Sunday, December 05, 2010
Shadow MPC votes 5-4 to hold rates
Posted by David Smith at 04:45 PM
Category: Independently-submitted research

In its latest monthly e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by a knife-edged margin of five votes to four to leave Bank Rate unchanged when the Bank of England’s rate setters assemble on Thursday 9th December. All four dissenting SMPC members believed that Bank Rate should be raised by 50 basis points to 1%.

This recommendation is consistent with the old adage that borrowing costs came down in quarters but went up in halves. The SMPC majority who wished to hold Bank Rate in December recognised that the third-quarter data for the British economy had been reasonably encouraging. However, the five SMPC members concerned still regarded a rate hike in December as inappropriate.

The reasons included: the continued de-leveraging of the banking system; the consequent slow growth of broad money and credit, and concern that the government’s fiscal tightening would reduce activity as it came into effect. The uncertain outlook for some other industrial economies was another reason why the majority of the SMPC favoured a rate hold.

A variety 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 the official rate risked becoming irrelevant.

Another concern was the indication of a modest build up of inflationary pressure in the private sector, especially that part exposed to international trade. A third worry was that the Bank of England risked losing credibility if it did not react to sustained above-target increases in the consumer price index and ignored the extent to which the inflation rate measured by the more popular retail price index was running above its consumer-price index equivalent.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold.
Bias: To hold; QE should only be implemented to ensure that broad money growth stays positive.

Recent data suggest that economic growth in the UK is recovering satisfactorily. However, there is much confusion about the causes and appropriate treatment of the higher-than-target inflation rate. To understand the overall situation in the UK and elsewhere one needs to be clear about what is happening in both developed and emerging economies because current business cycle conditions in each are very different.

First, consider the developed economies. During the credit and housing bubble of 2003 to 2008, households and financial institutions in the US, the UK, Spain, Ireland and elsewhere became seriously over-leveraged, and now require an extended period of balance sheet repair. While this balance sheet repair is on-going, bank lending has been shrinking or static as loans have been repaid, and bank credit growth is likely to remain very weak. Money or deposit growth on the other side of banks’ balance sheets is also very low. Already broad money – defined as currency plus bank deposit liabilities, corresponding to total bank credit - in the US, the Euro-zone and the UK are near their lowest post-World War II growth rates, while outside the banking systems there is credit shrinkage. This means that in 2011-12 there is much more risk of deflation in developed economies than inflation.

But what about QE and QE2? Surely they will generate inflation?

Not necessarily!! Most people have a huge misconception about Quantitative Easing (QE). They think that money is created by a kind of helicopter-drop of banknotes, but this is false. In a modern economy, money is created principally by commercial banks making net new loans, and, as just explained, because households and others are repaying debt, and because financial institutions are risk-averse, there is virtually zero growth of bank credit in the US, the UK or the Euro-zone. In the crisis economies of Greece and Ireland, bank credit and broad money growth are declining by 10% and 15% year-on-year respectively. QE implies that the central bank is expanding its balance sheet by purchasing government bonds or other securities. So far, however, the main counterpart to that on the asset side of banks’ balance sheets has been a huge increase of excess reserves of banks at the central bank, not an increase in bank lending. For example, out of the Fed’s current balance sheet of US$2.125 trillion, no less than US$1 trillion is bank reserves. Similarly at the Bank of England, out of a total balance sheet of £250bn, no less than £150bn is bank reserves. In other words, commercial banks are showing they prefer to build up capital and liquid assets instead of lending to customers. Alternatively, the credit or money multiplier has fallen abruptly. On the liability side of banks’ balance sheets, the new deposits created by central bank purchases of securities from non-banks have merely helped to counter-balance the deposit shrinkage that might otherwise have occurred as a result of loan repayments. The net result - as in Japan between 2001 and 2006 - is very slow money growth.

Consequently, there is currently no threat of sustained, generalised inflation in these developed economies. In the UK, Consumer Price Index (CPI) inflation at 3.2% is somewhat higher than in the US or the Euro-zone only because: (1) sterling has depreciated more than the US$ or the Euro; (2) imports are a larger share of GDP than in the US or the Euro-zone; (3) indirect taxes have been increased, and (4) money growth in the UK stayed higher for longer (until the autumn of 2009, just one year ago). This is supported by the fact that annual inflation as measured in the CPIY series, which excludes the price effect of indirect taxes, has been below target throughout 2010. Allowing in addition for some exchange rate effect, underlying UK inflation has stayed well below target.

Once these temporary effects have flowed through, inflation rates will fall. However, because deposit interest rates in the developed economies are virtually zero, there is a huge arbitrage/carry trade between them and the emerging markets of Asia and Latin America and the commodity-based economies, such as Australia, where interest rates are higher and growth is stronger. Interest rates are likely to stay low in the developed markets for an extended period, just as they did in Japan under QE. That resulted in a huge, multi-year yen-based carry trade, but no inflation in Japan.

Second, let’s turn to the emerging markets of Asia and Latin America. Most of these economies had serious banking, currency and debt crises in the 1990s. Mexico triggered the Tequila crisis in 1994-95; Brazil undertook a currency reform in 1995-96 to end hyperinflation, and non-Japan Asia had a financial crisis in 1997-98. Since then, these economies have undertaken balance sheet repair, and by and large they did not participate in the credit and housing bubble of 2003 to 2008. Consequently, in the major sectors - household, corporate, financial and government sectors - balance sheets are mostly in good shape. As a result, when the global financial crisis occurred in 2008 and 2009, these economies were able to cut interest rates and see monetary and fiscal policy gain traction quickly. This contrasts with what has happened in the developed economies where monetary and fiscal policy had not gained traction.

Policy makers in the developed world are likely to struggle to make monetary and fiscal policy effective over the next few years. The reason is that when widespread balance sheet repair is on-going, the growth of bank credit and money will tend to remain stagnant (as they did in Japan under QE), and inflation and interest rates will also remain low. This means that the carry trade and inflows to emerging economies will escalate. To combat the inflows, policy makers in the emerging markets have four choices: (1) allow their currencies to appreciate to avoid a monetary explosion; (2) keep their currencies stable against the dollar but sterilise the net inflows to prevent inflation - as China does; (3) impose some form of capital controls, as Thailand and Brazil have done, or (4) rely on macro-prudential controls - such as the loan-to-value limits on residential and commercial mortgages imposed in Hong Kong, Norway, Sweden, Canada, or China - to limit leverage in the household and financial sectors. If asset bubbles do develop in these economies, the damage on the downside will be limited as long as households and banks are not over-leveraged.

It would be a serious mistake to raise interest rates in the UK now on account of the temporary surge in inflation due to high commodity prices that are in turn responding primarily to the strength of demand in emerging economies. Monetary policy in the UK should not attempt to counteract supply or demand shocks abroad. For that reason, bank rate should remain unchanged.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate and no further QE.
Bias: To hold Bank Rate.

The third quarter GDP data were reasonably encouraging. After the erratically high increase of 1.2% in the second quarter, GDP growth was estimated to be 0.8% in the third quarter. There are always doubts about the accuracy of the estimates supplied by the Office for National Statistics (ONS) of course – but these are the figures we have. The behaviour of the different expenditure components made interesting reading. The increase in household consumption was a modest 0.3% in the quarter; general government consumption growth slowed noticeably compared with previous quarters; stock-building’s contribution was significantly less, and the increase in capital formation was satisfactory. But, most encouragingly of all, exports growth comfortably outstripped imports growth. Perhaps this is the harbinger of the ‘export-led growth’, as forecast by the Office of Budget Responsibility (OBR), which has so far proved so elusive.

CPI inflation was 3.2% in October and the November Bank of England Inflation Report clearly shows that the Bank expects CPI inflation to stay above the 2% target until the beginning of 2012, after which it dips to under 2%. This may yet prove to be the triumph of hope over expectations, but there are sound reasons to believe that inflationary pressures are not building up significantly. As Bank Governor Mervyn King pointed out on several occasions during the Inflation Report press conference, there were few indications that ‘red lights were flashing’. There is little sign that inflation expectations are picking up and earnings inflation remains (unsurprisingly) subdued.

Given the fiscal retrenchment ahead, which will act as a temporary drag on growth, there seems no compelling reason for increasing interest rates. But given the reasonably well established recovery, there seems no compelling reason for an extension of QE, though it can always be kept in reserve if the need arises.

Comment by Andrew Lilico
(Policy Exchange and Europe Economics)
Vote: Raise Bank Rate to 1%; increase QE by £50bn.
Bias: Raise interest rates to 1.5% as opportunity allows; loosen policy further with yet more QE (beyond the £50bn extra).

The current situation places policymakers in a highly unenviable position. The correct strategy is to loosen policy further, even though the probable consequence of doing so will be inflationary boom-and-bust. In terms of context, it is noteworthy that M4ex growth is still very modest (1.6% in the year to October) implying underlying deflationary pressures given GDP growth of 0.8% in the third quarter and that 2010 Q3 GDP was 2.8% higher than in 2009 Q3. Unemployment has increased remarkably little given the depth of the recession, and stands at 7.7%. Nominal pay rises have picked up a little to 2.0%, reducing the threat of imminent nominal pay falls driving Irish-style distress on mortgages. This is a fairly healthy picture, and suggests that there is an opportunity to try to restore interest rates to something close to a ‘normal zero’. The aim of an interest rate rise would not be to tighten policy. Central bank interest rates are currently largely decoupled from the monetary transmission mechanism (except as references), and it would be desirable to try to restore them as important components of money markets. The ECB, for example, has regarded 1% interest rates as its floor throughout the crisis. The ‘effective zero’ floor in the UK is likely to be around 1.5% to 2%. Interest rates lower than this simply provide a margin subsidy to banks, presumably as part of a strategy to allow them to recapitalise themselves through profits. It would be useful to take the opportunity of stronger domestic conditions to try to raise interest rates back towards an effective zero level.

However, partly in order to ensure that no tightening of policy occurred, a rise in interest rates should be accompanied by additional QE. Indeed, enough additional QE should be provided that the overall stance is further loosening, not tightening. From January 2011, the UK will commence fierce fiscal tightening, beginning with the VAT rise. An overall tightening of around £100bn should be accompanied by additional monetary loosening, to ensure that any temporary negative effects do not undermine recovery at a difficult and fragile stage.

Events in the Euro-zone only serve to reinforce the need for additional QE, as well as demonstrating how fragile recoveries around the world are. Even in Australia, growth has fallen back in recent quarters (from 1.2% in 2010 Q2 to 0.5% in Q3). The US may face an outright double dip. There remains the risk of a further, perhaps decisive, phase of banking crisis erupting at any time. The deflationary pressures implicit in money supply figures also suggest that further QE could be warranted to eliminate the residual risk of falling into Irish-style deflation - Ireland experienced 6.6% deflation at one point.

Many commentators urge that the fiscal consolidation will probably not result in even temporary setback to growth. They are right. They urge that we should not trust Bank of England models implying that inflation will fall back below target, given the poor performance of the Bank's forecasts over recent years. They are right. They urge that additional QE will probably be much more powerful than the previous phase, and drive inflationary boom-and-bust. They are right. Doing more QE at this stage is probably not necessary to secure growth, and will probably drive inflation up towards 10% on the RPI measure and 6% on the target CPI measure. But not doing it would leave a small-but-significant risk of perhaps 15% to 20% that the UK could fall into Irish-style deflation, with widespread defaults on mortgages as households gave up the attempt to service them, and a collapse in the banking sector despite sovereign guarantees, dragging the British sovereign debt rating into the abyss shared by the Icelandic and Irish. This is the unpleasant dilemma: to act is probably not necessary, and will probably create a damaging boom-bust cycle; but not to act leaves a small chance of disaster. My vote is to act: 0.5% rise in interest rates; obtain permission for £50bn more QE.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%; QE to stop but not yet to be reversed.
Bias: Bias to raise Bank Rate and to reverse QE.

The argument that has raged around the Comprehensive Spending Review (CSR) for months before and no doubt for months to come is about its effect on the economy. Labour has adopted the position that the cuts are too many too fast and will cause a ‘double dip’ recession. However, in its last budget before the election Labour’s plans were not very different - essentially 1% of GDP (£18bn) more spending in 2014/15 than in the current plans. These current plans call for total public spending to fall about 3.5% over the next four years in real terms. It is hardly ‘savage cuts’ to reduce real public spending by just under 1% a year, after ten years in which it was raised by over 50%.

The reason that both sides would have had to do more or less the same is obvious; whether we now face a double-dip or not, public opinion would not have tolerated a Greek situation here. People went through all that in the 1970s in the one-before-last Labour government that came hard on the heels of the spendthrift Conservative government of Edward Heath. In 1976, the then Labour Chancellor, Mr Healey, was compelled to turn back at Heathrow from a foreign trip to save the pound from falling below US$1 and go begging to the International Monetary Fund (IMF). In 1979, Mrs. Thatcher was elected to sort it all out. By and large, the UK finances have subsequently never really threatened insolvency - until now.

So the Coalition had no real option but to be tough. It chose to be a little bit tougher than Labour. Probably too, it decided to land the axe more on spending than raise taxes in the way that Labour probably would have done in the end. In the process, it aimed to tighten up on welfare benefits, to reform spending practices in education, health, the police and much else, to cut back public sector wages and net pensions, and in general to move away from the state-dominated society towards the ‘big society’. These are worthy aims. But the Coalition is up against strong vested interests and it may well not achieve them, certainly not in full. Nevertheless, the mere act of restoring the Treasury to its old self as the ‘nay-saying’ discipline on spending, from its recent role as Mr. Brown’s instrument of spending expansion, will bring back some efficiency into the public sector where productivity has fallen embarrassingly since 1997. This dreadful public inefficiency was not surprising considering Mr. Brown’s force feeding of departments with money from 2000 to 2010.

So, the programme is necessary to underpin the UK’s reputation in world bond markets, which if lost would really plunge us into crisis. But will it also cause a double dip recession? The chances of this are remote. The UK economy has been recovering now for a year - with third quarter estimates of GDP now giving a nearly 3% increase since the recession bottomed out in the same quarter a year ago. It is recovering against a world background of strongly resurgent growth; this year the IMF reckons the world will have grown 4.8%, not far short of the previous mid-2000s records of around 5.5%. Commodity prices have surged with it. This has led to a tightening of monetary conditions in many emerging market countries, such as China and India, that are facing rising inflation. But this tightening is just a restraint on a vigorous upswing.

If we look at the swing in the Treasury’s overall deficit or borrowing requirement, it is planned to fall from about 10% this fiscal year to 2% in 2014/15; a swing of 8% of GDP of which tax revenues contribute a quarter over and above the spending cuts. This is comparable to the swing between 1980 and 1986 from a deficit of over 6% to balance. That was a period in which strong growth began from mid-1981. The key to the prospects today, as always, is the tightness of monetary conditions. These are pretty loose. Worried sick by fears of deflation in the aftermath of the banking crisis, central banks in most OECD economies have printed shed loads of money and cut interest rates to virtually zero. The commercial banks in most major countries have stopped making net new loans; credit growth has stalled in the US, here and in the Euro-zone. Money as normally measured has accordingly stopped growing, making the creation of money by central banks look a safe bet; indeed one can argue that they need to do more to get money growth going again. In the financial markets those who are creditworthy can get loans at giveaway rates of interest. But of course those that are not in the new nervous world since the crisis cannot get loans at all. In the circumstances, central banks have veered on the loose side, so that those who can raise cash are especially favoured today.

This is hardly an environment for a double dip. There are enough firms and people around who do have access to these markets, to make sure that spending is growing again even in these older and slower OECD economies. With the world economy recovering so sharply, inflation is becoming a problem - again worldwide. This inflation spills over into developed countries via raw material prices. So far, the domestic prices and wages in these major economies have not responded. This is why inflation too has not taken off until now and there is not yet much pressure on central banks to tighten conditions.

But monetary conditions in the UK look too loose. The economy is recovering robustly, employment is rising and unemployment falling and inflation is now forecast to remain over 3% until 2012. Those low-growth broad money figures are now being affected by the falling demand for deposits whose yield is low. The credit stagnation on the other side of bank balance sheets reflects the poor competitiveness of banks, as yields on equities, corporate bonds and internal funds look lower. The mood of markets has shifted from one a year ago - when ‘cash was king’ and the main worry was keeping capital intact - to a world where people are searching for a ‘proper yield’ on their wealth. This search is pushing them back into property and is fuelling the recovery. What is the right way to tighten? It has been argued before that Bank Rate needs to be raised as it was becoming irrelevant. For this last reason, as it is raised, little will happen to market yields initially - even tracker mortgage rates may barely increase. Therefore, and while generally agreeing with the remarks of the Monetary Policy Committee’s (MPC’s) Andrew Sentance, I would ask for a larger rise in Bank Rate than he did at first, to 1% at once.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold: no extension of QE at present.
Bias: Hold QE in reserve.

Most economists’ recommendations about monetary policy are based on their forecasts of inflation, nominal GDP or real GDP. If they predict that growth is too slow, they advocate an easing of monetary policy. If they predict that growth is too rapid, they advocate a tightening. In the former case, they advocate QE if interest rates are so low that they cannot be reduced any further. When QE was first announced in March 2009, Mervyn King explained in a BBC interview that the object was to inject money directly into the wider economy, by-passing the banking system. In a speech this October, he elaborated,

“The Bank of England’s key role has always been to ensure that the economy is supplied with the right quantity of money – neither too much nor too little. But, in the wake of the financial crisis, and the sharp downturn that followed, the amount of money in the economy as a whole – broad money – is now barely growing at all. That is restraining activity and pushing down the outlook for inflation. So the Bank of England has taken extraordinary monetary policy measures – through our so-called ‘quantitative-easing’ programme of asset purchases – to ensure that the amount of money starts growing again in order to support a recovery and keep inflation on track to meet our target in the medium term.”

Following the Governor’s line of reasoning, the starting point of any analysis about the need for further QE should surely be whether the current amount of money in the economy is greater or less than the current demand for money. In my submission a month ago, I argued that the case for more QE was not proven. The crucial argument was that the demand for bank deposits as a home for savings has fallen sharply because of the abysmal rates of interest on them. In spite of sluggish growth of the amount of money in the economy, I judged that there was sufficient to accommodate the current demand for money. In other words, there was not a monetary squeeze any longer. Two months monetary data have been published since then, including those released on
29th November. The seasonally adjusted annual growth of M4ex was 1.6% in the year to October compared with 1.4% in the year to August. The growth rates of the deposits of private non-financial corporations over the same periods were 4.5% and 5.0% respectively. The changes are insufficient to alter last month’s conclusion. For the time being, there should not be additional QE.

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

The recovery seems to be progressing nicely. The official data for the second and third quarters of this year still look a little strong - especially the contribution of construction output - and there is room for scepticism about the quality of these figures. However, even allowing for this, the latest GDP release gives the impression of a reasonably firm and well-based recovery. The expenditure breakdown was more encouraging than in recent quarters. In particular there was a much smaller reliance on stock-building and a stronger contribution from net trade. The smaller contribution from government consumption is a sign of things to come. The subdued growth in consumer spending is also unsurprising in the context of the range of headwinds continuing to buffet households. Indeed, the public sector will soon become a drag on growth, while the consumer is unlikely to offer a significant contribution, so it is imperative that exports and investment sustain the momentum of the recovery. The outlook for output and inflation remains very uncertain.

As suggested in October, these uncertainties will add immensely to the tensions within the MPC over the next year or so. Indeed, there is now a clear divergence of opinion within the Committee. Andrew Sentance has for some time been voting for a rate rise, arguing that the recovery in the growth of money GDP risks inflation and that the monetary stimulus should be throttled back. Adam Posen has recently taken the opposite stance, arguing that we are a long way from normality let alone overheating, warning that the UK risks a ‘lost decade’ similar to that of Japan following its financial crisis in the 1990s. David Miles suggested in a recent speech in Dublin that economic commentators could look back at this period and “talk about the big mistake the MPC made”. Unfortunately it is not clear whether the Committee will be accused of maintaining the monetary stimulus for too long or not stimulating sufficiently. Either way, the majority of MPC members continue to believe that taking any decisive action would be premature and appear content to wait and see.

Ironically, although these risks are evident in other world economies they are probably exaggerated in the case of the UK. It seems clear that China is in the Sentance situation at risk of overheating, while the US is in the Posen position at risk of deflation. Yet, with CPI inflation at 3.2% and the underlying rate remaining low it seems that we are still steering clear of both the inflationary and deflationary rocks. High inflation outturns increase the risk of high inflation becoming entrenched in people's expectations, yet spare capacity in the economy and the weakness of disposable income is depressing underlying inflationary pressures. The risks seem fairly evenly balanced. As David Miles said, it is inconceivable that you can get monetary policy exactly right. However, it is just possible that those commentators will grudgingly conclude that the MPC got it about right. Anyway, in view of the latest evidence on the economy and on inflation, it seems appropriate to change my stance from a ‘bias to expand QE’ to neutral. However, Bank Rate will need to stay low to keep up the momentum in the economy, at least until the current uncertainty is resolved

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%; hold QE.
Bias: Raise Bank Rate gradually to 2½%; hold, but do not reverse, QE.

With government spending equivalent to 52.8% of the basic-price measure of UK GDP in 2009-10 – and with the similarly-defined regional spending ratios varying between 39.1% in London and 40% in the South East up to 73.5% in the North East, 76.9% in Wales and 80.9% in Northern Ireland – paying undue attention to the growth of real GDP, which includes both government and private sectors, is dangerously misleading. It is a logical impossibility for government to tax itself. The only solution to Britain’s massive structural fiscal crisis is to get the private sector motoring again even if that requires such a significant retrenchment of government expenditure that reported GDP shows a sluggish growth performance for several years to come. There is a highly vocal clique that claims that the main problem facing the UK economy is a Keynesian demand deficiency that can only be solved by maintaining high levels of government spending, financed by borrowing in the short-term and the inevitable higher taxes required to service the debt in the long run. The regional figures suggest that the fundamental structural issue is that the reasonably market-liberal economies of the London, South East and Eastern regions are supporting regions in the North-East, North-West, Yorkshire, Scotland Wales and Northern Ireland which should best be regarded as failed ‘Iron-Curtain’ economies, with South Western England and the East Midlands just about breaking even where the balance between spending and taxation is concerned.
When Keynes wrote his General Theory in 1936 the ratio of general government spending to national output was around one half of what it is at present, and it was less than one quarter of the present ratio in his formative years as an economist before the Great War. Current advocates of the Keynesian approach appear to be ignoring this massive structural change in the scale of the state. It is amusing to speculate what words Keynes would have been able to employ in 1936 to describe the modern British economy. Possibly, something between ‘quasi-’ and ‘thoroughly-’ Leninised would have been the best that he could have come up with: the pre-war fascist dictatorships were spending at least 10% less of GDP than Mr Brown managed. Keynes would almost certainly have also recognised the distinction between the appropriate application of a public-spending stimulus and a fatal overdose. This is something that the present day advocates of Keynesian measures appear to have forgotten.

The furore over the Governor’s alleged ‘political’ intervention in the fiscal policy seems to confuse two separate issues. The first is what it is politically-expedient/tactful to say in public, the second is what the objective realities on the ground are. The central bank always has a strong and legitimate interest in the fiscal policy being pursued by the government. This is because the output-inflation trade-off facing the monetary authorities tends to be worse in a heavily socialised economy and also because monetary policy has to force larger proportionate adjustments on private economic agents as the government sector increases its share of national resources (Editorial note: the interface of fiscal and monetary policy was discussed in more detail on pages 159 to 162 of David B Smith’s 2006 IEA monograph Living with Leviathan - www.iea.org.uk). Furthermore, there comes a point in the increasing socialisation of the economy where the fiscal backdrop becomes the main issue in monetary policy, a problem traditionally associated with the need to fund a massive military endeavour, such as World War I. Before he lost office, Mr Brown had managed to push the UK government spending ratio to almost 7 percentage points above the peak 1916-1918 costs of fighting the Great War, and was also employing a greater share of the working-age population than the peak military mobilisation during that period. Thus, it is hardly surprising that government spending significantly overshot the taxable capacity of the economy, leading to the worst fiscal deficits ever observed in peacetime, even if the government’s 2009-10 current deficit of 8.6% of national income was well below the 25% to 28% ratio observed at the peak of World War I. Mr Brown’s tainted fiscal legacy was close to the nightmare scenario for any central banker, even if the banking meltdown has meant that QE has not had the usual inflationary consequences so far.

Fortunately, the latest national accounts data imply that quite a strong recovery is now under way in both real and nominal private domestic expenditure (PDE), defined as non-welfare financed consumption, private investment and stock building. Real PDE fell by an average of 2.8% in 2008 and 11% in 2009, and showed a peak to trough fall of 15% between 2007 Q3 and the final quarter of last year. This collapse in the private-sector tax base explains the ballooning of the UK budget deficit during this period. However, there has already been quite a marked recovery this year, with the annual growth rate picking up from 0.4% in 2010 Q1, to 4.2% in the second quarter and 5.6% in the third. At the same time, the implied annual inflation rate in the private sector appears to have accelerated from a low point of 0.8% in 2009 Q3 to 4.4% in 2010 Q3, while the annual growth of nominal PDE has gone from minus 11.5% in 2009 Q2 to plus 10.3% in the third quarter of this year. This suggests that UK monetary policy has succeeded in doing the one and only thing that it can do, which is stimulating nominal demand in the private sector of the economy. As a result, it now seems appropriate to commence on a gradual and cautious normalisation of monetary policy, starting with a hike in Bank Rate to 1% on 8th December.

A final comment is that the forthcoming rise in VAT looks like being a damaging error. A brave evidence-based Chancellor would be well advised to think about cancelling it. The Bank of England has always carefully refrained from commenting on whether tax-based fiscal consolidations are more or less damaging than public-expenditure based ones. However, the UK now appears to be on the wrong side of the aggregate Laffer curve and tax-based attempts at fiscal consolidation are likely to make the deficit worse, not better. Having recently simulated an unchanged 17.5% VAT rate scenario on the Beacon Economic Forecasting (BEF) model, the results suggest that the effect of the forthcoming VAT increase will be to reduce real GDP by 1.4% on a ten year horizon, add 236,000 to claimant unemployment, and increase the ratio of general government net borrowing to national output by some 0.6% of GDP in the early period, fading to 0.2% after ten years. It would be interesting to see the results of similar simulations carried out on the HM Treasury forecasting model employed by the OBR and also the Bank of England’s forecasting model. That really would be transparency in action.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%; no extension of QE at present.
Bias: To raise Bank Rate further.

Each quarterly update of UK nominal spending strengthens the conviction that this is the true operational target of the Bank of England, rather than its official inflation target. Third quarter nominal GDP rose another 1% in 2010 Q3 to record a 5.9% annual growth pace. For household consumption, the quarterly nominal growth was 0.8% and the annual growth, 6.8%. The consumers’ expenditure deflator, a closely-watched indicator of inflation by the US Federal Reserve among others, recorded almost 5% growth in the year to the third quarter, after 5.5% in the year to 2010 Q2. For the April-June quarter, the strongest contributions were from transport, 9.7%; miscellaneous goods and services, 7.9%; housing, 6.9%, and clothing and footwear, 6.1%. Protestations from the Bank in its latest Inflation Report regarding the power of “temporarily unavailable capacity” to subdue inflation seem utterly unconvincing.

As these commentaries have warned for the past eighteen months or so, the rise in the UK inflation rate looks to have a structural component as well as a temporary one. The decomposition of the retail price index reveals that private sector inflation has returned to levels last seen before the 1992 recession. Domestic inflation franchises have been rebuilt during the past three years. A portion of this increase may be laid at the feet of the significant depreciation of sterling, but the concern is that supply conditions have tightened structurally. The forces of global oligopoly have been strengthened by the economic slump, as weaker rivals have either failed or been forced to retrench due to lack of credit access. The UK experience suggests that consumers have been unsuccessful in their resistance to producer pricing strategies. Moreover, sterling remains exposed to further declines as long as the UK yield curve offers such unappealing returns.

The governor of the Bank of England’s fulsome praise for the fiscal plans of the coalition government has prompted justifiable concerns that UK monetary policy has ceded some of its independence. There are clear dangers for the Bank in bending to the wish of the government for the continuation of exceptionally easy credit conditions without proper regard for our inflationary future. Periodic hints of a benign disregard for sterling’s external value have gained particular poignancy in the context of Ireland’s economic crisis. For a nation that has become so dependent on attracting large foreign net investment to its government bond market, the Bank’s MPC appears to be playing with fire, metaphorically speaking.

For the time being, the UK economy has ample momentum and does not require further assistance from monetary policy. The past year should have been used to begin the process of normalising Bank Rate towards 2%. Instead, a climate of fear has been allowed to develop around fiscal tightening which makes it very difficult to raise interest rates even if the MPC was minded to do so. To assert its independence and to doff its cap in the direction of the inflation objective, Bank Rate should be raised immediately to 1%. An extension of QE should remain under consideration, should 5-year gilt yields continue their sharp ascent.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: to loosen via QE if economy weakens sharply in first half 2011.

You would not be able to tell from looking at the data that the UK economy is facing anything other than a solid recovery. Economic growth was confirmed at 0.8% in the third quarter, taking national output to 2.8% up on a year earlier. What is more, with growth in the second quarter left unrevised at 1.2%, it seems that GDP in 2010 as a whole will be around 1.8% higher than in 2009, unless the fourth quarter performs worse than expected. There was good news in the breakdown of GDP in the third quarter. This showed that net trade accounted for 0.4% of the 0.8% increase, the first such positive outcome since 2008.

Further good news could be found in the manufacturing output, Purchasing Managers Index (PMI) and retail sales data released in November. These all suggested that economic growth will persist in the closing quarter of this year, albeit at a weaker pace than in 2010 Q3. With inflation still above 3%, the Governor of the Bank of England had to write his fourth letter explaining why it was more than 1% above the 2% targets – a task that he has now performed for three different Chancellors. The implication is that monetary policy should be biased towards tightening.

However, there are some concerns about whether growth can continue to recover as we enter 2011. Not least amongst these is that money supply growth in the UK continues to weaken towards zero; fiscal tightening next year has yet to impact; VAT has yet to rise to 20%, and the backdrop of weakening growth in Europe may hit UK export markets. These concerns are enough to imply that Bank Rate should stay at its present ½%, and for the bias of policy to remain towards further loosening via QE, if growth takes a bad hit in 2011. It is clear that the risks of inflation have risen but that it is a risk worth running at this time of great uncertainty. The prospects for a sustained recovery in the UK are not yet secure enough to warrant a tightening of policy, or ruling out further monetary loosening.

Note to Editors

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.