moving people out of low-productivity agriculture into high-productivity manufacturing. The problem for the West is that these countries also pre-empt available supplies of raw materials such as oil. So if the West grows any faster than its present moderate recovery, it would trigger renewed surges in raw material prices which in turn would reduce Western productivity growth (factories are less profitable as those prices rise). So there is a built-in drag on western growth. But nevertheless growth of the 2% to 3% order is in line with productivity growth at current raw material prices.

One concern is whether the spending cuts and tax rises themselves will derail the recovery. This is something that Labour is emphasising. However, the programme is spread out over five years and this should be gradual enough to be absorbed with monetary policy remaining supportive. Interest rates are projected to remain low, with inflation absent; and it is possible that QE will need to be resumed but on present prospects this seems unlikely to be necessary. Another concern is with the regulative proposals.

There is an anti-bank mentality developing in this coalition government which is most unfortunate; much of it seems to emanate from Vince Cable and the Liberal Democrats. Yet, a moment’s thought should be enough to convince one that we need bank credit expansion and a return to competition on the bank high street in order to foster recovery and enterprise. Ever tougher bank regulation is what was needed before, at the peak of expansion, not now in the slough of recession giving way to recovery. Talk of breaking up banks fails to recognise the natural economics of banks, which favours scale and risk-spreading. Talk of capping mortgage lending at modest percentages of income is also unfortunate when we want to see a revival of the housing market, now once again back in the doldrums.

A final concern is the labour market. We do have near ‘full employment’ if one discounts the modest temporary effect of recession. But this only applies to those normally looking for work. There exist a large slew of people who are claiming benefits to stay out of the labour market. Disability benefit is one route; another is the breeding of children to get child benefits and related parenting allowances, with tragic consequences for some children. Tightening up on this has been signalled in the budget but this has happened before, with no proper follow through. Another labour-market problem is the resurgence of union power as Labour loosened the union laws passed before 1997. One key loosening was the twelve-week rule which allows workers to breach their contracts with impunity until twelve weeks of strike have occurred. When strikes are designed for short periods for maximum disruption, this twelve-week period can take a long time to trigger. During it, the employing firm is unable to defend itself by recruiting a new labour force. Under the pre-1997 legislation, firms could dismiss workers in breach of contract, provided they did so in a non-discriminatory way. This led to a huge reduction in strikes and a large rise in UK productivity, to the great general benefit. As we have seen in recent years, certain unions are exploiting this twelve-week rule to damage the economy - the classic case has been the British Airways (BA) dispute where UNITE has persisted in attempting to defend well-above market wages for cabin crew.

In sum, the budget was a decent start in restoring fiscal sanity. But it was only a start. We now need urgent attention to the creation of a proper tax system with low marginal rates but generating a reliable revenue source - the two are perfectly compatible. We need sense and restraint in regulation. Finally, we need to reform the labour market one more time.

The problems these developments create for UK monetary policy are intense. As noted above, interest rates will need to remain low for a start. Inflationary pressure is weak with bank credit still refusing to come off the floor and alternative finance availability substituting as far as we can tell to a reasonable degree; but clearly none of this amounts to the sort of monetary pressure that can accommodate more than target inflation. Expectations remain solidly anchored by the inflation target, entirely rationally under the circumstances. Will QE be required again? It is possible. However, renewed QE will most probably not be needed since policy seems successfully to have encouraged alternative financial channels, notably equity and corporate bonds. The situation that could trigger the need for further QE would be a renewed banking crisis, most likely one that originated in the Euro-zone. But the member countries have little choice but to support their own banks and hence the more shaky Euro-zone governments. My vote is for continued low interest rates - no change - with no bias. Also QE to be available should crisis recur but otherwise kept on hold.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold.
Bias: Wait to see what happens to sterling. Intervening in the foreign exchange market would be a different form of QE.

During my working lifetime there have been two previous occasions when fiscal policy has been tightened substantially when the economy has been in a recession. The first was in 1976 when the UK borrowed from the International Monetary Fund (IMF). The second was in 1981 when Geoffrey Howe was Chancellor of the Exchequer. Both times there were dire warnings. On the first there were reports that Jim Callaghan, the prime minister, thought that the country might become ungovernable if he acceded to the IMF’s original conditions. On the second 364 economists wrote their infamous letter.

On the first occasion the economists who were worried were not confined to neo-Keynesians. Some monetary economists were worried too and I was one of them. Tightening discretionary fiscal policy reduces the budget deficit, more precisely the public sector borrowing requirement (public sector net cash requirement), which is one of the main drivers of monetary growth. Other things being equal the money supply declines in line with a fall in the budget deficit. I predicted that monetary growth would collapse and that, as a result, the recession would deepen. It was the worst economic forecast I ever made. Other things were not equal.

The most important offsetting factor was a huge inflow of money from overseas, as overseas investors regained confidence in the UK. The Bank of England intervened in the foreign-exchange market. Our foreign exchange reserves rose. The government borrowed from the banking sector to finance the increase in the reserves and this offset the effect on the money supply of tighter fiscal policy. I learnt the lesson from experience in 1977 and did not make the same mistake after Geoffrey Howe’s budget in March 1981. On that occasion the main offsetting factor was a boom in bank lending as confidence in the UK returned.

The question is will there be an offsetting factor this time? If there is, what is it likely to be? A boom in bank lending similar to 1981/2 is most unlikely but a repeat of what happened in 1977 is quite possible. My policy recommendations are for the Monetary Policy Committee (MPC) to wait and see. They should not change interest rates or carry out any more QE for the time being. Hopefully confidence in the UK will return and sterling will strengthen. The Bank should then follow a policy similar to what it did in 1977. It should intervene in the foreign exchange market to slow sterling’s rise and re-liquefy the economy that way. Such foreign exchange intervention would be a different form of QE.

Comment by Peter Spencer
(University of York)
Vote: Hold.
Bias: To hold Bank Rate and keep QE under review.

The June budget set a very ambitious fiscal target: the elimination of the structural current deficit over the next five years. Although there were no big surprises, the overall package was much tighter than most had envisaged and was about as much as the government could expect the public - not to say Liberal-Democrat back benchers - to swallow. When added to the cuts pencilled in by the previous administration, the package implies reductions of 25% in most departmental budgets. We will not be in a position to assess the feasibility of this package until the Comprehensive Spending Review in October, but no post-war government has ever been able to deliver reductions on that scale.

The worry is that this fiscal tightening could undermine the recovery. That would also upset the headline borrowing figures, arguably the ones that ultimately matter for financial markets. The OBR's 'before and after' forecasts give us an estimate of the effect of the extra £40 billion of fiscal tightening on the wider economy. However, this impact seems to me to be an underestimate. For example, in 2011, with VAT rising to 20% and current spending around £10bn lower than the pre-Budget forecast, the growth in consumption and GDP is estimated to be just 0.3 percentage points lower. The OBR assumed that consumers will react to having lower incomes by dipping into saving rather than making any significant adjustments to their spending, an assumption which looks highly questionable. The overall impact on GDP is neutral in 2012 and positive in the next two years, as the beneficial effect on investment and exports outweigh the effect of spending cuts and tax increases.

That having been said, the various announcements in the budget added up to a well-constructed package that should minimise the risk to the recovery. The tightening is a gradual one, with early tax increases being followed by expenditure cuts later. Delaying the increase in VAT until January will help maintain spending over the Christmas period and delay the impact on the CPI which is critical to the outlook for interest rates. The two-year pay freeze in the public sector will mean that the reduction in workers’ real take home pay will be felt gradually rather than kicking in immediately. This freeze will also help to maintain the level of services available as expenditure is cut back. In the longer term, the emphasis on expenditure reductions, rather than increased taxes, also increases the chances of success.

The package was remarkably business friendly, particularly for small businesses opening up in the regions where the public spending axe will cut deepest. Hopefully, the budget will help resolve the uncertainty that has been holding back business spending, allowing company cash flows to be released for investment. It is going to be tough but at least we all know where we stand. This time the consumer is in no position to pull us out of recession and the thrust has to come from business spending and entrepreneurial initiative. Without that response, it will be very hard for the government to pull off the trick of retrenchment and recovery. Monetary policy also needs to support the economy. Interest rates must remain low for an extended period. I would also keep the QE programme under review. If the economic recovery falters, this facility could prove to be very valuable.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise to 1%.
Bias: To tighten, but slowly and carefully, depending on events.

The first point about the 22nd June Budget is that the Coalition inherited an extremely bad fiscal situation by international and historic standards. The Annex Tables to the June 2010 Organisation for Economic Co-operation and Development (OECD) Economic Outlook reveal that the ratio of the cyclically-adjusted general government financial deficit to non-socialised GDP – which is the only part of the domestic economy that can absorb government debt - is expected to be 17.1% in Britain in 2010. This represents the worst imbalance in the OECD area, followed by the US with a structural deficit of 15.4% of private GDP, Ireland at 13.7% and France and Poland at 12.5%. Somewhat surprisingly, these are all worse figures than those for Greece (8.2%), Portugal (11.6%) and Spain (11.4%). Spain also has a lower ratio of general government net liabilities to total GDP than the UK (44.3% versus 53.5%), Portugal a lower net debt ratio than the US (64.3% versus 66.6%) and Greece a better net debt ratio than Japan (97.8% versus 114.9). According to taste, these comparisons suggest either that: 1) the loss of exchange rate flexibility associated with European Monetary Union (EMU) has caused, or brought forward, the bond-market crisis in the weaker EMU members; and/or 2) runaway debt servicing costs also pose, or posed, a major threat to Japan, the US and Britain.

It is customary when presenting the Budget forecasts to express the spending and borrowing figures as a ratio to the market-price measure of GDP, which includes indirect taxes and subsidies. This presentation is misleading at the best of times, but becomes especially so when indirect taxes are being raised because this can produce a spurious drop in the ratios concerned. The supplementary material to the Budget indicates that the ratio of general government spending to the market-price measure of GDP rose from 43.4% in 2008-09, to 47.2% in 2009-10, but will then fall by 0.5 percentage points to 46.7% in 2010-11. However, using the conceptually superior factor-cost GDP measure shows a rise from 48.8% in 2008-09 to 53.3% in 2009-10, followed by a minimal reduction to 53.2% in 2010-11. This difference is significant in the context of both the economic and the political debate. The factor-cost figures can be compared with the 46.5% peak cost of fighting World War I and the earlier post-war record of 52.5% recorded in the 1981 recession, both of which confirm the seriousness of the fiscal crisis inherited by the government.

As far as the 22nd June measures were themselves concerned, it is encouraging that Mr Osborne couched much of his speech explicitly in terms of the international fiscal-consolidation literature associated with bodies such as the OECD, IMF and European Commission. His measures were generally in line with best practice, apart from some damaging sops to the politics of envy, which were presumably required to gain Liberal-Democrat support. The ‘triple locking’ of pensions also represents a pretty disgraceful robbing of future generations to buy votes today, but there have also been large and necessary spending cuts – assuming that they can be delivered. The volume of general government current expenditure on goods and services is expected to be 10.1% lower in 2015 than this year, representing a saving of some £34.6bn in 2010 prices, and general government capital formation is expected to be 29% lower in 2015 than 2010, saving £10.4bn in 2010 prices.

The major reservation is to do with the increase in VAT to 20% from 4th January 2011 onwards. One reason is that the UK is probably on the wrong side of the aggregate ‘Laffer curve’ nowadays. It may be possible to tax one’s way out of a budget deficit of, say, 3% of GDP when government spending is around one third of national output but it may be impossible to do so when the spending ratio is well over one half, and the budget deficit well over 10%, of GDP. Ahead of the Budget, a series of simulations were run on the Beacon Economic Forecasting (BEF) model looking at various spending and tax hike packages. These showed that raising VAT to 20% would weaken economic performance and exacerbate the budget deficit. Re-running the BEF model after the Budget confirmed these results, even if the damage to the wider economy has been partly offset by the reduced rate of corporation tax (Editorial note: further details can be found on the website of the Tax Payers’ Alliance www.taxpayersalliance.com). Such model simulations are subject to all sorts of caveats. However, there is a strong case for the OBR to publish a set of ‘standard simulations’ on the HM Treasury model as a contribution to the wider debate.

The other adverse effect of raising VAT, apart from the likelihood that it has made the public finances worse at noticeable costs to output and employment, is that it could deliver an upwards shock to inflation expectations at a time when the output gap may be closing and inflation has been persistently overshooting its target. The BEF model was forecasting that CPI inflation would be not quite 1% in the final quarter of next year without the budget measures but this has now gone up to almost 2¼% following the increased rate of VAT. The latest monthly figures show that annual CPI inflation eased from 3.7% in April to 3.4% in May, while the equivalent figures for the ‘double-core’ RPI excluding all housing items eased from 5.3% to 4.9%, figures which remain higher than in many equivalent countries. The key uncertainty affecting forecasts of future British inflation concerns the relative weight that should be applied to the output gap as opposed to the external value of sterling. The majority of the MPC appear to be putting most weight on the output gap but this mistaken view explains their under prediction of inflation during a period in which sterling has been weak. Bank Rate should now be raised to 1% and there seems no case for re-activating QE at present. However, QE should be kept in reserve as an available option, in the same way as a fire engine. Longer-term, serious thought needs to be given to Mr Osborne’s regulatory proposals and their potential effects on the expansion of money, bank credit and the wider economy. However, that is a subject for another month.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1% and prepare to extend QE by up to £50bn.
Bias: To raise Bank Rate.

The emergency Budget, held on 22nd June, has potential implications for the conduct of monetary policy. The additional tightening of the fiscal stance, so as to provide a glide path to structural surplus by 2014-15, reopens the debate as to the underlying resilience of the UK economic recovery. From a starting point, at worst, of a structural budget deficit of 8.7% of GDP, it is hard to argue that the Keynesian effect of the tightening will be dominant. The risk of emergence of a real interest rate premium, as compensation for the increased risk of sovereign default, was perceived correctly as the greater threat to economic progress. The UK should enjoy a reprieve from the credit rating agencies as a consequence of this Budget and hence enjoy lower real interest rates than might otherwise have obtained. In addition, the planned reduction in the general government spending-to-GDP ratio from almost 48% to 40% over the parliament should enhance the dynamism and potential rate of expansion of the economy through the substitution of private for public sector activity.

My judgement on the Budget’s probable impact on the economic growth outlook is therefore benign over the medium-term and does not justify a change in the desired path for the policy interest rate. However, to the extent that there are near-term risks to growth, particularly in 2011 after the VAT rate increase takes effect, then it is important to have a contingency arrangement for monetary policy. The logical monetary policy response is to extend the programme of QE well in advance and to provide up to £50bn of potential support in reserve. Annual effective issuance of gilts (net of Bank of England purchases under QE) is set to increase from £43bn in 2009-10 to £165bn in 2010-11. The provision of more QE could play an important role in underpinning the gilt market during turbulent financial market phases.

Another Budgetary impact is the increase in VAT to 20% from 4 January 2011, which will raise the CPI inflation rate by approximately 100 basis points through the year and probably prevent a return of the CPI to its target rate until 2012. In the latest Bank of England Quarterly Bulletin, charts showing the slippage public inflation expectations towards 3% on a two-year and five-year view will not have made pleasant viewing for the MPC. There is a material risk that the UK inflation expectations have pulled away from their supposed anchor – the 2% target inflation rate. The VAT move – although it is simply a price level effect – is likely to harden public expectations of higher inflation over a longer horizon. Furthermore, we cannot rule out even higher VAT rates in future years. On balance, there is no justification for ‘going easy’ on UK policy rates in the face of a strengthening private sector recovery. The additional fiscal consolidation measures in the June Budget do not bite in a significant way until 2011 and the inflationary readings are likely to continue to exceed the Bank’s forecasts in the interim. My vote is for an immediate 50 basis point rate increase to signal the Bank’s unease with the inflationary outlook.

Comment by Trevor Williams
(Lloyds-TSB Corporate Markets)
Vote: Hold Bank Rate at ½%.
Bias: No change.

UK economic data are showing that recovery is solidly underway, albeit muted by the standards of the pace of recovery from downturns in the past. Recovery is being led by investment rather than consumer spending. The recovery and continued high price inflation is leading to a gap opening up on the MPC between those who believe that inflation will fall back as the large amount of spare capacity in the economy tends to lower inflation in the medium term and those who worry that the above-target rate of price increase may seep into inflation expectations. The latter would cause higher inflation than otherwise be the case in later years, making the MPC’s job even harder to do in future.

The Chancellor was true to his promise of ‘accelerated’ deficit reduction in the emergency Budget and announced an additional net fiscal tightening of £40bn (or 2% of GDP) over and above the £73bn pencilled in by Labour over the next five years. As widely flagged, the majority of the tightening will occur through public spending cuts rather than tax increases. The ratio between these two rises from 3:2 over the next couple of years to 4:1 by 2014-2015. Although the cuts in public spending will be difficult to implement, the government’s decision to focus the reductions in current spending rather than capital investment is a sensible one. However, to the extent that it slows the recovery in the short term, it raises the likelihood that inflation falls back over two years.

There are question marks over whether even the more modest growth rates predicted by the OBR are achievable given the new fiscal measures announced in the Budget. The June Budget aims to implement an additional tightening of £23bn over the next two years – which could hit growth by more than the Budget assumes. The single most significant new measure, the rise in the VAT rate to come into effect next January, is likely to mean that some big-item purchases are brought forward into late 2010, boosting growth in the final quarter of this year at the expense of the first and second quarters of 2011. Another important impact is that inflation could average around 1% more in 2011 than would otherwise be the case. That would mean inflation remaining above target for yet another year. This could prove difficult for the MPC to justify from a presentational perspective. However, the monetary response should still be modest as global financial markets seem more worried about deflation than about inflation as a result of the accelerated fiscal tightening being put in place in many of the developed economies. Bank rate should stay at 0.5% into 2011 until recovery is secured – money supply growth could yet weaken anew. Further rate increases in 2011 should be slow and steady as, although inflation will be rising due to the 20% VAT, the annual rise would still be below 2% excluding the VAT effect.

What is the Shadow MPC?

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.