Sunday, August 01, 2010
Shadow MPC on hold despite growth jump
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its latest quarterly gathering, the Shadow Monetary Policy Committee (SMPC) voted by seven votes to two to leave Bank Rate unchanged at the ½%, first set in March 2009, when the Bank of England’s rate setters announce their rate decision on Thursday 5th August.

The two SMPC dissenters both voted that Bank Rate should be raised to 1% immediately. However, there was no strong bias as to where Bank Rate should go in subsequent months. This was because the international and domestic uncertainties were such that ‘playing it by ear’ was the only feasible option. A similar consideration applied to Quantitative Easing (QE). The entire SMPC believed that QE should be kept on standby but only a minority wanted its immediate reintroduction.

One reason for the high level of uncertainty – that might be alleviated by appropriate institutional changes – was the potentially remediable inadequacies of the UK official statistics. Both SMPC hawks suspected that Bank Rate would have to rise beyond 1%, but only if circumstances justified it.

One thing highlighted by the shadow committee’s deliberations was the importance of the shift of economic potential from the US, Europe and Japan to the East Asian emerging nations, where bank balance sheets were broadly sound and recovery had been quicker and stronger as a result. Particular concern was expressed about the outlook for the US economy in 2011 because of the headwinds arising from the expiry of the Bush tax cuts at the start of the year – which will lead to noticeable rises in some marginal rates – and the recent ending of a tax subsidy for new home buyers.

The SMPC vote was taken before the release of the strong UK growth figures for the second quarter on Friday 23rd July, which showed non-oil national output 2% higher than it had been four quarters previously. However, nobody altered their vote as a consequence. This was partly because of doubts about the reliability of the figures.

Minutes of the Meeting of 20th July 2010
Attendance: Philip Booth, Roger Bootle, John Greenwood, Patrick Minford, David Brian Smith (Chair), Peter Warburton (Acting Secretary), Trevor Williams; External observers: David Henry Smith and Robert Watts (Sunday Times).

Apologies: Tim Congdon, Ruth Lea, Andrew Lilico, Kent Matthews, Gordon Pepper, Peter Spencer and Mike Wickens.

Chairman’s comments
David B Smith commented on the challenge for the SMPC of maintaining its media profile when there was little immediate prospect of a change in Bank Rate. In practice, the SMPC appears to be in the process of reinventing itself as the Shadow Macro Policy Committee, to reflect the greater frequency of commentary on fiscal matters. This seemed a sensible development, given the extensive feedbacks between monetary and fiscal issues and the considerable fiscal expertise available within the SMPC.

The Chairman then drew attention to some disturbing developments in official statistics since the general election. One example was that previous Budget documents had been removed from HM Treasury’s website and placed in the historic archive site where they were hard to find. This made it difficult to compare the June Budget forecasts with their predecessors, particularly as some long established tables dealing with the public finances appear to have been suppressed. There had also been a massive change to the National Statistics inflation news release in July, which had deleted almost all the detailed breakdown of the retail price index that had previously been a feature of the release. To his knowledge, there had been no prior consultation with data users about this major change, and he was disappointed that the new coalition government appeared no better than its predecessors where official data was concerned.

David B Smith commented further that the rebasing of the UK national accounts from 2005 chained prices to a 2006 base year had introduced noticeable revisions to nominal variables as well as the rebased volume series. One implication was that the Office for Budget Responsibility (OBR) Budget-day forecasts could no longer be matched against the official statistics as they were on the old 2005 basis. Finally, he was disappointed in the handling of the discontinuity in M4 that occurred between December 2009 and January 2010, when there was a break of £165bn (8%) in the level of the broad money supply. The Bank of England (BoE) has never published a break-adjusted historical series for M4X, despite claiming that it is the most accurate broad money measure. This dereliction made it difficult to trace the underlying path of broad money or to do any serious statistical research on its links with the economy.

The Chairman then asked John Greenwood to present his analysis of the monetary and economic background.

The Monetary Situation
International Background

John Greenwood characterised the situation in large developed economies as dominated by the slow recovery from a balance sheet recession. In the US, de-leveraging is still the key driver of financial markets and the pace of economic recovery. As evidence of de-leveraging he cited the absolute decline of bank credit within the banking system, while M2 growth was at historically low rates. Outside the banking system the overall debt-to-GDP ratio declined for a fourth successive quarter in 2010 Q1 thanks to reduction in private sector debt and a slower increase in government debt. John drew attention to the ongoing shrinkage of the US shadow banking system, which is of similar size to the commercial banking system. The expansion of the Federal Reserve (the Fed) balance sheet is small in comparison to the US$5trn decline in shadow banking assets.

US non-financial corporate sector balance sheets were in better shape than household balance sheets, and cash flow was now strengthening. The household sector continued to de-leverage, as evidenced by the declines in mortgage and consumer credit. The US personal savings rate had steadied at 3.7% after spiking higher in 2009.

The surge in US government borrowing should be relatively easy to finance – even at low interest rates – as the corporate and household savings rates rose. The household sector had reverted to a small surplus. Corporate cutbacks in investment and cost-cutting had raised the corporate savings rate. Meanwhile the federal government deficit remained close to its peak as government expenditures grew and tax revenues remained weak. Smaller capital inflows from abroad combined with household and corporate sector surpluses were able to finance the federal government’s enormous deficits at low yields.

In the Euro-zone, there was also negligible money and credit growth as households and firms de-leveraged. There were some tentative signs of a recovery in household borrowing but corporations were still repaying bank debt on a net basis. In contrast to the Fed and the BoE, the European Central Bank (ECB) had been less generous with credit provision or Quantitative Easing (QE). Consequently, growth prospects were poor, especially in the European economies that must deflate internally to regain competitiveness. These pressures were greatest for Greece, Portugal and Ireland but also significant for Italy and Spain.

John Greenwood concluded his International Background briefing by noting the contrast between the US, Europe and Japan and the parallel universe of economies, led by the East Asian emerging nations, where balance sheets were broadly sound and recovery had been much quicker and stronger as a result.

UK Background
Turning to the prospects for the British economy, John Greenwood stated that, in common with the US, the debt of the UK household and financial sectors had fallen over the past year. Non-financial companies had been replacing bank borrowings with issues of corporate bonds. After a rapid surge in government debt in 2008 and 2009, there had been some deceleration. Monetary growth remained disturbingly low with the preferred M4X measure registering a 1.1% increase for May. Household money balances were growing at a steady 3% per annum and money holdings of non-financial companies were growing similarly. The aggregate figures were dominated by the dramatic reduction in the growth of other financial corporations’ deposits over the past year. The BoE had maintained its balance sheet size at £250bn since February when QE was suspended. Mortgage lending remained subdued although residential and commercial property prices were enjoying a temporary bounce back. The pace of (negative) mortgage equity withdrawal had slackened in the first quarter, suggesting a more gradual upward pressure on the household saving rate.

The labour market had been stabilising with net job creation and a consistent decline in unemployment. Wage inflation slowed sharply in 2009 in both private and public sectors and has recovered partially in recent months. Retail sales volumes were holding up surprisingly well considering the weakness of mortgage lending activity. Industrial output and the Confederation of British Industry (CBI) output expectations survey had both improved impressively and there had been a rebound in business investment in 2010. Within private sector services there had been notable weakness in hotels and restaurants but otherwise a modest recovery had begun. The early signs of improvement in the public finances had been observed on both sides of the account.
UK consumer price inflation outturns had remained discouraging to the BoE Monetary Policy Committee (MPC). John Greenwood alluded to the long and variable lags in the transmission of sterling weakness as a factor in sustaining high inflation figures. He noted that the inflation of the Consumer Price Index (CPI) measured at constant tax rates was rather lower, at 1.6%. He expected less upward pressure on prices in the second half of this year but recognised the impact of the 20% VAT rate from next January. In summarising, he considered that the primary issue was balance sheet repair in the private sector and did not expect to see a strong recovery of the real economy no matter how low interest rates remained until balance sheet repair was well on the way to completion.

Global uncertainties and UK inflation debate

Patrick Minford recognised the structural impediments of many large countries but considered the world economy to have a more ‘V-shaped’ profile of recovery. He noted the rapid progress of the Asian and other emerging market economies and the restoration of world trade. Indeed, he could envisage upward pressure on raw material prices if western economies were to enter a stronger phase of recovery at a time when emerging markets were so strong. He considered that the recent signs of slowing, in the US and other large economies, were a natural characteristic of recovery and not a source for alarm. He believed that the economic recovery had been very conventional; thanks to inflation targeting, there had been no fundamental change to inflationary expectations.

David B Smith queried whether the impending expiry of the Bush tax cuts in America might have the effect of bringing forward activity from next year into this year, leading to a marked falling off in US activity in 2011. John Greenwood agreed that this was one of several headwinds facing the US, which has recently ended a tax subsidy for new home buyers. Roger Bootle remarked on the strength of German exports, industrial production and employment, in contrast to the softening of US data flow. He was concerned about passive fiscal tightening in the context of a weak banking system. Patrick Minford was less concerned about the fragility of the banking system, noting that other channels of finance had opened up to the financial sector. He remarked on a chart in the last Bank of England Inflation Report showing the large extent to which small firms were issuing equity - so the surge in equity issuance is not just a large firm phenomenon.

Philip Booth welcomed signs of an improving outlook for the supply side of the UK economy. He deplored the high marginal deduction rates bequeathed by the previous government, which he thought should be addressed. He was cheered by the government’s deficit reduction plan which he believed would provide a better supply side backdrop. He was not unduly concerned about the retrenchment in household spending. Trevor Williams believed there was enough global capital to finance economic activity but doubted whether there was much desire to invest. He did not think there was a problem with the fundamentals of the banking sector but was concerned about regulatory risks. The financial sector had begun to heal but he was disturbed by the threat posed by new taxation and regulatory initiatives. On UK inflation, Trevor supported the view that excess capacity would continue to bear down on domestic pricing. He expected UK economic growth of 1% to 2% per annum for the foreseeable future, which he considered respectable.

The Chairman then asked his near namesake, the Sunday Times observer David H Smith, for his views. David H Smith remarked on the vigorous growth implied by the IMF forecasts for World GDP: 4.5% for this year and the next. World manufactured trade volumes were expected to rebound by 10% in 2010 after an 11.5% fall in 2009. Thus far it could be described as a credit-less recovery. David H Smith did not see inflation as a concern at the moment in the UK. The pass-through CPI rate of inflation was around 2.5% rather than the headline rate of 3.2%. Referring to the earlier comments about official website changes he expressed some concern at the overhaul of the HM Treasury website but did not accept that a Conservative party equivalent of Alastair Campbell had been at work.

Peter Warburton commented that over the past several years, inflation had trended higher in the emerging world. While positive relative price trends for food and energy appeared less threatening in advanced economies, it was arrogant to suppose that the inflation initiative rested with rich countries. The credit and financial crisis had accelerated the transfer of economic power and influence from west to east and the supply pressures on food, water, mined commodities and energy showed no signs of abating. The scale and scope of monetary accommodation of inflationary pressures had yet to be fully worked out in many countries. Fear of government debt monetisation was weighing heavily on the minds of the investment community and the general public. Hence, there was an urgency surrounding the stabilisation of public finances that had yet to sink in fully. The UK government had acted responsibly in addressing its structural budget deficit.

Roger Bootle noted, with regard to the timing of the Budget decision to raise VAT, that this would cleverly avoid a misleading drop in the annual inflation rate next January. He expected the labour market to be a benign influence on inflation over the coming year as fiscal tightening limited the capacity for private wage inflation while public sector wages would reflect the impending job cuts. Patrick Minford reckoned that the unsung hero of the crisis was inflation targeting. Philip Booth countered that real wages were merely responding to the slackness of labour market conditions. Patrick Minford remarked that nominal wage growth had been resilient through the crisis leading him to expect the UK to suffer neither deflation nor inflation.

The Chairman then asked each member to make a vote on the monetary policy response. The votes are listed alphabetically rather than in the order they were cast, since the latter simply reflected the arbitrary seating arrangements at the meeting and two votes – those of Tim Congdon and Andrew Lilico – were cast in absentia, since neither could make it to the physical gathering. The Chairman traditionally votes last.

Comment by Philip Booth
(Institute of Economic Affairs)
Vote: Hold Bank Rate.
Bias: Neutral.

Philip Booth was unconcerned about departures from the inflation targets in the near term but considered there to be a risk of higher inflation expectations becoming established. He did not feel it appropriate to extend QE at the moment.

Comment by Roger Bootle
(Deloitte and Capital Economics Ltd.)
Vote: Hold Bank Rate.
Bias: Prepare to extend QE by £50bn.

Roger Bootle expressed the view that interest rates should remain on hold for a very long time due to the absence of an inflationary threat. It would be prudent, in the light of prospective fiscal tightening, for the BoE to stand ready to resume asset purchases as necessary.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate.
Bias: Prepare to resume QE.

In his post meeting e-mail submission, Tim Congdon stated that the stagnation/contraction of money in the USA, the Euro-zone and Japan – combined with the attempts to curb inflation in China and India by monetary restraint – suggested that the second half of 2010 will see a slower world economy, even though the recovery from mid-2009 had been less than impressive.

Although the UK had enjoyed much better macroeconomic conditions in early 2010 than a year earlier, the recovery remained fragile. The banking system was still under pressure to shed risk assets. Given the cloudy international background and the slow rate of money growth in the UK, Tim Congdon favoured: 1) no change in interest rates, and 2) an alert preparedness on the part of the UK authorities to maintain a positive rate of money growth by QE-type operations. He stood by the view, which he had explained on several occasions, that it would be simpler if the government borrowed directly from the banks with this aim in mind and so by-passed the BoE balance sheet.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Be prepared to reactivate QE if needed.

Whilst recognising the circumstances in which additional QE may be desirable, John Greenwood did not think it was politic or necessary to do it when inflation expectations were elevated. Monetary growth rates, although low, were not negative or threatening to become so. In regard to the implementation of QE, John Greenwood criticised the current method of quarterly announcements as unnecessarily disruptive to the gilt-edged market. He advocated moving to a longer time horizon for QE.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: Neutral.

Given the balance of risks, Patrick Minford was inclined to the view that rates should remain low for the indefinite future. He was concerned at the cooling of the housing market, which may be related to potential job losses. He commented on the serious uncertainty surrounding the effects of fiscal tightening and argued that additional QE should be ready as a contingent policy. He preferred a more proactive approach to QE; that it should be ready to use at short notice.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate.
Bias: Raise QE stock by £30bn over the next quarter.

Andrew Lilico stated in his post-meeting e-mail submission that the risks of a double-dip recession remained high. The adverse influences involved included: terrible US data; ongoing problems in the Euro-zone; perverse regulation incentivising reductions in bank balance sheets, in addition to underlying banking sector weakness; the UK housing market turning down again; and continued weak monetary growth. In addition, the June Budget's over-emphasis on tax rises (particularly VAT) early on means that the spending cuts programme may not be as positive for short-term growth as it ought to have been.

Now, it was certainly true that UK inflation was slightly higher than some had expected, in Andrew Lilico’s view, and UK growth figures had now been positive for nine months (and appeared to be accelerating). So it was possible that there would be merely a growth slowdown in the latter half of 2010 rather than the quarter of contraction he had previously expected. Either way, he did not believe that the underlying growth and inflation position was one of such strength as to justify a shift to a normalisation stance for interest rates. Indeed, he believed that the monetary authorities had now missed the window of opportunity that had earlier existed for even the technical rise he had previously favoured (to around 1.5%), which would have returned Bank Rate to a ‘normal-zero’ level.

Instead, Andrew Lilico believed that the dominant factor was that we faced an enormous fiscal contraction in a fragile economy with continued marked danger of deflationary slump. In this environment, although he had argued vigorously that fiscal contraction ought not to have threatened even short-term growth - if it had been focused on spending cuts rather than tax rises - his view had always been that it was not worth depending on such arguments. Instead, he had always felt that there should be an extension to QE. Tight fiscal policy combined with further QE was the correct formula for the next year to eighteen months. The country would have to face inflation later, of course, but that bridge should be crossed when we came to it, in Andrew Lilico’s opinion.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%.
Bias: To raise rates gradually towards 2.5%.

David B Smith stated that there existed huge difficulties in attempting to assess the progress of the UK economy because of the recent collapse in the quality of so much UK data. His personal view was that it was more important to sort out the problems at the Office for National Statistics and, to a lesser extent, the monetary statistics section at the BoE, than it was to implement such gimmicky reforms as setting up the OBR whose ‘independence’ was of little relevance without better data and whose forecasts were already obsolescent because of the re-based national accounts. He was also concerned that the BoE was using a closed economy domestic ‘output-gap’ model of inflation that was inappropriate to a small open economy such as Britain’s. The pass-through effects of the earlier sterling depreciation were significant and ongoing and should not be underestimated.

Because the data uncertainties made the outcome of discretionary policies no better than a lottery, David B Smith advocated the cautious normalisation of interest rates towards a more neutral stance. He agreed that there may well be a need for additional QE and that the BoE should be on standby to re-introduce it at short notice. His expectation was for spending cuts to be harder to achieve and slower to appear than the Chancellor had assumed. He registered his disapproval of the VAT hike, which made the budget deficit worse by some ¼% to ½% of national output as well as doing noticeable collateral damage to output and employment, according to simulations on his Beacon Economic Forecasting (BEF) model. He also commented that a significant credibility problem arising from the June Budget was that the tax increases were front-end loaded while spending cuts were back-end loaded, and could turn out to be ‘pie in the sky’. There would not be a favourable supply-side response from private-sector economic agents if people feared that taxes could rise even further than had already been announced – but that was probably the rational way to bet.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Bate to 1%.
Bias: To raise Bank Rate and to prepare for the resumption of QE.

Peter Warburton believed that there were three arguments for raising interest rates from their emergency low levels straightaway. First, economic recovery was strengthening and broadening, despite the impact of a severe winter and the restoration of 17.5% VAT in January. Industrial output was up around 5% from a year ago; sales turnover trends were robust for both manufacturing and service industries; employment was rising and unemployment was falling. The recovery still had fragile aspects, but could withstand the transition to moderately higher interest rates. Second, the Bank of England’s expectations of a fall in underlying UK inflation had been confounded over the past year. The misjudgement of supply-side inflation pressures required that interest rates should rise to restore the credibility of the inflation target. Third, very low interest rates, even though they are not generally accessible, had a strong historical association with asset price bubbles and resource misallocation. Savings incentives were pitifully weak. It was high time to encourage the rebalancing of the economy towards fixed capital formation. Should the recovery falter under the weight of fiscal normalisation, then the first remedy should be the extension of the QE programme.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Interest rates on Hold.
Bias: Prepare to resume QE.

Echoing earlier comments, Trevor envisaged additional risks for the economy from fiscal tightening and the recurrence of sovereign debt and banking tensions in the Euro-zone. He remained concerned at the lower rate of bank lending and money supply growth, which he believed posed an ongoing threat to economic activity. He was unconcerned about the inflationary threat in the near term. His preference was to stand ready to extend QE as required.

Policy response
1. On a vote of seven to two the IEA’s shadow committee voted to hold Bank Rate at its existing ½% in August.

2. The two dissenting members both voted to raise Bank Rate by ½% to 1% in August.

3. There was a general acceptance that the uncertainties were so large, in part because of the inadequacies in the official statistics, that it was not appropriate to have a strong bias with respect to future rate moves. ‘Playing it by ear’ was the only feasible approach. Both SMPC hawks thought that Bank Rate should rise further, but only if circumstances justified.

4. The committee expressed a strong preference for being prepared to resume QE at short notice, rather as firemen kept their engines ready for use at any time. However, most members did not foresee the need for an immediate resumption.

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.