Monday, November 01, 2010
More recovery evidence and a knife-edge shadow MPC vote
Posted by David Smith at 08:00 PM
Category: Independently-submitted research

Back from holiday and able to update the website once more. November has just started but it has already brought more recovery evidence, with a rise in the UK manufacturing purchasing managers' index from 53.5 to 54.9, its strongest since July. The read-across from the purchasing managers' surveys to GDP and other official data hasn't been great, but this was nevertheless an encouraging number.

Meanwhile, let me catch-up on the deliberations of the shadow monetary policy committee, which voted narrowly (5-4) to leave Bank rate on hold. These are its minutes:

Following its latest quarterly gathering on 19th October, the Shadow Monetary Policy Committee (SMPC) voted by five votes to four to leave Bank Rate unchanged at ½% when the Bank of England’s rate setters assemble on Thursday 4th November. Three of the dissenting SMPC members voted that Bank Rate should be raised to 1%, while one voted for a 100 basis points increase to 1½%. The majority on the SMPC who wished to hold Bank Rate did so for a variety of reasons. These included the slow growth of broad money and credit and concern that the fiscal tightening in the Comprehensive Spending Review would reduce activity. There was also a worry that the international recovery was running out of steam in the mature industrial economies.

A number of considerations explained why four members of the shadow committee thought that a higher Bank Rate was needed. One was the disconnection between Bank Rate and commercial banks’ marginal funding costs, which meant that Bank Rate risked becoming irrelevant. Another was the continued signs of inflationary pressure in the sectors of the economy exposed to international trade. There was also concern that the sharp rise in government spending over the past decade in the US, as well as in Britain, had reduced aggregate supply and that there was less spare capacity than the monetary authorities believed.

Some SMPC members also suggested that the problems confronting the mature economies looked more like a re-distribution of economic power from the tax-and-spend European and US economies to less sclerotic emerging market economies than a demand-deficient Keynesian recession. Finally, three members of the shadow committee wanted a second round of Quantitative Easing (QE) to be implemented over the next quarter, five wanted to hold QE in reserve, and one thought that its task was now completed.

Minutes of the Meeting of 19th October 2010
Attendance: Tim Congdon, Andrew Lilico, Kent Matthews (Secretary), Patrick Minford, Gordon Pepper, David Brian Smith, Peter Warburton (Acting Chair), Mike Wickens. Apologies: Roger Bootle, Philip Booth, John Greenwood, Ruth Lea, David Henry Smith (Sunday Times), Trevor Williams.

Chairman’s Comments
David B Smith commenced by stating that that he had made some critical comments about the Office for National Statistics (ONS) national accounts data and the Bank of England’s broad money supply figures at the 20th July SMPC gathering. There had been positive and helpful responses from both the ONS, who had accepted that there were indeed errors in the chained volume national accounts, and the Bank of England where he had had useful telephone conversations and a fruitful meeting. He then said that, as he was presenting the background briefing this quarter, he should not act as both referee and player and handed over the Chair to Peter Warburton.

Peter Warburton then invited David B Smith to give his assessment of the world and domestic economy.

The Economic Situation
The International Economy – shift in economic power from Europe and US to emerging economies
.

David B Smith referred to his previously-circulated Monetary Background Briefing (see: Appendix) saying that there had been a reasonably strong growth rebound in the Organisation for Economic Co-operation and Development (OECD) area. OECD measures of broad and narrow money have also picked up in recent months. He said that sense had prevailed regarding the application of the proposed Basle III banking regulations which were now going to be phased in gradually, providing space for the banks to reach the target capital conditions without causing a second credit implosion.

Strong commodity price inflation arising from a mixture of supply shortages and increasing demand in the emerging economies was part of the process of rebalancing the world economy away from the developed west to the dynamic eastern and southern economies.

The composite leading indicators show a mixed picture with the outlook for Canada, France, Italy, UK, Brazil, China and India pointing to a downturn while the US cyclical indicator was pointing to a peak, and those for Germany, Japan and Russia were pointing to a continued expansion. The US National Bureau of Economic Research (NBER) had announced in September that the US recession was officially over. However, this historic judgement said nothing about the future outlook, including the possible risk of a second downturn.

The Domestic Economy – destruction of capacity has reduced long term growth.
The Bank of England had accepted the superior information value of the broad money measure M4X (now called M4ex) which excludes other intermediate other financial corporation (OIOFC) deposits from the conventional M4 series. The statistical section of the Bank had constructed a break-adjusted series for M4ex going back to 1997 for seasonal adjustment purposes, which it hoped to place in the public domain in the foreseeable future. While total M4 contracted by 0.1% in August, representing an annual rise of 1.9%, M4ex showed monthly and annual increase of 0.8% and 1.6%. Other measures of money, including M2 retail deposits and notes and coin, had risen at an annual rate of 4.8% to 5.2%.

Britain’s real Gross Domestic Product (GDP) rose by 1.7% in the year to the second quarter. Industrial production was up 4.2% in the year to August reflecting the recovery in world trade and the improvement in competitiveness from the sterling depreciation. Recovery was also evident in the service sector, which grew at 1.2% in the year to July. Household spending remained muted but retail sales excluding automotive fuel showed a more optimistic picture with growth of 2.3% in the year to June-August.

Revisions to the balance of payments data showed a slightly worse performance last year than was previously believed by the ONS. The monthly trade figures revealed sharp increases in export and import volumes in the order of 14% to16%. The high propensity to import in the recovery stage raises doubts about the extent of spare capacity in the economy.

Unemployment on the claimant count rose mildly in August and September to stand at 1.473 million. Surprisingly, this was 144 thousand less than in September 2009. The annual growth in unit labour costs had declined sharply in the second quarter, to 0.3%, compared with 2.4% in the first quarter and 5.2% in 2009 as a whole. British workers have preserved their jobs by accepting a 3% reduction in real take-home pay. Annual inflation measured by the RPI excluding mortgage interest and house price depreciation was 4.4% in September.

There is widespread concern that the world economy had lost some of its steam recently but this cannot be confirmed as yet from the published data. The rise in the share of the government sector between the periods 1996-2000 and 2006-10, which smoothed out the current recession, may have reduced the underlying sustainable growth rate of the British economy to only 1¼% a year. Lax monetary policy in a supply constrained world was likely to stoke up speculative bubbles and eventual stagflation. David B Smith finished by saying that several members of the SMPC had called for the implementation of an additional £50bn tranche of Quantitative Easing (QE). He was puzzled by the exactness of the £50bn figure and wondered how this had been arrived at.

Discussion and Policy Response

Andrew Lilico said that a serious problem concerning the international economy was the possibility of the de-pegging of the Gulf currencies from the dollar. The United Arab Emirates (UAE) had problems of speculative inflows, followed by rapid inflation. When there was talk of de-pegging, there was a rapid outflow followed by a banking crisis. If de-pegging occurs, there is the possibility of disorderly currency markets and further financial crisis.

Mike Wickens said that there were dangers from the commodity price boom generated by the growth in the Asian economies. In China, the internal labour migration policies were adding to the underlying growth pressure hastening the return to the pre-crisis growth position. Andrew Lilico questioned if all the generated growth and commodity price inflation was due to real factors. David B Smith said that the rise in commodity prices was due to both fundamental and monetary factors. Low real interest rates had the effect of raising commodity prices by cutting the so-called ‘cost of carry’.

Tim Congdon said that the figure of £50bn for QE was no mystery and explained how the figure could be arrived at from an analysis of the credit counterparts to money creation. He said that it was the growth of the global money supply fuelled by US policy that initiated the inflationary process during the 1970s. Peter Warburton added that the Asian economies were showing rapid monetary growth. Patrick Minford said that monetary easing had been going on all over the world. While banks in the UK and USA were on their knees, money supply had been growing rapidly elsewhere. In the UK, money supply growth was weak but, with a near zero rate of interest, monetary policy could be viewed as easy.

Tim Congdon said that asset growth was weak in the Basle III dominated western economies and the growth in the money supply will be low even with zero interest rates. Thankfully, the full implementation of Basle III had been delayed to 2019. Gordon Pepper said that the purpose of QE was to bypass the banking system and get money into the economy. He added that corporate liquidity had increased rapidly and QE should be held in reserve until it was clear what was happening. A lot of QE had been mopped up by companies using the bond market to repay debt and banks issuing capital. QE has had the beneficial effect of cushioning the downturn by arresting the fall in asset prices. He said that there was useful information in the counterparts of the money supply and the sector holding of broad money. In spite of sluggish growth of M4ex there could still be a situation of excess money, with the investment demand for broad money having fallen because of a very low rate of interest.

Patrick Minford said that the public spending squeeze had to be factored into the outlook, but since the cuts were spread over the next five years it meant that the fiscal correction would result in flat growth in the public sector. The size of the negative output gap was uncertain. It was clear that some capacity had been destroyed. Tim Congdon said that with the fiscal consolidation going on and broad money growth continuing at a low level, George Osborne would not be averse to some QE to cushion the effects of fiscal adjustment. Andrew Lilico said that the present fiscal consolidation represented the strongest fiscal squeeze since the Second World War. The government was trying to bring the public sector down from 48% of GDP to below 40%. He said that every recession since the war had experienced a double-dip in the recovery phase. Therefore the side to err on was monetary easing.

Individual Votes

Peter Warburton (as acting chair) next asked the members of the committee to vote on a rate recommendation requesting that each member clarify their position on QE. He asked that individuals comment on first, whether there should be further QE, or if it should be held in reserve for discretionary use. Second, he asked members to explain the perceived rationale for QE. Was it a) to expand broad money; b) to raise asset prices; or c) to increase the demand for risky assets in order to facilitate capital spending. As eight SMPC members were present at the meeting, only Ruth Lea’s vote needed to be cast in absentia. All the votes are listed alphabetically, according to the usual SMPC practice.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; increase QE by £25bn.
Bias: Neutral.

Tim Congdon said that an extension of QE of £25bn over the six months would raise broad money by 1½% to 2% which will generate an overall annual growth in M4 of about 3% to 4%. Bank lending to the private sector will be flat so there is a need for broad money growth to be positive during the fiscal consolidation.

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

In her vote in absentia, Ruth Lea stated that the Chancellor had basically stuck to the overall spending plans announced in the June Budget when he released his Spending Review on 20th October, to the approval of the markets. Total Managed Expenditure was projected to be a tad higher by 2014/15 – just £3bn in cash terms. In addition, there was some switching from Annually Managed Expenditure (AME) to Departmental Expenditure Limits (DELs). Even so, the macroeconomic implications of the Spending Review were minor. As has been commented many times before, the real cuts to total public spending are really fairly modest. Under the Spending Review, total spending in real terms is projected to fall cumulatively by just 3.3% over the four years from 2010/11 to 2014/15. In 1977/78 spending fell by 3.9% in the year. Some sense of proportion is required. There are, however, other economic concerns.

In particular, the second quarter’s 1.2% GDP increase was erratically high and should be taken with a pinch of salt. Third quarter growth will inevitably be lower. However, the key issue is whether underlying growth is slowing down. Surveys suggest a drop in consumer confidence (recent retail sales data are soft) and weaker business activity. Under these circumstances the Authorities should keep a watchful eye on the need to stimulate the economy further. There is no need to raise interest rates and further QE should be kept in reserve. Inflation was not a problem.

Comment by Andrew Lilico
(Policy Exchange and Europe Economics)
Vote: Raise Bank Rate to 1%; increase QE by £50bn this quarter.
Bias: Neutral.

Andrew Lilico stated that the fierce fiscal consolidation about to commence should be paired with additional monetary easing, as this provides the best prospect that the deficit can be cut without impairing growth. In addition, he noted that, if Japan and the US engaged in large-scale QE whilst the money supply expanded rapidly in the Euro-zone, the pound would be likely to strengthen without additional domestic QE, tightening the UK's monetary stance at a fragile moment.

Regarding interest rates, his view was that Bank Rate was below its natural ‘zero-base’ level at ½%, and that it had become unhooked from the monetary system except via its role as a reference in ‘Bank Rate plus basis points’ loan contracts. Thus, having Bank Rate at ½% as opposed to, say, 1% provided no additional monetary loosening. It would be useful to try to return Bank Rate closer to a natural ‘zero-base’ level of 1.5% to 2%, so as to give interest-rate decisions traction once again. It was also desirable to limit the volume of contracts based on ‘Bank Rate plus large numbers of basis points’. Such contracts rendered borrowers vulnerable to the rapid interest rate rises that must come by 2012. The latest GDP data provided a brief opportunity to raise Bank Rate closer to a ‘zero-base’ level. If we waited, then there was the risk that emerging data on a double dip would close this window of opportunity.

Comment by Kent Matthews
(Cardiff Business School)
Vote: Hold Bank Rate; increase QE by £50bn.
Bias: To raise Bank Rate.

Kent Matthews said that he was sanguine about the fiscal consolidation. The fiscal contraction had been fully anticipated and the output effects should be minimal as private sector demand rose to take up most of the slack. His rationale for QE was to raise the supply of broad money and aid the process of recovery. The effects on assets prices and capital spending are part of the effects of higher money growth and they were not an objective in themselves. Kent Matthews admitted that he did not know how much QE should be increased by. Even so, he was willing to err on the side of easing. One reason was that the policy could be reversed once it was clear that the recovery was in full swing.

Unlike others on the committee, he was not convinced that the recovery was strong enough to reverse monetary policy at this stage. Even with the Ricardian-equivalence benefits from the expected fiscal contraction, there was no evidence that the private sector was rushing to fill the gap left by the public sector. The corporate sector may be flush with liquidity but they have not as yet committed to an expansion in capital spending. He was not in favour of holding QE in reserve to be used on a discretionary basis. Part of the reason for QE was to influence expectations by announcing how much money supply was to increase, which will impact on the exchange rate. Discretionary policy of any kind only adds to the current state of uncertainty. He expected that interest rates would have to rise and QE be reversed sooner rather than later - but not right now.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1½%; use QE if necessary to stabilise money-market yields at around their current levels for the time being.
Bias: Raise Bank Rate; stop QE
.

Patrick Minford said that there was a need to make Bank Rate more integrated with the money market. Bank Rate had become decoupled from interest rates in the market. It no longer reflected funding costs to the banking system. Interest rates should be restored to around 3% eventually. Current policy was running the risk of higher inflation, which is around 5%. World inflation is out of control and policy in the USA along with the Asian economies was feeding a rapid growth in the world money supply. Although there was uncertainty about the fiscal situation, interest rates should be raised to 1½%, with QE being used to prevent a rise in market yields until this uncertainty was resolved in the next few months.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold Bank Rate.
Bias: Hold QE in reserve.

Gordon Pepper stated that he was not at present in favour of additional QE, which may seem surprising because he had been one of its early advocates (see October 2008 SMPC minutes). However, the current situation was very different from that in the fourth quarter of 2008. Generalising, the crucial issue was whether the current amount of money in the economy was greater or less than the current demand for money. If it was greater, some of the excess would be spent on goods and services and some would be spent on assets. If it was less, expenditure on goods and services would be curtailed and assets would be sold. A shortage or an excess might be caused by a change in either the supply or the demand for money. Data for the supply of money, that is, the published data for broad money, might need adjusting from time to time. Examples were the distortions caused by the ‘corset’ constraint on banks’ interest bearing eligible liabilities in 1979 and 1980; the change from M3 to M4 when building societies became similar to banks in 1980; and the recent switch from M4 to M4ex. The demand for money may also behave unusually.

In the 1970s, when Ted Heath was prime minister and would not agree to a rise in Bank Rate, bank deposits appeared to be a very poor home for savings and the savings demand for money fell. Given the buoyant data for broad money at the time it was clear that the supply of money far exceeded demand. The opposite happened to the savings demand for money when Margaret Thatcher was prime minister in the early 1980s. Rates of interest on bank deposits were relatively high and bank deposits appeared to many to be an excellent home for savings. The savings demand for money rose and, although the data for broad money were buoyant, it was not clear that the supply of money was excessive.

During the financial crisis of late 2008, the data for M4 became distorted (the data for M4ex had not yet been published). The clearest sign of trouble came from the behaviour of the deposits of the private non-financial corporations (PNFCs), mainly industrial and commercial companies. In the twelve months to December 2008, they had fallen at an annual rate of 4.9% in nominal terms. The demand for money depended partially on the availability of credit and the efficiency of the markets in liquid assets that were a close substitute for money. The demand rose because credit was no longer available and the markets in liquid assets had ceased to function efficiently. It was abundantly clear that there was a severe monetary squeeze with supply falling and demand rising.

In the present situation, the deposits of PNFCs had risen at annual rates of 4.9% seasonally adjusted during the six months to August and 11% during the latest three months. The liquidity ratio (deposits divided by loans) of PNFCs was now at its highest level since immediately before the credit crisis broke in mid-2007. The rate of interest on bank deposits was derisory. The savings demand for money had fallen sharply. It was by no means certain that the supply of money was currently inadequate. Further, it should be noted that asset prices reacted more quickly to a monetary squeeze than real economic activity - a fall in the equity market had always preceded a recession. Currently, the equity market had not fallen, which was further evidence that there was not a monetary squeeze at the moment. Gordon Pepper’s conclusion was that the case for an immediate extension of QE was not proven. QE should, however, definitely not be abandoned as a weapon. It should be held in reserve in case it is needed during the coming months. (Editorial note: Professor Pepper would like to thank Jamie Dannhauser, Senior Economist, Lombard Street Research, for his contribution to the detailed analysis.)

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%; keep QE on standby.

David B Smith said that QE should be used as a contingency but he thought that there was no immediate cause for it. He added that GDP was an almost irrelevant concept now that approximately one half of national expenditure was that of the government sector. The recession had fallen mostly on the private sector and real private domestic expenditure had fallen by some 13¾% since its peak. If cuts in the government sector reduced total GDP, but allowed the private sector to recover, then so be it. This would allow the Budget deficit to be reduced from both the spending and the revenue side, giving a favourable ‘double whammy’ where public borrowing was concerned, irrespective of what the GDP figures were saying. However, political economy considerations suggested that the actual cuts were likely to be smaller than expected. Strong company liquidity had potentially created the conditions for sharply increased capital spending and employment.

However, businessmen were reluctant to invest because of uncertainty about the future level and structure of taxes once their projects come to fruition. He humorously suggested that if an Act of Attainder was passed stating that all politicians and senior bureaucrats were to be beheaded if the tax burden rose any further, people would be amazed by the strength of the positive supply-side response. Fiscal consolidation through the spending side was far less harmful in its economic consequences than tax-based attempts at consolidation which simply destroyed capacity and created supply-side problems. Bank Rate was a slack variable that had become disconnected from the money markets. This was one of the main reasons for wanting a gradual normalisation in Bank Rate. The other was the late Eddie George’s ‘a stitch in time saves nine’. While he could see a very short-term tactical reason for holding Bank Rate in the immediate aftermath of the Comprehensive Spending Review, this would be for political-economy, not monetary, reasons.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%; hold QE as contingency reserve.
Bias: To raise Bank Rate.

Peter Warburton’s view was that monetary policy had become entangled. There had been sufficient evidence of economic recovery since the fourth quarter of 2009 and it would have been much better to have begun to raise Bank Rate at that time. With three further quarters of robust recovery behind us, there could hardly be a better time to begin the normalisation of Bank Rate. Whenever Bank Rate is raised for the first time in an interest rate cycle, there is always a negative consumer, business and financial market reaction. The extended delay has exacerbated this announcement effect. A further complication is that the structure of variable borrowing and saving rates has disconnected from Bank Rate over the last three years. The marginal cost of deposits to the UK banking system is well over 2% and this may be a better indication of short-term interest rates than Bank Rate. Accordingly, it is far from clear what impact the initial increases in Bank Rate will have on the cost of borrowing to homeowners and corporate borrowers.

For all these reasons a Bank Rate rise is long overdue and is likely to be well tolerated by the economic system. To the extent that growth momentum might fade over the next two or three quarters, it would be perfectly consistent to use additional QE as a contingency. To be clear, the available evidence suggests that the UK economy is performing well enough to withstand the gradual tightening of fiscal policy and not to require any additional monetary stimulus. There is also a technical argument for additional QE in relation to the stabilisation of UK medium-term gilt yields. The past few months have been characterised by abundant overseas net gilt purchases that are unlikely to be sustained. There is a case for the contingent use of QE to reduce the volatility of gilt yields. In summary, Bank Rate should be raised immediately to 1% and the Bank of England should be granted the flexibility to undertake additional QE up to a limit of £50bn.

Comment by Mike Wickens
(Cardiff Business School)
Vote: Raise Bank Rate to 1%; hold QE.
Bias: To Raise Bank Rate.

Mike Wickens said that further monetary easing would be ineffective. QE has done its job and this has been confirmed by the data. There is a risk to inflation and the Bank of England must realise that the time has come to raise interest rates. QE has done the job of reducing the spread between the London Inter Bank Offered Rate (LIBOR) and Bank Rate and that was an important feature of the policy. Subsequent events do not warrant a further increase in QE.

Policy response

On a vote of five to four there was a recommendation for interest rates to remain on hold in November. Three SMPC members voted to raise rates by ½%, two with a bias to raise Bank Rate further in subsequent months, while one member voted to raise rates by a full 1% with a bias towards further increases subsequently. Two of the members who had voted to hold possessed a bias to tighten through rate increases in later months. Three members of the shadow committee voted for QE to be resumed, five members voted for QE to be held in reserve as a contingent policy option, and one thought that QE had now completed its task.

Date of Next Meeting
Tuesday, 18th January 2011.

Appendix: SMPC Monetary Background Briefing, 19th October 2010

David B Smith

This Appendix provides a summary of recent international and British economic developments as a background to the 19th October 2010 meeting of the Shadow Monetary Policy Committee (SMPC). It has since been updated to include data published up to the morning of 26th October. The note starts with comments on the international background, followed by a discussion of British monetary conditions, UK demand and output, the UK labour market, prices and the recent behaviour of UK financial markets.

The International Background

The main current features of the global economy are as follows:

First, the latest (upwards) revised data show that aggregate Gross Domestic Product (GDP) in the Organisation for Economic Co-operation and Development (OECD) area rose by 0.9% in the second quarter and grew by 3.1% in the year to 2010 Q2, having risen by a yearly 2.4% in 2010 Q1 and fallen by an average of 3.4% in 2009. The industrial production sub-component of GDP rose by 10.1% in the four quarters to 2010 Q2 and was up by 8.5% in the year to July alone. National statistics show that US GDP expanded by 3.0% in the year to 2010 Q2, and Canada and Australia grew by 3.4% and 3.3%, respectively.

‘Euro-zone’ GDP has grown by 1.9% over the same period, with Germany alone up 3.7%. Britain’s market-price GDP expanded by 1.7% in the year to 2010 Q2 and national output in Japan increased by 2.4%. Amongst the leading Tiger economies, China’s growth was 9.6% in 2010 Q3, India’s 8.8% in 2010 Q2, and Singapore’s no less than 18.8% in Q2, although this slowed to 10.3% in Q3. Latin America has also seen some robust yearly increases, with Brazil up 8.8% on the year in the second quarter and Mexico showing annual growth of 7.6%. These developments look more like a rapid re-distribution of economic power from the ‘tax-and-spend’ European and US economies to less sclerotic emerging market economies than a classic demand-deficient Keynesian recession.

Second, the OECD has, rather annoyingly, discontinued publication of its long-established series for inflation and broad money growth, excluding the former high inflation economies such as Turkey and Mexico. However, with Turkish inflation now down to 9.2% and Mexican to 3.7%, it is reasonable to assume that these are no longer distorting the recent figures too badly. Even so, the historic data look very different, posing serious problems for people running economic models. Overall OECD inflation was 1.6% in the year to August 2010, the same as in June and July. The more-timely figures for inflation in the leading developed countries in the year to August or September ranged from minus 0.9% in Japan, to 0.3% in Switzerland, 1.3% in Germany, 1.4% in France, and 1.7% in Canada. Annual inflation in the USA was an unchanged 1.1% in September (‘core’ 0.8%), when Euro-zone inflation was 1.8%. Chinese inflation is 3.6%, compared with 9.9% in India and 4.7% in Brazil.

Third, annual OECD broad monetary growth including the former high inflation countries was 3.5% in August compared with 3.1% in July and 3% in June. Annual broad money growth in the year to August was 2.8% in the US, 5.2% in Australia, 6.9% in Canada, 0.4% in Japan and 0.5% in the Euro-zone according to the OECD data bank. However, the figures need to be treated with care because the equivalent UK annual growth rate would be 9.7%. This is arithmetically correct if one works with the published M4 level but this fails to allow for the very large £176bn (8%) break in M4 between December 2009 and January 2010. This UK ‘error’ will have had some positive distorting effect on the OECD monetary growth total and there may be similar problems with the data for other nations. As they stand, the OECD data show Chinese year-on-year broad money growth at 18.4% in August, India’s at 15.6%, Brazil at 14%, Russia at 22.3%, and South Africa at 4.2%. The OECD’s measure of M1 narrow money showed an annual rise of 7.4% in August, compared with 7% in July. The general impression is that both narrow and broad money growth were accelerating in the summer, albeit from a very low base in the case of broad money. The robust monetary data and 3% plus growth figures for Canada, Australia and South Africa - all of which originally based their banking systems on British practice - indicate what might have happened in the UK if our regulatory authorities had done their job properly.

Fourth, the 25th October data for the Bank of England’s trade-weighted exchange rate indices show that the trade-weighted Yen has appreciated by 4.4%, since the SMPC last gathered on 20th July, the US$ has eased by 6.3%, and the Euro has strengthened by 3.7%. The trade-weighted sterling index, which has a different January 2005 base, has declined by 2.6% since the last SMPC gathering.

Fifth, the price of a barrel of Brent crude oil was $83.5 on 25th October, compared with $76.2 on 20th July. The weekly ‘Economist’ index of dollar non-oil commodity prices is presently 251.3 (2000=100), representing a rise of 25.8% on the year and of 21.3% on the level recorded just before the July SMPC meeting. Rapid commodity price inflation reflects a mixture of: specific supply shortages; the low costs of carry for those speculating in commodities; and buoyant activity in the emerging economies. Higher commodity prices are part of the process by which living standards are reduced in the sclerotic West as economic power shifts to newer more dynamic eastern and southern economies.

Sixth, the FT S&P-A world equity index measured in local currencies closed at 291 (31/12/86=100) on 25th October. The US S&P Composite Index was 1186 while Britain’s FTSE All-Share index was 2975. The world index is 8.7% higher than when the SMPC last met on 20th July, while the S&P composite is 9.4% up, and the FTSE All-Share is 12.1% higher.

Seventh, the US Fed Funds rate is currently fluctuating in a 0% to 0.25% band while US Prime Rate is 3.25%, the European Central Bank (ECB) REPO rate is 1%, UK Bank Rate is 0.5%, and the Japanese overnight call rate is 0% to 0.1%. Three-month money market rates are currently 0.20% in Japan, 0.31% in Switzerland, 0.36% in the US, 0.67% in Britain, 1.03% in the Euro-zone, and 1.44% in Canada. The US ten-year bond yield was 2.55% on 25th October, the equivalent Bund yield was 2.46%, the Japanese bond yield was 0.90%, and twenty year gilts offered 4.05%. The Greek ten-year bond yield, which peaked at 12.04% on 8th September, is currently 9.44%, representing a real yield of 3.6%. Greek inflation was 5.6% in September.

Eighth, the OECD’s composite leading business cycle indicator has often proved a reliable guide for the aggregate OECD area in the past, albeit less so for particular countries. The composite leading indicator for the OECD area as a whole decreased by 0.1% in August 2010 marking the fourth consecutive month that the index has shown negligible or negative growth. The outlook given by the composite leading indicators for Canada, France, Italy, the United Kingdom, Brazil, China and India points strongly to a downturn. Stronger signals of a peak are emerging in the United States. For Germany, Japan and Russia the leading indicator points to a continuation of the expansion phase.

Finally, the US National Bureau of Economic Research (NBER) stated on
20th September that the recent US recession had lasted eighteen months from December 2007 to June 2009. The NBER methodology does not say anything about the likely strength of the subsequent recovery or future prospects.

British Monetary Conditions

The main recent British monetary developments are:

First two important changes to the UK monetary data are being implemented by the statistical section of the Bank of England. The first is that the Bank will cease publication of the provisional estimate of M4 broad money after this month. One reason is that there is now a widespread acceptance that the M4ex monetary measure, which excludes other intermediate other financial corporation (OIOFC) deposits and was previously called M4X in SMPC reports, is the better guide. The second development is that the Bank are now planning to seasonally adjust quarterly M4ex in its own right rather than by subtracting unadjusted OIOFC deposits from seasonally-corrected total M4, which was the previous procedure. This should not only lead to improved seasonal adjustment but has had the incidental benefit that the Bank has compiled a break-adjusted levels series for M4ex back to late 1997. The publication of this series would be of great help to anyone who takes broad money seriously.

Second, provisional total M4 contracted by 0.3% in September, representing a yearly rise of 0.9%, compared with 1.9% in August, while M4ex showed monthly and annual increases of 0.8% and1.6%, respectively, in August. M4 equivalent lending was unchanged on both the month and the year in September. However, the latter figure becomes minus 1%, if securitisations etc are excluded. Retail deposits and cash (M2) - which arguably is the classic Friedman definition of money - rose by 0.3% in August, giving a yearly rise of 4.8%, while wholesale deposits fell by 1.2% on the month and 1.6% on the year. Notes and coin went up 0.4% in September producing a yearly rise of 5.0%, against 5.2% in August.

Third, the Office for National Statistics (ONS) Public Sector Finances Statistical Bulletin for August published on 21st September switched from reporting figures for public sector net borrowing gross of financial sector intervention to figures excluding financial intervention. This represents another change to an established data series without apparent consultation with the user community. The cumulated figures for the first six months of 2010-11, which were released after the SMPC meeting on 20th October, showed a cumulated Public Sector Net Borrowing deficit excluding financial sector intervention (PSNBX) of £73.5bn, compared with a £77.4bn deficit in the first half of fiscal 2009-10. Annualising the difference and adding it to the total for 2009-10 would yield a projected PSNBX of £148.2bn in 2010-11. The PSNB including financial intervention was £70.2bn in April-September 2010, compared with £75.1bn a year earlier, yielding a naively projected PSNB of £135.7bn in 2010-11.

Fourth, a similar calculation with the Public Sector Net Cash Requirement would yield a projected deficit of £114.8bn in 2010-11, compared with £134.4bn in 2009-11. Given the strength and frequency of the political attacks on the banking sector, it is interesting that the PSNB was reduced by £9.6bn in 2008-09, £10.4bn in 2009-10, and £3.4bn (£6.8bn annualised) in the first half of 2010-11 as a consequence of the government’s financial intervention.

Finally, the 20th October Comprehensive Spending Review (CSR) made a slight upwards adjustments to public capital formation but otherwise had few significant new macroeconomic implications that were not apparent after the June Budget. Rather surprisingly, the CSR was not accompanied by a new set of official macroeconomic forecasts. These will be published by the OBR in late November.


UK Demand and Output

The main features of the recent British demand and output data are as follows:

First, the third estimate of the expenditure components of UK real gross domestic product (GDP) in 2010 Q2, published on 28th September, showed: the volume of household consumption 1.4% higher on the year; non-profit institutions 1% down; a quarterly rise of £88m in inventories measured in chained 2006 prices; a yearly rise of 1.9% in general government current expenditure; and fixed capital formation 3.7% higher on the year. The volume of gross domestic expenditure rose by a reasonably robust 2.9% in the year to the second quarter but the benefits were offset by a substantial deterioration in real net trade. Exports were 6.2% greater in the year to 2010 Q2 but real imports were up by 10.4%. The result was that overall national output was 1.8% higher in year-on-year terms on the basic-price measure, and 1.7% up on the officially-preferred market-price estimate, but 2.0% higher on the basic-price measure that excludes North Sea oil and gas production. The ‘flash’ output-based measure of third quarter GDP, released on 26th October, showed a rise of 0.8% on 2010 Q2 and 2.8% on the year. Noon-oil GDP increased by 2.9% in the year to the third quarter.

Second, recent figures for UK industry have been reasonably strong, reflecting the recovery in world trade and the competitive exchange rate. Total production went up by 0.2% in August giving a yearly rise of 4.2%, against 2% in July, while manufacturing output increased by 0.3% on the month and by 6.0% on the year. However, manufacturing output dropped by 2.9% in 2008 and 10.8% in 2009 before showing annual rises of 1.6% and 3.6% in the first and second quarters of this year, respectively. The recent strength of manufacturing really represents a recovery from a depressed base so far, albeit an accelerating one.

Third, the output of the UK service sector in August 2010 was 2.7% higher than in August 2009. All five components of the service sector increased over the year. Distribution rose 5.4% compared with August 2009, while hotels and restaurants output rose 2% on the year, transport, storage and communication output increased 0.4%, business services and finance output rose by 3.4% and government and other services output went up by 1.3% when compared with August 2009. Total service sector output increased by 0.6% between July and August while a three-month average shows service output up 0.3% on March-May and 1.8% greater than in June-August 2009. These service sector output figures appeared on 26th October, a week after the SMPC gathering.

Fourth, Britain’s seasonally-adjusted value of retail sales including automotive fuel declined by 0.2% in September, giving a modest yearly increase of 0.5%. The seasonally-adjusted value figures were 2.4% up on the year in September, implying that retailers raised their prices by 1.9%. The three-month comparison shows that the volume of retail sales rose by 0.9% in the year to 2010 Q3 and by 1.0% between the two most recent quarters. However, the retail sales data excluding automotive fuel were rather stronger, showing yearly and quarterly volume rises of 2.2% and 1.2% when 2010 Q3 is compared with the relevant earlier quarters. In September alone, non-fuel sales were unchanged on the month but 1.8% higher on the year in volume terms. The September retail sales data were published on 21st October, which was after the SMPC gathering.

Finally, the ONS balance of payments data released on 28th September showed an upwards revised £17.6bn current account deficit in 2009 and deficits of £11.3bn and £7.4bn in the first and second quarters of this year, respectively. The UK deficit on goods trade was £8,227m in August, made up of a £3,533m deficit with the European Union (EU) and a non-EU deficit of £4,694m. There was a £3,584m surplus on trade in services, however, producing an overall deficit of £4,643m compared with the £4,991m deficit recorded in July. The volume of UK good exports showed a 14.5% increase in the year to June-August while the volume of imports rose by 14.4%, but the increases were 16.9% and 15.5%, respectively, if oil and erratic items are excluded. Export prices increased by 5.7% in the year to June-August, while import prices rose by 7.3%. These figures suggest that UK activity is being boosted by the rebound in world trade. However, the high propensity to import in an economy with an alleged large margin of spare capacity implies serious supply-side inadequacies. Furthermore, the rapid rise in export and import prices suggests that there is a risk to the internal domestic rate of price increase as the high inflation in the internationally-trading sector works through.

UK Labour Market

The main features of the UK labour market data are summarised below:

First, the claimant-count unemployment measure seems to have hit a temporary trough of 1,464,000 in July. The claimant count rose by 3,800 people in August and 5,300 in September. It now stands at 1,473,100 or 4.5%. Possibly slightly surprisingly, this is 144,100 less than in September 2009. Male unemployment increased by 1,100 to 1,042,100 (5.9%) in September 2010 while female joblessness rose by 4,200 to 431,000 (2.9%). There is a tendency for female employment to be concentrated in the public sector, while males are more commonly employed in the private sector. Public sector employment reductions might be correspondingly more likely to boost female than male unemployment. However, many females are part time and cannot ‘sign on’.

Second, the Labour Force Survey (LFS) shows that the working-age employment rate was 70.7% in June-August 2010, unchanged on the year and 0.2 percentage points higher than in the preceding three months. LFS unemployment went down by 20,000 between March-May and June-August. The LFS showed 2,448,000 people seeking jobs, equivalent to a rate of 7.7%, in June-August. Male joblessness was 1,436,000 (8.4%) on the LFS measure, while female joblessness was 1,013,000 (7.0%). The LFS measure of total employment in May-July was 29,158,000, 0.6% up on the previous three months and 0.8% higher on the year.

Third, average weekly earnings including bonuses were £451 in August 2010 representing a rise of 0.2% on the month and 2.1% on a year earlier, while the three-month average figure showed a rise of 1.7%. Private sector earnings rose by 0.2% in August to 1.8% up on a year earlier (1.2% three-month average) while public earnings also increased by 0.2% on the month and showed annual and average rises of 2.0% and 2.9%, respectively. Reflecting the marked recovery in British industrial activity (see above), manufacturing earnings rose by 4.9% in the year to August (4.3% averaged). Excluding bonus payments economy-wide earnings rose by 2.3% in the year to August (2.0% averaged) when private-sector pay increased 2.4% (1.7%) and public-sector pay 1.7% (2.2%). These are well below the annual rise in the tax and price index (see below) and indicate a substantial reduction in the real living standards of most employees.

Fourth, economy-wide unit labour costs were 0.3% higher over the year to 2010 Q2, compared with the 2.4% rise in the first quarter and 5.2% increase recorded in 2009 as a whole. Economy-wide output per hour had declined by 2% last year, but showed annual increases of 0.9% and 1.4% in the first and second quarters, respectively. The ONS series for total weekly hours was 2.5% lower in June-August than it had been in the corresponding period of 2008, but was up 1.9% on June-August 2009 and 0.8% greater than in March-May 2010. Male hours were up 2.1% in the year to June-August while female hours were 1.5% higher.

Finally, the better unit-cost figures should be regarded as good news by people who believe that unit labour costs are a key influence on inflation. The poor data on productivity and unit costs in 2009 seems to have resulted from the decision by employers to hoard workers rather than let them go in line with falling output, and productivity is now rising as output recovers. This contrasts with the US experience where employers aggressively cut payrolls in response to declining output. British workers have behaved responsibly and secured their jobs by accepting a sharp reduction in their real take-home pay. This is something that arguably cannot happen, according to Keynesian theories. It also suggests that the adverse ‘hysteresis’ effects of previous job losses on future employment may be less marked in the UK than in the US.

UK Prices

The main features of recent UK prices data are as follows:

First, the latest producer price figures show that input prices rose by 9.5% in the year to September, compared with the 8.7% annual increase recorded in August. Input cost inflation was 6.4% in the year to September if the costs of food, beverages, tobacco, and petroleum are excluded. The wide measure of producer output prices, including food, drink tobacco and petroleum products, went up by 0.3% in September and increased by 4.4% on the year, compared with 4.7% in August. ‘Core’ output prices rose by 0.4% in September, giving an annual increase of 4.6%, unchanged on August. Output prices excluding customs and excise duties went up by 4.5% in the year to September, following a yearly rise of 4.6% in August.

Second, the target Consumer Price Index (CPI) held steady in September to give a year-on-year increase of 3.1%, the same as in July and August. The ‘headline’ retail price index (RPI) rose by 0.4% in September while its annual rate of increase eased from 4.7% to 4.6% and the RPIX ‘old’ target measure increased by 0.4%, taking its yearly rise from the 4.7% recorded in August to 4.6%. CPI and RPIY, both of which exclude indirect taxes, went up by 1.5% and 3.4%, respectively, in the year to September. This suggests that 1.6 percentage points of annual CPI inflation and 1.2 percentage points of the annual rise in the RPI were caused by higher indirect taxes. The tax-push element of UK inflation is arguably not something that the MPC should be considered responsible for. It could be argued further that tax-push inflation can only be offset by enforcing an unnaturally low inflation rate on the private sector, something that might require a deepened recession.

Third, the RPI excluding both mortgage interest rates and house price depreciation, which is the most historically consistent inflation measure rose by 0.4% in September when it was 4.4% up on the year, compared with the 4.5% rate recorded in July and August. Normally, one would expect CPI inflation to run some 0.5 to 0.6 percentage points below the ‘double-core RPI’ rather than the 1.3 percentage point gap observed in September. The unusual discrepancy between the two may cast doubt on the quality of the ONS estimates. The tax and price index (TPI) went up by 0.35% in September while its annual rate of increase eased from 5.2% in August to 5.0% in September. The TPI implies that economy-wide real post-tax earnings fell by 3.0% in the year to August, with the private sector down by 3.2% and the public one down 3%. Lastly, the ‘Rossi’ index, which in the past was used to up rate most welfare benefits, rose by 4.8% in the year to September, the month traditionally used to protect welfare payments against inflation.

Lastly, there are the usual problems in reconciling the various house price indices. The official Communities and Local Government (CLG) index rose by 0.7% between July and August and by 8.3% in the year to August, representing a noticeable slowing on the recent peak increase of 10.6% recorded in the year to May. There have, however, been massive differences between the regions with house prices in Northern Ireland down 18.8% in the year to August but those in London up by 12.4%. The Eastern region, South East and South West also experienced double-digit house price increases in the year to August, counterbalanced by noticeably smaller increases in the old industrial heartlands.

UK Financial Markets

The FTSE All Share index has gone up by 12.1% since the 20th July SMPC meeting, while the UK twenty year gilt yield has eased from 4.2% to 4.05% (having been down to 3.8% on 31st August) and the sterling index has weakened by 2.6%. Bank Rate has been held at ½% since 5th March 2009 and the next MPC rate announcement is due on Thursday 4th November. The British three-month inter-bank rate is currently 0.67% while three-month Certificates of Deposit are yielding 0.85%.

Concluding Remarks

Neither the international nor the UK economic backgrounds appear to have changed massively since the 20th July SMPC meeting. Indeed, there appears to have been rather more good news than bad after allowing for the extensive random wobble present in the official data as well as the financial markets. However, the most recent monthly indicators expire in August or September while the detailed national accounts data run out in 2010 Q2, and are still prone to revision. There appears to be a widespread concern that the world recovery has recently lost most of its momentum, but this cannot be confirmed from the official data as yet. Business and consumer confidence surveys can also generate ‘false negatives’ when the media are full of doom and gloom – this happened after Britain’s withdrawal from the Exchange Rate Mechanism (ERM) in 1992, for example. It is essential from a monetary-policy perspective to diagnose whether weak activity is a Keynesian demand-side phenomenon or reflects a withdrawal of aggregate supply by private sector economic agents.

In particular, the view that there may be more shafts of sunlight than dark clouds playing over the world economy may appear irrelevant from the perspective of the sclerotic tax-and-spend Western economies. This group now includes the USA where the government spending ratio is higher than Britain’s was in 2002. 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 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. In the case of the US, spending has not risen as much and the damage has been less marked, but a growth deceleration of 0.6 percentage points still seems the most likely outcome of the ‘big-government’ policies of President Obama and his predecessor. The likelihood is that the trend growth rate of the British economy has now slowed to some 1¼% each year and that of the US to barely 2%. The implication is that the negative output gap that central banks are relying upon to offset the potential inflationary consequences of near zero official discount rates and quantitative easing is smaller than they are assuming.

Neither the Bank of England nor the US Federal Reserve have ever devoted enough attention to the supply side in their rate setting, despite the extensive evidence from time series analyses that permanent supply-side shocks are at least as large and frequent as temporary demand side ones. 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. Arguably this is what happened during the Greenspan era at the US Federal Reserve, when Mr Greenspan failed to recognise that President Bush’s ‘Big-Government Conservatism’ was causing a deceleration in potential supply, and attempted to artificially stimulate growth through the unduly low interest rate policy that was a major cause of the financial crash. The only effective solution to a supply-side problem is supply-friendly measures of de-regulation and tight fiscal discipline operating through the spending side, not higher taxes.

Unfortunately, politicians and regulators have found it easier to attack ‘greedy bankers’ than the powerful government spending lobbies, in part because it distracts attention from their own collusion in the credit boom. Such attacks are perverse from the viewpoint of economic recovery because they weaken entrepreneurial ‘animal spirits’ and give rise to cuts in investment spending and a withdrawal of employment opportunities. This is because economic agents will not invest in physical or human capital if they fear the prospect of future tax increases, especially if these are capricious windfall taxes that are also inconsistent with the rule of law. The front-end loading of the Coalition government’s tax increases, and rear-end loading of the spending cuts leaves the impression that any adverse unforeseen events will lead to further tax increases. Nobody will invest in a risky venture on, say, a five-year time horizon if they have no idea what their tax liabilities will be at the end of the period.

Fortunately, the latest Basle III proposals on international bank regulation have paid some limited attention to the people who have warned that abrupt rises in bank capital requirements endangered a collapse in money and credit growth and a renewed downwards leg to the global recession. It remains a mystery, however, why so much emphasis is being placed on capital requirements, which lead to a perverse gaming of the regulations, and so little on liquidity requirements where there is a long record of successful implementation. There is a further danger that national regulators will ‘gold-plate’ the Basle III proposals, leading to a further contraction in bank balance sheets. Both the US and British central banks appear to be preparing the ground for a second batch of quantitative easing (QE). As far as the UK is concerned, recent SMPC polls have indicated a strong majority in favour of implementing an extra £50bn or so of QE. This has included most of those who favoured a rise in Bank Rate to 1%. One puzzle is where this recommendation comes from? In particular, how does one calibrate the amount of QE required in a situation where none of the official forecasting models incorporate QE effects on the bond yield or allow the bond yield to influence activity?

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.