Sunday, January 09, 2011
Shadow MPC votes 6-3 to hold rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by six votes to three to leave Bank Rate unchanged at ½% when the Bank of England’s rate setters assemble on Thursday 13th January. All three dissenting SMPC members wanted Bank Rate to be raised to 1% in January.

The six SMPC members who wished to see Bank Rate held unchanged did so for a variety of considerations. One was the continued de-leveraging of the banking system, which meant that the growth of broad money and credit was likely to remain sluggish.

Another was the uncertain outlook for activity in Britain’s traditional mature-economy trading partners. However, there was also a counter view that buoyant Asian activity meant that the aggregate global economy was closer to overheating than depression.

The third main reason for wanting to hold Bank Rate was concern that the government’s fiscal tightening would reduce activity as it took effect during the course of 2011.

Several factors explained why three SMPC members wanted a higher Bank Rate. One worry was that the Bank risked losing credibility if it did not react to sustained above-target increases in the consumer price index (CPI) and ignored the extent to which CPI inflation was running below the more popular retail price index (RPI). However, there was also debate as to whether the present ultra-low Bank Rate was as expansionary as the authorities seemed to believe. In particular, the fact that the household sector’s bank deposits were not much smaller than its borrowings meant that consumers in total gained little when rates were low.

This was especially so when banks were widening their rate spreads and draining income out of the non-bank private sector. An associated concern was that ultra-low interest rates at a time of record fiscal deficits might look so indistinguishable from ‘printing money’ that it increased the perceived uncertainty about future inflation and perversely boosted precautionary saving.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; further QE should be implemented if UK home demand proves weaker than expected.

The dominant monetary theme in 2010 was that, because banks were obliged to restrict their balance sheets (and particularly their risk assets) because of the threatened Basle III rules, the growth of the quantity of money – on the broad measures – was negligible or very low across the industrial world. The dampening effect of this pattern on economic activity was countered in two main ways by the policy-making authorities. First, money market rates were held at virtually zero. Secondly, central banks created money by issuing cash reserves to the commercial banks and using the proceeds to purchase assets from non-banks. A fair comment is that officialdom’s intellectual rationalizations for the second of these responses, and indeed the implementation of the various measures, were both confused. Nevertheless, the quantity of money did not fall, as it had done in, for example, the USA in the early 1930s. With the return even on interest-bearing deposits being poor relative to non-money assets, weak money growth was compatible with good recoveries in asset markets and a return to economic growth. Nevertheless, at the end of 2010 output remained well beneath its trend level in North America, Europe and Japan. Countries outside the Basle rule framework – notably China and India – had very different monetary conditions and macroeconomic outcomes. The growth rates of bank credit and money remained rapid; demand was buoyant, and the main macroeconomic issue was the control of inflation.

In the Basle rule group of industrial nations, advance indicators of the growth of bank balance sheets remain worryingly sluggish. In the Euro-zone, banks in Portugal, Ireland, Greece and Spain (the so-called PIGS group) have severe and apparently worsening difficulty in funding their assets from market sources, while the European Central Bank seems determined to wean them off their dependence on it for loan support. The pressure on the PIGS countries’ banks to shrink their balance sheets is therefore intensifying nearly two-and-a-half years into the Great Financial Crisis (GFC), if it is accepted that the GFC began in August 2007. This is a shocking comment on the incompetence of Euro-zone banking regulation and monetary management. Admittedly, the specification of the central bank’s role as lender of last resort in a multi-country single currency area is inherently problematic - as some of us had warned in the early 1990s.

In the USA, Ben Bernanke, the chairman of the Federal Reserve, has said that his institution will pursue large-scale asset purchases (dubbed ‘quantitative easing (QE)’ by markets) to whatever extent is necessary, meaning ‘whatever is necessary to ensure that the recovery continues’. The positive impact of this statement on market confidence was considerable. Nevertheless, it might have been greater if either Mr Bernanke or his officials recognised that an increase in the growth rate of the quantity of money, broadly defined, was vital to the wider success of the Fed’s operations. Instead, he and his officials decry or even deride the role of money in macroeconomics, and emphasize ‘credit spreads’, ‘credit conditions’ and the like. In their work on the Great Depression, notably chapter 7 of A Monetary History of the USA, Friedman and Schwartz belaboured the Fed for neglecting the role of money in the determination of macroeconomic outcomes, and emphasizing ‘credit conditions’ etc. What was that someone said about history, that it may not repeat itself, but it rhymes?

As far as the UK is concerned, Mervyn King – the governor of the Bank of England – made statements in 2010 which suggested that he had bought into a monetarist view of the world, where the relevant aggregate was broadly-defined. Since King signed the notorious 1981 letter from the 364 against the then government’s fiscal restraint, a radical and very welcome intellectual shift seems to have occurred. The implied interpretation is that – in the UK, as in the USA – the authorities will prevent the quantity of money contracting. They will do this, despite the sheepishness and muddle of nearly all official statements on the matter. The UK does indeed seem to be enjoying a relatively benign macroeconomic prospect at present, certainly compared to some of its European neighbours. 2011 will see necessary and overdue measures to curb public expenditure. Easy money conditions (i.e. a positive rate of money growth as well as zero interest rates) are therefore appropriate to ensure that, for the public and private sectors combined, demand, output and employment keep on rising. Inflation is high relative to target, but underlying upward pressures on labour costs are very weak. Bank Rate should be kept at ½% at least for the next few months, while policy makers should remain open to the need for another round of QE if demand is weaker than expected.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; QE to be implemented only to avoid M4 contraction.

Last year witnessed the second year of balance sheet adjustment by the household sector and by the UK financial sector, following the deepening of the global financial crisis in late 2008. The year 2011 is likely to prove to be a third year of balance sheet repair, but that does not rule out a moderate growth of real GDP. The balance sheet repair process can best be seen in the household sector in the continuing decline of the household debt to disposable income ratio. This peaked at 174.0% in 2008 Q1, and had fallen to 158.3% by 2010 Q3. From a starting point of around 110% in the year 2000, it is highly likely that this ratio has further to fall. The recent decline is mainly accounted for by the growth of household disposable incomes (up 10.3% in nominal terms since 2008 Q1), and much less by the decline in debt outstanding. Although unsecured borrowing - mainly credit card debt - has fallen sharply, secured borrowing - mainly mortgage debt - has risen by 4.1% over the same period. Nevertheless, the combination of the need to lower indebtedness and the pressure of debt servicing in a time of very slow real income growth means that both household borrowing from banks and building societies and household’s M4 balances are hardly growing at all.

The balance sheet repair process in the broad financial sector is perhaps best captured by the dramatic plunge in bank lending to, and the bank deposits held by, Other Financial Corporations (OFCs are private financial institutions other than banks and building societies). From growth rates of 46.5% and 51.6% (year-on-year) at the height of the financial panic in early 2009, these figures have now plunged to minus 3.9% and minus 5.5% respectively. For the banks and building societies themselves, the freezing of the interbank markets from late 2007 resulted in a disastrous plunge in the size of their balance sheets - and especially their interbank lending and borrowing - but they were then rescued or at least stabilised by the Bank of England’s large-scale emergency loans amounting to some £200bn immediately after the Lehman bankruptcy in September 2008. Without the Bank’s lending, the contraction in the banking sector and in the wider financial sector would have been much worse.

The non-financial corporate sector is in much better shape than either the household sector or the financial sector, but nevertheless such industrial and commercial companies continue to reduce their bank borrowings (which are currently declining at 3.8% year-on-year), while their holdings of M4 are growing quite modestly (at 4.5% in October). However, aside from responding to demand overseas, it is difficult to envisage a recovery led by the UK corporate sector so long as household demand remains subdued. On the inflation front we are about to see the impact of the January hike in VAT to 20%, but beyond that one-time event and some further increases in commodity and utility prices, inflationary pressures should be very restrained, eventually causing inflation to fall to below the target (as suggested by CPIY inflation which excludes indirect taxes and was only 1.5% in November). UK inflation is still reflecting the sustained, double-digit growth rates of broad money in the years preceding, and in the early stages of, the crisis. It would be wrong to raise interest rates in the UK now on account of either temporary factors such as the VAT hike or high imported commodity prices, or past events such as the excessively high monetary growth rates permitted up to 2008/09. With M4 (excluding OFCs’ balances) currently growing at close to 3% year-on-year, 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 and keep QE in reserve.

There are a few signs that economic growth is easing after the better-than-expected recovery in the second and third quarters. But it should be noted that the latest National Institute of Economic and Social Research (NIESR) estimates suggested GDP grew by 0.6% in the three months to November, slightly up on the 0.5% estimated for the three months to October. This, in itself, is encouraging. Bad weather will of course knock activity in December. The latest official labour market data were less positive. In the three months to October Labour Force Survey (LFS) employment was down and LFS unemployment up – though the claimant count figure was marginally down in November.

But the ‘big story’ over the last month has been the higher-than-expected CPI inflation rate, which was 3.3% in November. Crucially the Monetary Policy Committee (MPC) have shifted their position from the inflation forecast they made as recently as November. The MPC minutes of the December meeting reported “the MPC noted that inflation was likely to rise further over coming months and could well reach 4% by the spring, somewhat higher than the November Inflation Report central projection”. The MPC attributed the higher-than-expected inflation numbers to the effect on import prices of sterling’s past depreciation (two years ago!) and to the impact of substantially higher prices for food, oil and other commodities, of which the upward trend, one might add, shows no sign of flattening out.

But these higher-than-expected prices inflation numbers are insufficient to justify triggering monetary tightening. The fiscal consolidation has only just begun and that in itself is good enough reason to keep monetary policy accommodative. The key issue is whether Britain risks locking into a 1970s-style ‘wage-price’ spiral that would become difficult to control. There are, as yet, no signs that this will happen. Earnings inflation (ex. bonuses) was only 2.3% in the three months to October. And even though there is evidence that strike action over pay is picking up there are few signs that employers, especially in the public sector, where money is very tight, are prepared to countenance inflationary pay awards. They will surely do all they can to resist them. Under these circumstances, there is no compelling reason for increasing interest rates. But given the reasonably well established recovery, there seems no compelling reason for an extension of QE either, though it can always be kept in reserve if the need arises.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold; seek permission for additional £50bn QE this quarter.
Bias: To hold.

The January VAT rise means that the serious phase of the fiscal consolidation has begun. There is good reason to believe that the deficit is so high that even raising taxes, rather than cutting spending, might bring it down without damaging growth even in the short term. But is it worth the risk of finding out? On the surface, this is perhaps the case. Growth has been better than one might have anticipated this year. Inflation has been just enough to keep nominal wages rising. Indeed, inflation over the next few months seems likely to accelerate further as recent energy price increases feed through. All this suggests that a case is emerging for monetary tightening to prevent inflation rising excessively. Households have managed a little further balance sheet repair, with mortgage equity injections and a rising savings rate.

And yet, household balance sheets are still extremely fragile, with perhaps as many as three million households liable to fall into financial distress if mortgage interest rates rose by even 2 percentage points. Unemployment is rising again, and is likely to go up further as the fiscal consolidation bites. Although fiscal consolidations are often associated with rising growth, they are almost invariably associated with rising unemployment. The financial sector appears to be so fragile that the government has felt obliged to provide billions in further funding for the banks, thinly veiled by the subterfuge of a bailout for the Irish government. The US recovery is far from robust; some part of the Euro-zone could blow up any day, and even China appears to have switched to a tightening mode.

Thus, although the central scenario is probably that of a sufficiently robust recovery which has not been materially derailed by fiscal tightening - implying that further QE is not required and would actually be counterproductive (indeed, perhaps even that we should be tightening now, not loosening) - the downside risks to that central scenario are sufficiently serious that it would be wiser to err on the side of excessive monetary ease, even at the expense of a little more inflation down the line. Furthermore, certain of the standard arguments about the damage inflation causes do not apply in the current situation. Specifically, there are the arguments that inflation damages incentives to hold fixed income securities or to save in cash terms. The truth is that the current situation is massively distorted in favour of depositors and bonds. Between 2007 and 2009 (and perhaps even now), some banks should have gone into administration, with bondholders and, perhaps, also depositors losing some of their money. Some of these owners of fixed income loans - and a deposit is a loan, too - should have lost some of their money.

The fact that they did not do so creates a huge distortion. It is arguable that that distortion would be reduced by all fixed income loan-holders losing some of their money, via inflation. It is also arguable that inflation, in this situation, would lead, in the next financial crisis, to holders of high-quality loans (i.e. those that did not loan their money to banks that went bust) being opponents of bailouts - since the consequence of bailouts might be inflation that would damage the interests of those that had made wise, as opposed to imprudent, loans. It is not being contended that this is a central direct consideration for policymakers (i.e. it is not being suggested that they should deliberately create inflation so as to punish depositors in bust banks). However, the overall inflationary impact arising from optimal policy geared towards growth, employment and financial stability objectives is likely to be to the detriment of depositors and bondholders in institutions that would not have gone bust if proper market processes had been permitted to proceed.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1% and hold QE.
Bias: To raise Bank Rate further and reverse QE.

The latest figures around the world suggest two things. The world recovery is strong and inflation is high and mostly rising - towards 5% for example in China, and nearly double-digits in India. The OECD central banks have loose monetary policies, keeping rates extraordinarily low and in the case of the US Federal Reserve aggressively printing new dollars via QE2. Money is flowing from the OECD to the East and, there, it is not being allowed to raise Eastern exchange rates. Instead, it is being bought by local central banks with newly printed local money. We have de facto a world economy on fixed exchange rates with the world monetary printing presses whirring.

The question that arises is how OECD central banks react to this situation in the post-crisis world? Essentially, they are deciding to ignore 'imported' inflation, such as commodity price rises, as being temporary or 'non-core'. This contrasts with their reaction in 2007, when the European central banks treated this inflation as needing monetary tightening. Thus, interest rates in Europe generally, including non-Euro-zone countries like the UK, were not lowered much in 2007, despite the incipient crisis, and this attitude continued into 2008. Only in the US, where the sub-prime crisis had already become serious, was money loosened sharply and imported inflation totally ignored.

The difficulty about treating imported inflation as ‘non-core’ in this world environment is a world fallacy of composition. If everyone does so, world money supply growth will be uncontrolled; this is what is now happening. OECD countries have 'inflation targets' but in practice are ignoring them, replacing them with implicit wage-inflation targets. If, when wages start rising in response, the central banks treat this too as temporary, the target underpinnings will be in difficulty. We will be witnessing classic time-inconsistent responses where the response to inflation becomes deferred because of the desire to postpone 'derailing' of the 'recovery'. Such a tendency to defer the response to inflation could easily spill over into an upward drift in the target itself. This in turn will feed higher inflation expectations. At this point, the benign effect of 'expectations anchoring' will dissipate and turn into the dreaded effect of 'expectations drift' that worsens the inflation-output trade-off.

The danger, therefore, is of a progressive undermining of the target's credibility. Nowhere is this more the case than in the UK where inflation will shortly go over 4% on the official CPI, and no doubt much higher on the RPI. This is bound to generate a response in wages. At some point, the situation will tip over, with the Bank of England losing the initiative and having to act violently to restore its credibility. When the target policy is working properly, then there is never any need to be too strict in response to temporary shocks. This is like the Swiss village in which order is maintained without any visible police presence because everyone knows that any eruption of lawlessness would be met with an iron response. However, once that response gets into doubt, the village becomes more like a UK inner city where violence is endemically out of control and the police presence sporadic and unconvincing.

What is disappointing today is that the Bank is also failing to recognise that the UK economy is growing at a reasonable rate considering the raw material availability constraints facing it and the world generally. Therefore, there is no longer any serious risk of 'derailing' it; on the contrary the environment is increasingly one where real yield is again being hunted by households and firms tired of getting pathetic returns on monetary assets. If the Bank, which ought to be the repository of anti-inflation 'toughness' starts to sound like a Keynesian nanny, where will credibility go? When credibility is so fundamental to the whole monetary policy transmission process, we cannot trifle with it.

The conclusion from all of this is that it is time to hear the smack of firm monetary government. Interest rates should rise forthwith; QE should be ended. Soon it will need to be reversed. We need rapidly to see a shift in views about inflation and the monetary environment. At this stage the Bank can probably get away with only modest rises in rates, say to a 1½% to 2½% range. Bank rate has become detached from normal market rates and the interbank market is hardly being used. Thus, much of an effect of its rise on market rates is not to be expected. It may even be that the revival of the interbank market will ease banks' fears about lack of liquidity and improve their lending growth. This would in turn help to reassure policymakers about the recovery, even if monetary channels appear to be bypassing the banks currently anyway.

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

It is widely accepted that a reduction in interest rates should stimulate the economy. Existing borrowers certainly gain but how about depositors? They lose. Thus, the predominant effect of lower interest rates is simply to transfer income from one set of households to another. The private sector’s deposits with banks are not all that much smaller than the loans that banks make to the private sector. If the rates of interest on deposits and loans fall by the same amount, the net impact on the cash flow of the private sector is normally small. However, this time banks have widened their profit margins. Loan rates have not fallen anything like as much as deposit rates. In effect, banks have pinched cash flow that should have gone to the private sector. The impact of lower interest rates on the net cash flow of existing borrowers and depositors may have been mildly contractionary as a consequence.

How about new borrowers, more importantly net new borrowing? The Times on 30th December reported that the reduction in mortgage debt between July and September was the second-largest rate on record and gave two reasons. One was low interest rates! But low interest rates are meant to encourage rather than reduce borrowing. The explanation is that many borrowers, according to mortgage lenders, have chosen to maintain their monthly payments, despite the fall in interest rates, thereby paying off more of the capital owed each month. If this is correct, the impact of lower interest rates on net new borrowing may have exacerbated rather than offset the negative impact of low interest rates on the cash flow of existing depositors.

So, if the impact of lower interest rates has been negative overall, why not raise Bank Rate? Reversing the above argument implies that the effect would be expansionary if banks can be discouraged from increasing their lending rates. Furthermore, foreigners would be attracted by higher interest rates on deposits. The Bank of England might then intervene in the foreign exchange market to stop sterling from rising. The effect would be to re-liquefy the economy as happened after we borrowed from the IMF in 1976, which offset the contractionary impact of the tighter fiscal policy imposed by the IMF.

The conclusion from this analysis is ‘do not judge the stance of monetary policy by the behaviour of interest rates’. It should be judged instead by in depth analysis of the behaviour of the monetary aggregates. The monetary data for November, published on Tuesday 4th January, show little change on the previous month. The annual growth of aggregate M4ex has fallen from October’s 1.5% to 1.4% in November. The annual growth rate in the M4 holdings of private non-financial corporations declined from 4.4% to 2.6% between October and November but that of households has risen from 2.5% to 2.7%. These changes are not significant, given the error margins in the data, so my conclusions that interest rates and the stock of QE should remain unchanged are the same as last month. One would merely add that, if sterling strengthens, the Bank of England should intervene in the foreign exchange market to stop it from rising. Allowing money to come in from abroad would be a different form of QE.


Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%; hold QE at present level.
Bias: To raise Bank Rate further during course of 2011.

The New Year is traditionally a time for looking forward and our latest forecasts for the British economy incorporating the revised national accounts and balance of payments figures released just before Christmas are summarised below. However, it is first necessary to say a few things about recent changes to the Beacon Economic Forecasting (BEF) macroeconomic model. This is because these changes throw light on the effects of the 2008 financial crash and help indicate how likely the international and British economies are to return to their pre-recession trends. This analysis is possible because the BEF model has been largely re-estimated in recent weeks as a result of: major changes to the OECD data; the switch of the UK national accounts from chained 2005 prices to a 2006 price basis; and the availability of a consistent break-adjusted series for the M4ex broad money supply from the Bank of England. These data changes meant that twelve statistical relationships in the ‘world’ model have been re-estimated and twenty-four in the UK model. These relationships cover most of the major output, real expenditure, price, and money supply figures. The re-estimation used quarterly data from the 1960s or 1970s onwards up to 2010 Q2 or Q3. During the estimation process, an attempt was made to quantify the effects of the 2008 financial crash by, first, including dummy variables for each separate quarter from 2008 Q1 onwards and, second, by stopping the estimation period before the crash and running forecast stability tests afterwards.

The results were reassuring to some extent. In particular, there were a significant number of relationships where there was no sign of any breakdown as a result of the financial crash – UK real imports, for example – or situations where apparently extreme movements in the variable concerned were predictably linked to their driving variables; the relationship between OECD imports (world trade) and OECD industrial production is one example. There were also a large number of relationships where there were extreme but sometimes offsetting movements in 2008 Q4, when Lehman Brothers went bust, and 2009 Q1 or 2009 Q2, but no signs of further shocks subsequently. This applied to several of the price equations - although there was no significant disturbance to be found in other cases - and also the relationships for OECD broad money, Britain’s M4ex and the trade-weighted sterling exchange rate. All the relationships concerned were then back on track well before the second or third quarters of 2010, when the data ran out.

The main area where there were strong signs of a major and longer lasting shock was in the real output and expenditure relationships where there were typically a series of large negative shocks running from 2008 Q4 up to 2009 Q3, OECD industrial production and UK household consumption would be representative examples. However, the adverse effects of the global financial crash were not so drawn out in the case of UK stock building or private investment, for example. The more recent data have shown a noticeable tendency for the statistical equations to come back on track at the rate one would expect from the ‘error-correction’ terms in the relationships concerned. There are not enough recent data observations to make confident statements and, ultimately, only time will tell. However, it looks as if the international and British economies are gradually returning to their earlier trends following the mother of all shocks in late 2008. The corollary is that it is important that this self-healing tendency is not offset by misguided political or regulatory interventions that lead to a relapse.

In the light of the published data up to 2010 Q3, it looks as if Britain’s national output expanded by an average of 1.7% last year. However, some 0.15 percentage points might come off this figure if the adverse December weather badly reduced activity in the fourth quarter. The UK economy is expected to grow by 2.5% on average this year, before slowing very slightly to 2.4% in both 2012 and 2013. The latest inflation data show that the target CPI increased by 3.3% in the year to November 2010, while the RPI, RPIX and the ‘double-core’ RPI measure, which excludes house prices as well as mortgage rates, all rose by 4.7% over the same period. However, there was a large element of ‘tax-push’ in these inflation rates and CPIY and RPIY, which both exclude indirect taxes, rose by a far more modest 1.6% and 3.4% in the year to November. It is debateable how far the central bank should respond to tax-push inflation. Arguably, the Bank should ignore it – and seems to have done so in practice. However, that assumes that inflation expectations do not become un-tethered as a consequence, otherwise the outcome will be ‘stagflation’. CPI inflation is expected to ease to 2.7% in the final quarter of this year, 1.8% in 2012 Q4, and 1.6% in the closing quarter of 2013. However, the CPI has been running unusually low recently compared to other inflation indicators. The annual increase in the ‘double-core’ RPI, which is the most historically consistent inflation measure, is expected to ease to 3.6% in the final quarter of this year, 2.5% in late 2012, and 2.2% in 2013 Q4.

An important factor constraining inflation in the longer term is the slow growth of the M4ex broad money measure. Our recent statistical investigations appear to confirm that M4ex is a reasonably good monetary measure, but also that it is highly sensitive to the level and structure of interest rates, especially the gap between bond yields and the ‘own’ rate paid on monetary deposits. The same applies to the aggregate OECD broad money supply, which also appears to bear a stable but interest-sensitive relationship to the wider economy. The growth of break-adjusted M4ex apparently averaged 1.4% last year. This is expected to pick up to a still modest 2.5% this year and around 4½% in 2012 and 2013. This is less than its OECD equivalent. With the current negative real interest rate gap between the UK and the rest of the world also anticipated to narrow, there is a good chance that sterling will be a stable or appreciating currency over the next few years. However, a potential source of weakness is the UK’s balance of payments deficit. This was running at an annualised rate of £32¾bn in the first three quarters of last year, despite the weakness of inventories, which have a high import content. The current account deficit could deteriorate noticeably in 2011 and 2012 as inventories are built up again.

Another concern is whether the coalition can achieve its targets for public borrowing. On a ten-year view, it is possible to foresee a broadly balanced budget on the Public Sector Net Borrowing (PSNB) definition by 2016-17, followed by small but growing surpluses thereafter. It is also likely that the deficit in 2010-11 will come reasonably close to the official forecast (we are forecasting a £147.2bn PSNB compared with the official forecast of £148.5bn). However, it is hard to replicate the strong downwards momentum over the next few years that appears in the latest forecasts from the Office of Budget Responsibility (OBR). This is not because the BEF growth forecasts are more pessimistic - they are actually higher than the official ones for this year – but because we disagree about the taxable capacity of such a highly socialised economy as Britain. It is also not obvious that some of the more ambitious detailed expenditure reductions set out in the OBR projections are achievable. It has also been argued previously that the VAT hike to 20% will have made the Budget deficit worse not better. The central BEF forecasts show a modest rise in the PSNB to £153.2bn in 2011-12 before the downward trend starts in earnest.

As far as Bank Rate is concerned, a ‘pure’ model based forecast incorporating historic relationships would yield a projection of 1¾% in the final quarter of this year, rising to 2½% in late 2012, but not increasing noticeably further in 2013. Such small movements are unlikely to have a major economic impact, particularly as Bank Rate has become a slack variable that has little influence on wider lending costs which nowadays appear to be driven off the higher Swaps market rates. The real reason for wanting to raise Bank Rate is to demonstrate that the Monetary Policy Committee (MPC) remains committed to its inflation targeting obligations and has not covertly abandoned them. Private sector savers, who do not have inflation-linked pensions, are also less likely to spend their savings if they fear inflation may take off, than if they believe that inflation is securely anchored. By creating increased uncertainty about the range of potential inflation outcomes, and with it future borrowing costs, the current ultra-loose interest rate stance in the US and Britain is probably encouraging increased precautionary saving, not discouraging it as the authorities say that they are trying to do on Keynesian demand management grounds.

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.

The interpretation of the UK monetary aggregates remains problematical. The
annual growth rates for headline M4 (minus 1.4% at end-November) and M4 lending (minus 2.0%) have continued to deteriorate in recent months. Once the disruptive influence of Intermediate Other Financial Corporations (IOFCs) is removed, these annual growth rates improve to 1.4% for M4ex and minus 0.8% for M4ex lending. M4ex growth has recovered modestly during 2010 but its lending counterpart has not. How concerning are these weak trends for the sustainability of UK economic recovery? Only by examining the monetary behaviour of the component sectors is it possible to arrive at a satisfactory explanation of the whole. The household sector has sustained positive deposit growth throughout the crisis and this stands at 2.7% currently; household liabilities are increasing very slowly indeed, at 1.1%. From equity withdrawal data, it is seen that households are injecting over 2% of disposable income into the housing stock. A decline in the financial saving rate over the past year has allowed nominal spending growth to run well ahead of nominal disposable incomes, suggesting that consumers are becoming less worried about future income security. Banks and building societies wrote down 17% less in 2010 Q3 than a year ago, implying that credit cardholders and other credit users are coping with these commitments more easily than hitherto. On balance, consumers seem to be content to chip away at the most expensive forms of debt, yet within a gradual accumulation of credit obligations.

Private Non-Financial Corporations (PNFCs) have manoeuvred themselves into a very strong financial position over the past eighteen months. The gross disposable income of PNFCs fell from £44.4bn in 2008 Q1 to £28.8bn in 2009 Q2, but has since recovered to £42.9bn and £41.1bn in the second and third quarters of 2010, respectively. The recovery in gross capital formation has lagged significantly behind, enabling the net lending (financial surplus) of the sector to reach 4.3% of GDP in 2010 Q3 and an average of 4.9% of GDP during the past four quarters. Unsurprisingly, PNFC deposit growth is a healthy 2.6% while bank debt is shrinking at a 3.5% rate. Banks have signalled to corporate borrowers that they require very full compensation for the risks of so doing; companies are signalling to their lenders that they are managing their businesses such as to minimise the need for bank borrowing.

It is difficult to conceive of the UK corporate sector as being in equilibrium whilst running a 4% of GDP financial surplus in a near-zero deposit interest rate environment. This appears only to make sense if the real return from the repayment of bank loans is judged to be superior to the expected real return from the deployment of capital in fixed assets and/or transactions in business assets. It is more likely that the corporate sector will erode its financial surplus and begin to use bank facilities more widely again to finance the inventory cycle. This suggests that the pace of bank debt repayment will wane in 2011 and eventually turn around to become net debt accumulation. Probably, this change of behaviour will be most evident in the manufacturing, utilities and distribution sectors and least evident in the construction and property development sectors. Debt repayment by the construction sector totalled £3.3bn in the year to October and £6.8bn by the property development sector.

Finally, the aggressive normalisation of financial sector balance sheets, especially IOFCs, shows little sign of winding down. However, towards the end of 2010, there has been a suggestion of bank borrowing growth in the securities dealers (investment banking) sector, which would be consistent with a gradual re-leveraging of the financial system in the period from September. (This was after US Federal Reserve chairman Bernanke signalled the resumption of additional monetary easing at the Jackson Hole symposium in late-August).

In summary, there are reasonable prospects for the corporate and financial sector drag on M4 and M4 lending growth to recede in 2011 to allow more positive trends to emerge. With the PNFCs running such large surpluses, it is difficult to sustain the argument that UK monetary conditions are tight, despite the very low overall pace of broad money growth. For the time being, therefore, 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%. To assert its independence and to take notice of the upward drift in the inflation expectations of the general public, Bank Rate should be raised immediately to 1%. An extension of QE should remain under consideration, should five-year gilt yields continue their sharp ascent and threaten to exert too powerful a tightening effect on the mortgage market.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold Bank Rate.
Bias: More QE if money supply contracts.

It is true that consumer price inflation, at 3.3% in the year to November 2010, is well above the 2% target. On the face of it, this implies that, as we enter 2011, monetary policy is too loose. Moreover, given the lags between changes in interest rates and the eventual effect on inflation, monetary policy should have been tightened early in 2010 - not necessarily just to attempt to mitigate an inflation overshoot but to prevent a drift upwards in inflation expectations amongst the general public, even if these still seem modest at present. But this ignores that fact that the underlying CPI rose by 1.6% in the year to November 2010, if tax increases are taken out, not 3.3%. Thus, monetary tightening would have been to try and offset the effects of higher taxes on the CPI. Of course, the fact that interest rates were not raised suggests that the MPC took the view that it should not try and do anything about this, even though many observers argue that there has been enough of a consistent overshoot of inflation for some six years to suggest that the MPC is biased towards acceptance of high inflation or of not paying enough to inflation drivers.

The MPC may well have made policy errors in the period running up to 2007 when, for instance, it allowed double-digit money supply growth for almost a decade. But to have raised interest rates last year, in the midst of a global recession, would have been to compound earlier errors. The MPC now has to look ahead, and in doing so refocus on the drivers of inflation in the next few years. It should start by looking at the monetary data and the balance sheet implications of the bursting of the biggest global property and credit bubble since the 1930s in the advanced economies. For the UK, sharp cuts in interest rates, QE and central bank liquidity injections (via balance sheet expansion) have partly offset the dramatic reduction in money supply caused by deleveraging by banks, households and companies since the crash of 2007. Analysis, and commonsense, would seem to suggest that the effects of the deflation of the bubbles that led to this crisis will still take some time to unwind.

Reduction in leverage is part of this process, meaning that lending growth and borrowing growth will continue to be weak for some time yet. Evidence of this continues to be reflected in the monetary and balance sheet data. Annual broad money growth has slowed from double digit rates prior to the 2007 credit crisis to record minus 1.4% in November. Admittedly, the figures look better when adjusted for the travails of the non-bank financial sector, but still shows an increase of just 1.4% in the year to November. Lending growth is barely better, down 0.8% in the twelve months to that period, as companies build a bigger surplus and households borrow only modestly for mortgages but repay other consumer loans.

In some countries, including the UK, the size of the government’s liabilities is now also a problem and is being scaled back. This is the context for the UK’s action to reduce its public sector deficit. Cutbacks in UK government spending and tax hikes starting this year and set to last for the next five years, at least, will help the economy in the long run, but in the short run will likely make the recovery weaker. In practise, what does this mean for inflation in the year ahead? With ample spare capacity in the UK, price inflation should begin to shift lower in the second half of 2011. With unemployment starting to edge up again, as the fiscal cuts start in earnest, annual pay growth will likely weaken. Given the current weakness in monetary growth and continued deleveraging, albeit with less intensity, my view is that interest rates should remain on hold. More QE might be required but only if money-supply growth turns negative. Pre-emptive official rate rises will likely be required later this year, but only after the recovery is assured, i.e. after the short term risks from the fiscal tightening have been allayed.

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.