Sunday, October 03, 2010
Shadow MPC votes 6-3 to hold Bank rate wants more quantitative easing
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by six votes to three to leave Bank Rate unchanged at ½%, when the Bank of England’s rate setters gather on Thursday 7th October. All three SMPC members who desired an increase voted that Bank Rate should be raised to 1%.

The majority on the SMPC who wished to hold Bank Rate did so for several reasons. These included: the continued de-leveraging of private-sector balance sheets; the associated slow growth of broad money and credit, and concern that fiscal tightening in the forthcoming Comprehensive Spending Review would reduce activity. There was also a worry that the international recovery was running out of steam and that this would weaken UK export demand.

A number of considerations explained why three members of the shadow committee thought that a higher Bank Rate was needed. One was that persistent stubborn inflation could lead to a loss of central-bank credibility and an upwards ‘gear shift’ in inflation expectations. Another was the disconnection between Bank Rate and commercial banks’ marginal funding costs, which meant that Bank Rate risked becoming irrelevant.

There was also concern that ‘big-government’ policies had reduced aggregate supply, with the consequence that there was less spare capacity to dampen inflation than the authorities believed. Several SMPC members noted the remarkably responsible behaviour of the British workforce, who had accepted a 3.2% reduction in their real post-tax take home pay in the year to July. This seemed to be a major reason why unemployment had not risen in the way that most forecasters had expected.

Finally, virtually all the SMPC members, including most of the rate hikers wanted a second round of Quantitative Easing (QE), with a further £50bn of asset purchases being the most widely recommended figure.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate but increase QE by £50bn to £250bn over the next year.
Bias: Be ready to increase asset purchases (QE) further.

The process of balance sheet repair and de-leveraging is continuing in the UK economy. Households had reduced their ratio of debt to disposable income from 174% at the peak in 2008 Q1 to 158% by 2010 Q1, although this is still far above the level of 110% at the start of 2001, and well above the level of 150% in 2005. It remains an open question how much further this ratio will decline before UK households feel they have adjusted to an appropriate level of debt relative to income.

In the financial sector, balance sheet repair or de-risking of portfolios by banks and building societies has taken three forms: first, raising capital (in part, from the Treasury, in part from share issues to private sector investors and sovereign wealth funds); second, selling off assets and using the proceeds to pay down debt, and third, shrinking wholesale money market borrowing and lending as well as the conventional loan book and replacing these assets with short-term government securities or deposits at the Bank of England. As so frequently occurs, changes in the reporting of UK financial statistics make it hard to track these developments accurately. Overall balance sheets in the banking sector grew excessively rapidly between 2004 and 2007. Starting in 2004 the growth rate of sterling assets and liabilities accelerated from 10% per annum to a peak of 23% to 24% in 2007 (although these figures may include some double-counting of credits to special purpose off-balance sheet vehicles etc. which ought properly to have been netted out). Overall balance sheets then declined abruptly in 2007 and 2008, and then resumed moderate growth in 2009. However, since the start of 2010 sterling assets and liabilities of the banking system have been reported in a different format, but once again overall assets and liabilities have shown a steep decline since the start of the year.

The latest monetary statistics for August also illustrate the process of de-leveraging. Sterling M4 declined by £4.1bn or minus 0.2% compared with July, and increased by only 1.8% when compared with August 2009. This reflects both the repayment of debt by households, firms and financial institutions, as well as the reluctance of banks to make new loans. On the asset side of banks’ balance sheets the contraction in August was even sharper for M4 lending which declined by £18.0bn the equivalent of minus 0.7% over the month, an increase of only 0.6% over the previous year (and an absolute decline of 0.5% over the previous year when securitisations and loan transfers are excluded).

As long as this process of balance sheet repair is on-going, it is unreasonable for politicians or commentators to expect banks to increase their lending or to expect households to expand their borrowing. Commercial and industrial companies - which went into the recession in better shape financially - are not so constrained, and larger firms have been able to tap the debt markets for longer term bond issues. However, except for the exporters among them, their ultimate customers are the UK households that are themselves de-leveraging. As de-leveraging is inherently deflationary, the general conclusion is that these very low rates of growth of broad money (M4 or M4 excluding the deposits of intermediate OFCs) are likely to result in sub-par economic growth and significantly lower inflation over the next two to three years.

The evidence I have cited in the preceding paragraphs endorses the idea that the process of de-leveraging or balance sheet shrinkage is still very much in progress – the unfortunate consequence of the central bank and the regulatory authorities having permitted excessive growth of money and debt over the 2004 to 2008 period. The private sector is now painfully unwinding this poisonous legacy. The best thing the authorities can do is to administer another dose of Quantitative Easing (QE). QE can play a supportive role by counteracting the tendency of money and credit to shrink in an environment of extended de-leveraging, preventing an unnecessarily sharp contraction of money and credit. It is now time to deploy QE again.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold.
Bias: To hold Bank Rate and be prepared to extend QE.

There has been a rising crescendo of debate over the possibility of a ‘double-dip’ recession in the face of the fiscal retrenchment to come. But much of the talk is politically inspired in the run-up to the forthcoming 20th October Comprehensive Spending Review and so should be taken with a pinch of salt. And much of the talk hypes up the sheer scale of the ‘draconian’ spending cuts to come. The cuts should be kept in perspective. In particular, the Spending Review will be for four financial years - from 2011/12 to 2014/15. Between the current financial year and 2014/15 total managed spending is due to increase by £40bn – or nearly 6% - in cash terms. Granted that this increase is accounted for by the ballooning debt interest payments, but it is an increase nevertheless. In real terms, total spending is due to fall by only 4% over the 4 years, slightly ‘front-end’ loaded for political reasons. This is equivalent to an average decrease of 1% annually. The private sector would have to perform extraordinarily feebly for the economy to ‘double dip’, though such a scenario cannot be ruled out. And the fiscal retrenchment in the offing will pull down growth in the near-term.

The rather modest real cuts in total spending do not hit the headlines, however. It is the prospect of average cuts in departmental spending (outside the ring-fenced NHS and aid budgets) of 25% over the next four years that has caught the eye. And it does seem that the blood-curdling rhetoric about the tough cuts in the pipeline have hit confidence recently. Recent surveys of household and business confidence show deteriorating optimism across the board. This suggests that underlying growth may be weakening. Even allowing for the fact that the GDP increase for 2010 Q2 was erratically high, growth data for the second half of the year could disappoint. As a result, I remain unconcerned about inflation. Earnings inflation remains weak. In the three months to July, average earnings annual inflation (including bonuses) was just 1.5%. Given the possibility of weakening underlying growth and the fiscal tightening ahead I vote for no change to the Bank Rate. Prepare too for further QE.

Comment by Andrew Lilico
(Policy Exchange and Europe Economics)
Vote: Hold Bank Rate; extend QE starting with £30bn in first quarter.
Bias: Obtain permission from HM Treasury for up to £200bn QE.

The necessity of large spending cuts in the UK has been argued at length elsewhere, with the conclusion that spending cuts on the scale of those proposed by the Coalition are more likely to promote growth than impede it, even in the short term. Indeed, the evidence suggests that this would be likely to be so even without additional monetary loosening. However, it is not worth the risk of experimenting to see whether this would in fact be so. The proper course must be to combine the fierce fiscal tightening shortly to be underway with additional monetary loosening – in other words, more QE. This is doubly required given that - for reasons unconnected to the spending cuts - the economy is likely to experience a short-lived double dip in 2010 Q4 or 2011 Q1. Every UK recession since quarterly records began has involved a double dip. There is no reason why this one should be different.

Critics suggest that printing additional money at this stage would: (a) threaten the Bank of England inflation target's credibility, given that CPI inflation is well above target and has been so for most of the past four years; and (b) would be inflationary down the line. But the appropriate response to point (a) is that the Bank's inflation target has no credibility to lose. The credibility of the inflation target was damaged with the 2007 overshoots and totally destroyed by the huge overshoot in 2008. Meeting the inflation target has clearly not been a key driver of policy since the financial crisis began. It is an irrelevance. The response to charge (b), that more QE will be inflationary, is ‘you are quite correct - that is the idea’. As matters stand, there is a risk that we fall into deflation, household defaulting on mortgages, and more financial sector problems. That must be avoided. There will be a modest inflationary price to pay on exit - perhaps annual CPI inflation will reach 6% and RPI inflation might reach 10%. But that is a problem for 2012 or 2013. There is an urgent problem to address now – double-dip recession and fiscal tightening - and the right policy response is more QE. Regarding interest rates, there always has been a case for returning rates to around 1.5% to 2% as a ‘normal zero’ instead of the 0.5% rate at present. The case for this is very tempting, and one should seek to achieve this at the earliest opportunity - particularly to discourage loans being taken out on a ‘Bank Rate plus basis points’ basis.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold.
Bias: Hold Bank Rate; increase QE by £50bn in stages.

There has been quite a lot of press recently about chucking economists off their throne and possibly replacing them with physicists or historians. While there is much that economists can learn from these two disciplines, it does not mean that we should throw out the theories and the models that have held economics together for so long. When it comes to the appropriate stance of monetary policy in an inflation targeting environment, theory tells us that interest rates should be raised if the economy is in danger of gearing up into an inflationary state created by an excess of aggregate demand. A number of economists (including members of the SMPC) have cautioned that that is precisely where the economy is heading. But what is the evidence for this? The optimist can point to signs of recovery and indeed there are signs in an upturn in manufacturing and hours worked - although this latter indicator may change with public sector job cuts - but elsewhere the recovery is fragile. Recent retail sales figures paint a picture of a subdued household sector. The mortgage market remains depressed; and bank lending to consumers and businesses continues to be weak. It is no good beating the banks for not lending enough. As the recent Bank of England Trends in Lending reports, the demand for credit is subdued. What the commercial banks mean by this is that the demand for credit by good-risk customers is subdued and the cost of risk to small businesses measured by the spread has widened. Households are using every opportunity to repay debt and rebuild balance sheets. Big firms are using the bond market (ironically buoyed by QE) to restructure their liabilities and repay bank debt, leaving the banks with a weaker portfolio of borrowers at a time when they are expected to make greater provisions.

The most important indicator of weak demand is the growth in the monetary aggregates. Broad money (M4) is hardly moving and fiscal policy is rightly expected to be tight in the coming year. However, weak demand may not be the only problem if a larger public sector has commensurately destroyed capacity. The so-called output gap may not be as large as people think. This, indeed, is a theoretically valid argument and if there was evidence of capacity constraints following capacity destruction, then there would be an argument for early tightening. But the evidence for this is weak. The number of labour hours worked is 3% below its peak in February 2008 and there is no evidence that the most recent figure has reached a plateau. The trend in earnings growth in both the public and private sectors is in the region of 2% a year – hardly indicating a capacity constrained labour market. But, even if it can be argued that the labour market is backward looking, which is a questionable assumption, the forward looking bond markets do not suggest a resurgence of inflation. The gap between nominal and index-linked yields on long-term government debt suggests an expected retail price inflation of marginally above 3%. Given that retail price inflation has a 0.7 percentage point gap on CPI inflation, long term inflation expectations are only marginally above the current target.

This would suggest that there is room for a mild tightening but the issue is one of timing. While broad money growth continues to stagnate, raising Bank Rate would not only send the wrong signal to the market that interest rates are on the rise, it would be counterproductive on its effect on sterling. The only policy option left is to continue with QE. A resumption of staggered increases in QE over the next year is called for. Interest rates will have to rise sometime and it may have to rise rapidly when QE is reversed but not yet!

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate until inter-bank rate is aligned with wholesale deposit rates; also, to resume QE to hold market rates down at current levels.

There was a time when, in the language of Keynesians, the West, and the US in particular, were regarded as the ‘locomotives’ of the world economy. What was meant was that aggregate demand for world goods and services was most reliably growing in the US and so through to the West; this growth in demand then ‘pulled’ the developing world along behind it. Then, the saying went that ‘if America sneezed the rest of the world caught a cold’. Later, the locomotive analogy was expanded to include such major western economies as Germany. Still later, it was said that China and other eastern emerging economies were not ‘decoupled’ from these western economies; by that was meant that if the latter did not grow, eastern growth would collapse.

How different it all seems today. If ever the Keynesian locomotive theory was correct, then certainly the roles today are reversed. The East is the locomotive and the West is far from decoupled. We look anxiously at the leading indicators for China and world stock markets react if they weaken, as much as they do to developments in the US itself. This Keynesian story never gave the right prominence to productivity growth as the ultimate causative process, driving both demand and capacity in the western economies, while the mechanisms of emerging growth were still in their formative stages, especially for China, India and the other larger emerging economies. Thus, productivity growth was stuttering in these emerging economies still while it was moving confidently and steadily in the West.

Now, what we see is assured and rapid productivity growth in these emerging economic powers. They now know how to transfer resources between low-productivity sectors like subsistence agriculture into high-productivity sectors like manufacturing and low-cost services such as software writing and call centres. Meanwhile, the West has lost its manufacturing cash-cows and is focused on newer sectors where productivity growth involves painful domestic choices; nowhere is this more visible than in Japan where growth in services requires the adoption of competition and change in staid and conservative social environments. The UK achieved massive change in these service sectors central to renewed growth (‘Big Bang’ in the City, fees for students in universities and so on), and so its growth rate has been respectable in the last three decades. The US has been adept at such change but the post-crisis malaise is causing problems; in Europe change is as always fairly slow but the expansion of the European Union is pushing it along faster than otherwise.

The world economy’s recovery, for all the recent talk of double dip, is not in doubt. Indeed, world growth is likely to exceed 4% in 2010, close to the mid-2000s record rates of just over 5%. The balance of growth mirrors the balance of productivity growth: fast in the East, slow in the West. Overall growth cannot exceed current forecasts, as inflationary pressures in India, China and elsewhere make clear. The resource constraint limiting productivity growth remains commodity shortage.

In the UK, the recovery also appears assured, with typical ‘wobbles’ in the data for this stage of recovery. Looking at the GDP growth and unemployment, the figures suggest that growth is settling in the 2% to 3% range while employment is not falling and unemployment is flattening off. Thus the reaction of firms to the downturn has not been to dismiss workers in anything like the numbers one might have expected some decades ago. This seems to be due to the nature of the new service economy where workers embody skills in a way that in those earlier days machines did. The manufacturing sectors that survive in the UK are also highly skill-intensive and so basically similar to these dominant service sectors. In the US, by contrast, employment has been highly responsive. This exacerbated job shedding seems partly due to the importance of basic manufacturing still and may be due partly to a greater embodiment of service skills in computers.

What are the implications of this UK recovery for monetary policy? Repeatedly, the Bank of England has said that the recent inflation of just over 3% is temporary, just as it said the under-shoot below 2% in 2009 was temporary. In support of this position one can see wage growth is moderate, at 1.5% in July, and taking productivity growth of around 2% off the figures one obtains cost growth well below the 2% inflation target. It is hard to see any sign that the upcoming wage settlements will be anything other than cautious given the projected cutbacks in the public sector likely from the October fiscal planning exercise. Therefore, my view is in line with this Bank judgement. However, there remains the question of how monetary policy is to be conducted tactically. We can see that currently the Bank Rate at ½% is essentially disconnected from the money creation process. The commercial banks are not obtaining funds from the Bank or the inter-bank market to which Bank Rate is connected. Rather, they are getting funds directly from deposits in the retail and wholesale markets by offering considerably higher interest rates. It is as if the inter-bank market has died of irrelevance.

This is an unhealthy situation since the Bank has lost its power to influence market rates except via QE, in which it goes into the open market for bonds and buys bonds with money it prints. Traditionally, it has used Bank Rate to set market rates indirectly through its effect on inter-bank rates but this mechanism no longer works. This mechanism is preferred by the bureaucracy because the Bank’s balance sheet is less affected; currently QE has loaded the Bank up with bonds acquired from the open market and theoretically this puts its balance sheet at more risk. Consequently the Bank needs to get Treasury permission which makes monetary policy less flexible. In substance this ‘risk’ is a misunderstanding since the Bank is a wholly-owned subsidiary of the taxpayer; however bureaucracy matters because it is hard to alter and hence it is desirable to rely less on QE and to restore normal monetary rate-setting. My proposal is that Bank Rate be raised in modest steps until it ‘bites’ once again; by that I mean that the inter-bank market rates rise back to the level at which they are competitive with retail and wholesale deposits. Meanwhile QE should be resumed to offset any rise in market rates while this is going on. This reflects my judgement that monetary policy should not be tightened while the fiscal cuts are being rolled out. Indeed, it may be necessary for it to be loosened if the recovery appears genuinely threatened even though it now seems unlikely. Hence, and in summary, my vote is to raise Bank Rate by ½% with a bias to increase it further until inter-bank rate is aligned with wholesale deposit rates. Also, to resume QE in amounts sufficient to hold market rates down at current levels.

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

As an economist, you get used to saying that ‘the outlook is unclear’, but it is hard to recall a situation more uncertain than the present one. The economic and financial data have been mixed, consistent with all sorts of different views. The second-quarter UK GDP figure was a surprise but was arguably due to special factors – for example, the weather-related surge in construction output - that are not going to be sustained. The employment figures have also been remarkably strong, but the claimant count, which provides a more timely indication, appears to be weakening. Survey indicators and the housing market are also weakening. However, the real problem is that the effect of fiscal and monetary policies on the economy in present circumstances is unclear. It is hard to understand why inflation remains so stubbornly high given the general weakness of the economic indicators. It is hard to know how the programme of QE is affecting the economy and the outlook for future inflation. This forthcoming 20th October Spending Review adds to the feeling of uncertainty.

These uncertainties will add immensely to the tensions within the Monetary Policy Committee (MPC) over the next year. CPI inflation will possibly remain stubbornly above target, supported by rising food, fibre and perhaps other commodity prices. Then in January, VAT will go up too. The longer inflation remains above target the greater the risk that public perceptions of future inflation will shift upwards. The MPC minutes show that they are monitoring these expectations closely. If perceptions shift upwards, Bank Rate will have to go up, threatening the fiscal retrenchment as well the economic recovery.

Another tension arises because, although food prices, VAT and the like increase the inflationary arithmetic in the short term, they act as a deflationary force in this economic environment. That is because British workers are in a weak position in the labour market, subject to the forces of global competition. Wages fail to compensate for higher prices, which depress real incomes and spending. Over the last year average earnings grew by 1.9%, well below any measure of inflation. We are now seeing a wide range of medium-term forecasts of inflation and interest rates. The Treasury’s August comparison of medium term forecasts shows a range on the CPI of 0.3% to 3.3% for 2012. However, my own view is that if the government comes anywhere near achieving its fiscal objective, then CPI inflation will move decisively below the 2% target as the VAT increase drops out early in 2012. In the meantime, I think that inflationary expectations will remain below the actual rate of inflation, wage inflation will remain relatively subdued and that Bank Rate should be kept close to its current level.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%.
Bias: Raise Bank Rate gradually to 2½%; fundamental UK problem is the supply side and it is not remediable by monetary means.

If the proverbial Martian economist landed in London today and tried to comprehend British economic policy without having visited Planet Earth for several decades, he would probably draw four conclusions. First, that UK monetary policy was being primarilly used as a Keynesian demand-management tool in the way that fiscal policy was employed when he last visited this planet in the 1960s and early 1970s. His second conclusion would be that, to the extent that the monetary authority was concerned with inflation, the implied target was somewhere around 3% to 5% since most of the published measures of retail and consumer price inflation were in that range. If our hypothetical Martian economist then looked at what the regulators were doing, he would conclude that the world was being confronted with an unsustainable credit boom and that the international and domestic financial regulators were using increased capital requirements and liquidity constraints to cut back the excessive stocks of money and credit. His final conclusion would be that the English language had mutated while he was away, so that expressions such as ‘no more boom and bust’ meant ‘crazy-credit boom and mega-bust’ and ‘public expenditure cuts’ meant ‘significant increases in the cash expenditure of government’.

These would all be reasonable conclusions for our imaginary Martian to draw from the revealed behaviour of the UK’s monetary, fiscal, and regulatory authorities as distinct from their public statements. The question that naturally arises is how long the British political class and officialdom can maintain their credibility if their actions and their rhetoric are separated by an apparently growing chasm. The forthcoming 20th October Comprehensive Spending Review will be a crucial determinant of the credibility of UK fiscal policy, and probably the credibility of the Coalition government in the financial markets. Where monetary credibility is concerned the future course of UK inflation will eventually emerge as Judge and Jury. The latest cost and price figures suggest that the earlier depreciation of sterling is still working its way down the cost pipeline albeit with possibly reducing force. Thus, producer input costs in August were 8.1% up on the year, compared with the 10.8% rise recorded in July, while producer output prices were up 4.6% on the year, as against the annual rise of 4.7% recorded in July. The ‘double-core’ retail price index excluding both mortgage rates and house price depreciation, which is the most historically consistent inflation measure, rose by an unchanged 4.5% in the year to August, while both the ‘headline’ retail price index and the old RPIX target measure showed annual rises of 4.7%. The target CPI demonstrated an unchanged annual increase of 3.1% in August. Normally, one would expect annual CPI inflation to run some 0.5 to 0.6 percentage points below the ‘double-core’ RPI, rather than revealing August’s 1.3 percentage point gap. The main reason seems to be the different ways in which clothing and footwear are treated in the two indices but it does cast doubt on the coherence of the official inflation estimates. However, the CPIY and RPIY measures, both of which exclude indirect taxes, went up by 1.4% and 3.4%, respectively, in the year to August. This suggests that 1.7 percentage points of annual CPI inflation, and 1.3 percentage points of the yearly rise in the RPI, were caused by higher indirect taxes rather than policy errors by the monetary authority.

Perhaps the most remarkable aspect of the recent inflation indicators is the fact that economy-wide average earnings increased by only 1.9% in the year to July during a period in which the tax and price index (TPI), which corrects the retail price index for changes in the burden of direct taxes, increased by 5.3% - it then eased to 5.2% in August. The TPI implies that economy-wide real take home pay fell by 3.2% in the year to July, with the private sector down 3.4% and the public one down 2.8%. The implication is that British workers have behaved extremely responsibly and secured their jobs by taking a sharp reduction in their take home pay, something that arguably cannot happen according to simple Keynesian theories. This helps explain why the claimant count measure of unemployment has confounded all the forecasters and actually fell by 135,000 people in the year to August.

The 10.2% rise in industrial production in the Organisation for Economic Co-operation and Development (OECD) area in the year to 2010 Q2, and the 12.3% rise in the year to June alone, suggest that quite a strong rebound has occurred in the industrial sectors of the mature industrial countries as well as in the Brazil, Russia, India and China (BRIC) group that are not yet members of the OECD. It also suggests that the 5.0% rise in UK manufacturing output in the year to July represented something of an underperformance by the standards of its mature-economy peer group, especially given the competitive edge that should have been provided by the depreciation of sterling. The Bank of England has often claimed that UK inflationary pressures will abate as a result of the large margin of spare capacity in the economy as a whole. This is arguably incorrect because it treats the UK as a largely closed economy, rather than as a small open one in which the exchange rate has a powerful role to play. However, the official reliance on the output-gap model of inflation also flunks the question of what is happening to aggregate supply, despite the evidence from time series analyses that permanent supply-side shocks are at least as large and frequent as temporary demand ones.

The 8.4 percentage points rise in the British general government spending ratio between 1996-2000 and 2006-2010, a comparison that smoothes out the recent recession, would be expected to cut the sustainable growth rate of real GDP per head by some 1.3 percentage points if the normal rule of thumb is applied that each extra 1 percentage point of national output absorbed by the state cuts the long-term growth rate by 0.15 percentage points. The likelihood is that the trend growth rate of the British economy has now slowed to some 1¼% each year and that the negative output gap that the MPC are relying upon to offset the potential inflationary consequences of near zero official discount rates and QE is smaller than they are assuming. Trying to ‘rev-up’ a supply constrained economy through a hyper lax monetary policy is a policy almost guaranteed to generate speculative bubbles and eventually stagflation. The only effective solution to a supply-side problem is supply-side friendly measures of de-regulation and tight fiscal discipline operating through the government spending side, not higher taxes. This is why the forthcoming Comprehensive Spending Review is important for monetary policy as well as having the obvious fiscal implications. Bank Rate should be raised to 1% immediately and be followed by a series of modest further increases until a ‘half-normal’ figure of 2½% is achieved, after which a pause for breath may be appropriate. QE may have to be extended if the economy weakens again but, fundamentally, ‘it is the supply side, stupid!’ to paraphrase the Clinton election slogan.

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

On 27th August, the Office for National Statistics released some knockout figures for the output of the economy in the second quarter. Against a first-estimate expectation of a 0.6% quarterly gain, the second estimate was for a broad-based 1.2% increase, with industrial production rising 1.0%, service sector output by 0.7% and construction output by a cracking 8.5%. Has there been rejoicing in Threadneedle Street or Parliament Square? Not a bit of it. Everyone is playing it down as an economic freak story, soon to be erased from the public record or negated by an appalling figure for the third quarter. Neither seems at all likely to us, having examined the underlying data.

The revised level of construction output for the April-June quarter remains 8.6% below its pre-crisis peak; 5.7% down, in the case of new work, and 15.4% lower for repairs and maintenance. When identified by sector, private construction output is 18.2% less than its peak in 2008. Public sector output has risen 53% since 2007 Q3 and 40% since 2008 Q4; infrastructure spending (unidentified by sector, but initiated mainly by the public sector) is up 71% since 2007 Q1 and 59% since 2008 Q4. The extraordinary relaxation of monetary and fiscal policy is plainly visible in the support given to the construction sector during the slump. The public sector has contributed 20% of the improvement in the latest quarter and 66% of the gain over the past year. No-one expects the public sector to be able to sustain this degree of support in the years ahead, given the drastic curtailment of the capital spending budget, but this should not be necessary as the private sector takes up the running.

In the production industries, it was the third quarter of last year that marked the low point, with a particularly weak reading for August. Extended summer layoffs and short-time working were widespread. Even if there were no quarterly increase in the third quarter of this year, the annual growth in output would improve from 1.6% to 2.5%. However, further output increases are extremely likely as intermediate goods and energy have scarcely begun their recovery. Thus far, capital goods, represented by the basic metals, metal products, engineering and allied industries have led the way in industrial output recovery.

Employment data, released on 15th September, substantiate the improvement in the output data. A quarterly gain of 286,000 jobs in the May-July quarter, equivalent to a 1.0% increase, was well ahead of expectations. It was pleasing to find that full-time employment contributed 121,000 of the net gains. Part-time employment has been rising for a couple of years, up 4.7% in the past year alone. Total weekly hours worked boosted 1.4% in the May-July quarter to stand 1.5% above year-ago levels; full-timers and part-timers are working longer hours than a year ago as short-time working and extended shutdowns are revoked. The male unemployment rate fell from 9.1% to 8.5%, and the male inactivity rate from 17.4% to 17.0% in Q2: both marked trend reversals. These are strong indications that the UK economy will not be thrown off-course by a series of small rate increases.

The failure of UK consumer price inflation to fall in August, despite the benefit of a favourable base comparison for both fuel prices and second-hand car prices is another reminder of the ease with which commodity prices are being passed through to domestic food and clothing prices. Supply-side inflation pressures are likely to remain a persistent feature of the inflation outlook.

Over the summer months, UK monetary policy discussions have fragmented. Those fearing an imminent relapse in economic activity have pressed for a pre-emptive easing of policy, while a minority of inflation-worriers have maintained that it is high time to begin the removal of the extraordinary degree of accommodation represented by the 315-year Bank Rate low. The argument for a contingency plan has merit, but should not and need not obstruct an interest rate increase. By operating in two dimensions of policy, it is possible to unify the concerns of both camps. The logical response is to provide for the contingency of an extension of QE by another £50bn, while signalling a transition to Bank Rate in the region of 2% during the next few months.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold Bank Rate.
Bias: Resume QE with additional £50bn to be spent.

Signs of a weakening in the UK economy are becoming more widespread. Since GDP growth of 1.2% in the second quarter, UK purchasing managers’ indices have turned lower; volume retail sales has shown the first fall in four months, and business and consumer confidence is turning down. With interest rates pretty much as low as they can go, the only real monetary option left is QE – directly injecting liquidity into the economy via the central bank buying securities from the financial markets. The Lloyds Corporate Markets business Barometer - a better lead indicator of economic activity in the next three months than the Purchasing Managers Index (PMI) survey - is suggesting that economic growth could be flat by the end of the year.

Normally, a loosening of fiscal policy would also be an option for the authorities at a time of economic stress, but of course that is ruled out by the size of the UK’s budget deficit. Instead, fiscal policy is being tightened in order to ensure that the UK avoids being tainted with the funding concerns associated with the sovereign risk crisis facing a number of the smaller members of the Euro-zone, like Greece and Ireland. Latest figures (for August) suggest that annual borrowing this year could be closer to £155bn rather than the Office for Budget Responsibility (OBR) forecast of £149bn. Not least, this prospect makes further spending cuts or tax rises more likely if the government is to meet its June Budget forecasts.

With fiscal policy ruled out and interest rates already low, the only viable option for loosening policy falls to QE. Whilst the MPC predictably left interest rates at ½% in September, the minutes of the meeting suggest that the debate was dominated by the fact that data suggested the economy was likely to be weaker in the second half of the year. Bearing in mind that the Bank’s forecast of growth for 2011 is at the high end of expectations, close to 3%, weaker growth would leave the economy with more spare capacity, and so lower inflation, than expected previously by the MPC.

Admittedly, not all of the economic news on the UK has been negative in the last month. Manufacturing activity seems to be holding up well. Reports from the Bank of England's own officials suggested that consumer demand was still rising and that services activity and company exports were up in September. In addition, surveys of sales activity by the Confederation of British Industry (CBI) showed that retailers’ expectations were still fairly robust. Unfortunately, the overall bias of the data in the last month still point to a slowdown being underway. One bit of good news is that the economic data do not suggest a double-dip, or a return to falling output.

However, with annual money supply growth falling and the economy weakening, there seems to me little option but for further QE. And this should start before the fiscal squeeze kicks in next year. Therefore, I vote for interest rates to remain on hold in October and a further £50bn total of QE, starting in November. Nor should concerns about inflation stand in the way of further QE. With the economy weakening, the output gap will widen and inflation will eventually subside once the effects of higher VAT and other temporary pressures ease. In my view, downside risks to growth and inflation are now greater than a month ago and well above the upside risks.

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 (Policy Exchange and 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.