Sunday, April 03, 2011
IEA's shadow MPC votes 5-4 to hold Bank rate
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by five votes to four to hold Bank Rate at its present ½% when the official rate setters meet on 7th April. All four dissenting SMPC members wanted to raise Bank Rate to 1%.

There were several reasons why the majority of SMPC members wanted to leave Bank Rate unaltered. One was concern that the UK economy would struggle this year as increased taxes and high energy costs damaged household budgets. A second justification for a rate hold was the continued weakness of the banking sector. This meant that there was little elasticity in the supplies of money and credit.

A third reason was the potentially malign effects of government spending cuts and increased National Insurance Contributions on employment. Finally, there was concern that the political turmoil in the Middle East and the tragic events in Japan would adversely affect the global economic environment.

The main reason that four SMPC members wanted to raise Bank Rate to 1% was the persistent overshooting of the inflation target and the fear that this risked undermining the credibility of the entire monetary framework. Another issue was that accelerating inflation meant that real interest rates were negative and falling.

This was unfair to savers but also inappropriate now that the worst phase of the financial crisis was over. As far as the 23rd March Budget was concerned, there were few strong views expressed by the SMPC membership. This was mainly because it was felt that the important fiscal initiatives had already been taken in 2010. However, one member feared that the upwards-revised official borrowing projections were still over-optimistic and that there could be financial-market difficulties once this became apparent.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold.
Bias: To increase Quantitative Easing (QE) as and when the need arises, but not yet.

All the signs are that the economy will struggle this year. The chief difficulties continue to be the pressures on consumers, the reluctance of banks to lend and the fiscal squeeze, only now getting under way. Inflation may well move considerably higher under the pressure of higher oil and commodity prices. But with average earnings not reacting, the pressure on consumers’ real incomes will be intense. In due course, this will bring underlying inflation much lower.

It is true that inflation expectations have increased considerably and that this does pose some sort of a threat. But the evidence from the period 2007 to 2009 is that such expectations are heavily influenced by the experience of inflation itself, without themselves necessarily having that much impact on inflation. Expectations should fall back when inflation starts to fall at the end of this year. The inflation danger will subside and the economy needs all the help it can get from monetary policy. Even a small rise in interest rates might deliver a serious blow to confidence.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold.
Bias: To hold Bank Rate and expand QE if M4 or M4ex money contract further.

Numerous recent research papers and books have shown that recoveries after severe banking and financial crises are almost invariably sub-par. The reason is that banks, firms and households have only limited means of repairing their balance sheets after a prolonged period of credit expansion. These means are: 1) raising equity, which is difficult for banks and firms and not feasible for households; 2) selling assets and using the proceeds to pay down debt, which is problematic after the bubble has burst; or 3) cutting consumption and increasing savings to pay down debt year by year out of savings, which necessarily undermines the strength of any economic recovery.

Added to this, in the current episode in the UK, government expenditure had already increased substantially ahead of the recession, and even more during the recession, further burdening the private sector with huge pre-emptive claims in the form of both taxation and public sector borrowing.

In these circumstances, the Coalition’s fiscal strategy has been designed to reduce the structural budget deficit and hence the amount of official borrowing as quickly as reasonably feasible. The Budget of March 23rd reaffirmed this broad strategy, without significant changes in target or timing, despite the downgrading of economic growth forecasts by the Office of Budget Responsibility (OBR). Against this sombre background, the question for members of the Bank of England’s Monetary Policy Committee (MPC) is how to set monetary conditions so as to fulfil the inflation mandate while facing so many headwinds to economic recovery.

If the underlying sub-par rate of growth was the only problem, the answer would be fairly simple – namely to keep monetary policy on an expansionary or accommodative course until inflation was forecast to approach its target. However, with Consumer Price Index (CPI) inflation now at 4.4% year-on-year and more than double the 2% target, the question is whether there has been a series of external shocks that cannot be handled adequately by tighter monetary policy, or whether there has been some inherent failure of monetary policy.

The mainstream line from the MPC has centred on the first of these explanations, offering four main reasons for the series of inflation shocks: the weakness of sterling, the external nature of commodity price increases, the extent of their pass-through by firms, and exogenous VAT and fuel duty increases. All of these do, indeed, provide a measure of comfort to policy-makers. Nevertheless, this debate misses some of the key, quantitative issues, given that inflation rates in the US and the Euro-zone are far lower than in the UK.

In my view, the primary failure of monetary policy was in the years preceding the credit crisis, and less so subsequently. Broad money growth in the UK has persistently exceeded that in either the US or the Euro-zone. For example, in the decade from 2001 to 2010, Britain’s M4 broad money growth exceeded the equivalent increase in the Euro-zone’s M3 by as much as 2.4% each year on average, generating a cumulative gain of 28% relative to the Euro-zone during that period. All of the excess money growth in the UK was concentrated in two sub-periods: 2004 to 2006 and in 2008 to 2010, the latter being during the crisis itself. The earlier error resulted mainly in a big increase in asset prices and has by now washed out of the system, but it should leave policy-makers with a strong lesson not to ignore or overlook sustained excess monetary growth in future.

The more recent error (2008 to 2010) occurred as a result of the re-intermediation of funds from the capital markets and from Structured Investment Vehicles (SIVs) and conduits, etc. back into the banking system and to that extent was unstoppable. But this simply pushes the problem back one step – why was such rapid growth of credit in the non-bank financial sector tolerated for so long? This highlights both the failure to control or adequately monitor the growth of credit and money-like instruments beyond the regulated banking perimeter, and the pro-cyclical tendencies inherent in a leveraged financial system.

Two issues remain relevant today – scale and timing. First, there was a substantial overhang of money and credit that had been allowed to build up, and was likely to emerge at some stage in either asset prices or goods and service prices. This is the underlying source of today’s inflation overshoot. Second, rapid credit growth in the broader UK financial system continued at double-digit growth rates until as recently as the second half of 2009, or less than two years ago; therefore, it should naturally be expected to impact prices in the economy during 2011 given the standard lags between monetary policy and inflation.

Money and credit growth rates, both inside the regulated banking system and outside it, have fallen dramatically in the past two years and no longer pose an inflation threat. Therefore, there is no need to raise interest rates now to slow money and credit growth. On the contrary, the problem is to ensure these growth rates are adequate to avoid a deflation problem in two years time. For this reason I vote to keep Bank Rate at its present ½% and to keep QE at the ready in case money and credit start to decline in absolute terms.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold.
Bias: Strong bias towards a ¼% rise.

The outlook for the economy continues to worsen. Unsurprisingly, the OBR, in their March 2011 Budget forecast, downgraded their GDP projections for 2011 yet again. Instead of the 2.3% growth forecast last June and the 2.1% forecast in November, they now expect 1.7%. Changes further out were minor, comparing the November 2010 and March 2011 forecasts. It should, however, be questioned whether this is a sufficient downgrade, given the very weak 2010 Q4 figure and the rather patchy evidence to date from the ‘Markit’ Purchasing Managers Index (PMI) surveys. These reveal that manufacturing, which makes up 12% of GDP, is doing well but that growth in services (70% of GDP) could be slowing. The OBR is forecasting 0.8% quarterly growth for 2011 Q1, which seems optimistic.

Whilst the OBR’s forecast for household consumption is commendably restrained, business investment is expected to be buoyant and net exports very positive. Given the persistence of a positive ‘output gap’ over the forecast period business investment could disappoint. Furthermore, whilst exports have grown well in recent months their growth rate has been outstripped by that of imports, acting as a drag on GDP, despite the weak pound. Given the modest expectations for growth in our export markets there is a real risk that net exports could disappoint also.

CPI inflation has continued to overshoot projections and was 4.4% in February. It is expected to rise to 5% by mid-year and the OBR expects it still to be as high as 4.2% in 2011 Q4. Much of the inflationary pressures have been driven by higher commodity prices. Here, there is more to come, as the turmoil in North Africa and the Middle East pushes up oil prices. Libya’s production is about 2% of global output and could arguably be replaced by other sources. Libya’s problems are, therefore, containable as far as the oil market is concerned. If supply were severely disrupted in the UAE or, even more drastically, Saudi Arabia, then such disruption would clearly have very major implications for oil prices and inflation generally.

Higher prices inflation is still not feeding into wage inflation to any degree. Thus, earnings growth was 2.3% including bonuses in the three months to January. Furthermore, the various surveys are suggesting that pay settlements might only pick up modestly in 2011. A significant ‘wage-price spiral is not expected to materialise in the foreseeable future, given the current economic uncertainties.

The Bank of England is caught between Scylla and Charybdis. In other words, the only choice available to it is between: 1) rising inflation and concerns over lost anti-inflationary credibility if no action is taken; and 2) damaging a fragile recovery through higher interest rates when the economy is also confronting fiscal retrenchment. The Organisation for Economic Co-operation and Development (OECD) recently advised keeping interest rates low, “for longer than investors currently think likely, even if headline inflation is significantly above target”. My central view remains that the Bank should start ticking-up interest rates fairly soon, not least of all to ‘normalise’ them away from the emergency ½% level agreed in March 2009. If the first quarter GDP figure, which is due at the end of April, suggests that underlying growth has resumed then May looks an appropriate time to increase Bank Rate to ¾%. However, Bank Rate should be held at its present level before then.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate to 1%.
Bias: To raise further and to hold QE.

Retail Price Index (RPI) inflation reached 5.5% in February, representing its highest level since the early 1990s, and it is set to rise even further over the coming months. This increase in inflationary pressure is confirmed by producer output price inflation, which accelerated to 5.3% in February, while producer input price inflation reached 14.6%. There is little need to point out what has happened to CPI, since that is merely a policy index and not, contrary to government policy on benefits and tax allowances, a cost-of-living index. Since the Bank of England has long since ceased to have any interest in keeping to target, CPI has ceased to be of relevance.

Broad money growth is very weak, with M4 actually shrinking in the year to January and M4ex recording only 2.1% growth. However, the scope for broad money to expand rapidly and suddenly if there is GDP growth is considerable, reflecting the quadrupling of the monetary base as a consequence of QE and other liquidity measures. This means that the current very low broad money growth does not indicate that there is little scope for inflation to accelerate over the next eighteen months under present circumstances. This contrasts with more normal times when broad money growth can be an excellent indicator.

There is definitely scope for GDP growth to accelerate. Following last December’s negative snow-blip, the survey data indicates some modest return to growth in the first quarter of 2011, although probably less than 0.5%. The second quarter of 2011 may not involve much faster growth, as tax rises and spending cuts commence in earnest. Thereafter, however, one might expect rapid investment-driven growth, unless there is a meltdown in the Euro-zone, China or Japan, or political turmoil in the major Arabian-peninsula oil producers. This investment boom will be driven by: 1) a calming down in corporate bond markets; 2) catch-up on investment foregone during the recession, once it is clear that double-blip will not turn into sustained malaise; 3) exploitation of negative real interest rates; 4) use of large corporate sector cash balances, and 5) the desire to get into real assets ahead of further rises in inflation. Quarterly growth could be, in the region of 1% to1.5% by the second half of 2011.

Much commentary focuses upon the consumer, as if consumption-led growth were the only possibility, or government spending, as if more government spending made economies grow faster, rather than slower! However, we do not need rapid consumption growth or government spending growth - or, indeed, rapid export growth - to have a rapid growth in GDP. Falling investment was a key driver of the contraction in GDP. Investment expansion can be the key driver of recovery.

There is almost no reason to believe that inflation will ease in the way that the Bank hopes. Why, if inflation is 6%-odd, Bank Rate is below 2% (implying negative real interest rates), and the economy is growing at 1% to 1.5% per quarter, should inflation be expected to fall back? The Bank's case rests on the output gap. However, the output gap is difficult to observe ex ante at the best of times - even if it may be useful as a tool for ex post analysis of policy. Large recessions typically have an adverse effect on the sustainable growth rate but we can only observe how large the impact has been many years later. Some pre-recession investment becomes stranded in a large recession (i.e. it was ‘mal-investment’) but we have only a tenuous basis for estimating by how much. This means that estimates of the output gap depend on adjusting something difficult to observe at the best of times, to take account of a change in the sustainable growth rate that we can only guess at. This then has to be adjusted downwards by a further guess at the amount of capacity ‘permanently lost’. Consequently, the output gap is almost useless as an analytic tool under current circumstances even if it may have some value in placid economic conditions.

Furthermore, output gap analysis neglects the point that, following a very deep recession, as well as there being a levels constraint driving inflation - i.e. once we are above capacity prices rise because of scarcity - there may be a rate constraint in that the economy can only add additional capacity at a certain rate without that creating its own forms of scarcity. Output growth in the second half of 2011 and early 2012 could well impinge upon rate constraints - the UK economy will struggle to expand at 1.5% without that being inflationary.

Altogether then, although it is no longer possible to have any clear idea what basis the MPC has for decision-making, it has clearly long-since ceased to be anything to do with any inflation target. One can only assume that the Bank should be conceived of as exercising a discretionary approach. However, the economy faces a brute inflation problem next year that even a discretion-exercising central bank with no nominal anchor should care about. There is no point in trying to prevent that now; it would not be possible to raise Bank Rate to the 5%-odd required without inflicting a further terrible recession. All we can do, for now, is to try to keep pace with inflation as it rises through 2011. This would reconnect Bank Rate to the monetary transmission mechanism and place the authorities in a position where the rises are a little less steep when the serious work of raising interest rates comes in 2012. In this context, I note that the OBR's Economic and Fiscal Outlook for March 2011 included a scenario (paragraphs 3.117ff) in which CPI inflation peaked at 4.5% in the third quarter of 2011, but starts rising again in early 2012, eventually rising back above 4.5%. The OBR forecast was that, under this scenario (which I consider too optimistic) Bank Rate would average 4.8% in 2012 and 6.1% in 2013. In 2012, Bank rate will need to rise very aggressively - much more aggressively than financial markets or households are expecting. The sooner we start acting, the less of a surprise it will be when we act later and the less steeply rates will later need to rise. The time to start is now.

Comment by Peter Spencer
(University of York)
Vote: Hold.
Bias: To ease using QE.

The tension posed by the strong inflation pressure and the anaemic economic recovery mounts with every set of monthly figures. It is now an understatement to say that this poses a dilemma for the MPC. Although the reasons for this situation are plain to see, there is little consensus about the best way of handling it.

The money and credit markets remain depressed following the crunch and will continue to hold back the recovery. The retrenchment in the public sector will have a similar effect. At the same time the strong recovery in Emerging Asia, together with tension in the Middle East and a series of terrible natural disasters, has pushed up commodity prices across the board. World prices for food, fuel and fibres are now working through to the consumer inflation figures with a vengeance.

In the bad old days, this would have triggered a vicious wage-price spiral. But this time it has been totally different. The workforce realises that it would be futile, or rather counterproductive, to try to compensate for this by demanding higher wages. The median settlement has drifted up a bit, as wage freezes have ended in the private sector, but it is still running at around half the rate of CPI inflation. The paradox is that high inflation is a deflationary force, hitting household disposable income spending hard in this situation, a reality that most people are coming to accept. The Chancellor, instead of worrying about runaway inflation, is concerned about the impact on hard pressed families, desperately trying to find a few crumbs of comfort for them in the Budget. It not just families that have been caught out by the squeeze: the OBR and other forecasters have been busy revising their growth figures down as inflation has risen.

It is not clear how much further the boom in commodity prices has to run. Talk about a ‘super-cycle’ sounds very much like the ‘new paradigm’ that was used to justify the excesses of the dot-com boom. Historically, commodity prices are mean-reverting, though that is probably no longer true of oil prices. Fortunately, they only need to stabilise for the effect on headline consumer price inflation to wear off, allowing this to gravitate back to the low underlying rate. This year’s increases in indirect taxes will wear off in exactly the same way next year. Indeed, the Budget cleverly postponed the hike in fuel duties to next January, when the echo effect on the CPI will provide plenty of cover for additional increases in duties.

While there seems to be some measure of agreement about the nature of our predicament there is little agreement about what to do. On the one hand it has been suggested that the effect of indirect tax and commodity prices is temporary and that there is nothing that the MPC can do about it in any case. Domestic cost inflation, like the economy remains depressed. On the other hand, it has been argued that the MPC is damaging the inflation framework by allowing inflationary expectations to increase and that sterling commodity prices can be influenced through the effect of interest rates on the exchange rate. I am firmly in the first camp.

There is no need to be too concerned about rising inflation expectations as long as they do not provoke a rise in wage inflation. Moreover, with the economy so depressed, I doubt that base rates would have much purchase over the exchange rate. The last time we were saddled with a depressed economy and base rates were stuck at a lower bound – when we were in the Exchange Rate Mechanism in the early 1990s – Bank Rate increases proved entirely counterproductive. The markets could see that they would simply depress the economy further. The economy and, eventually, the pound only recovered after we removed the lower bound by leaving the system.

It is a pity that we could not kick the lower bound away this time. Had we been able to lower real interest rates faster initially, without relying on rising inflation to do the job, I do not think we would be in this predicament now. QE was arguably effective and allowed monetary policy (like diplomacy) to be continued by other means. However its effects remain unclear. Lower interest rates would surely have had a more obvious impact. I would not raise interest rates now, but wait until there were clear signs that the economy was taking the retrenchment in its stride. An increase in Bank Rate would intensify the pressure on households (especially those with tracker mortgages) and further weaken the recovery. It could also backfire badly in the foreign exchange markets once traders could see the effect on the housing market and the high street. Despite its uncertain impact, I would also revive the QE programme if the weakness in economic activity persisted.

(Editorial note: Peter Spencer was a founder member of the SMPC in 1997. He has now generously volunteered to step down from the SMPC in order to make way for the three new members of the committee who will be joining in April. The Institute of Economic Affairs and the other SMPC members are deeply grateful to Peter Spencer for his contribution to the work of the committee over the past fourteen years.)

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 again.

The Bank of England is usually reluctant to change Bank Rate in the months each side of a Budget, in case their actions are seen as an implied criticism of the Chancellor’s measures. It would, correspondingly, be a major surprise if there were to be Bank Rate change at the 7th April MPC meeting. It is also arguable that the Bank is so far ‘behind the curve’, where inflation and the money-market ‘swaps’ rates that drive lending costs are concerned, that raising rates in April would indeed be a ‘pointless gesture’. The main reasons for wanting to increase Bank Rate now are to demonstrate that the monetary authority remains seriously committed to its inflation target and to prevent accelerating inflation leading to an unwarranted further reduction in the real rate of interest, which is already highly negative. In terms of natural justice, also, it is hard to see why savers, people buying annuities, and private-sector pensioners should be robbed of the fruits of a lifetime’s savings through a covert inflation tax in order to make life easier for buy-to-let speculators, the financially improvident, and a feckless political class who have come close to losing control of the national finances. While there may be a tactical case for holding Bank Rate this month, it would certainly have been preferable if the MPC had chosen to half normalise Bank Rate – by which is meant raising it to a figure of around 2% to 2½% - during the autumn of 2010 before the latest VAT hike, had pushed up inflation and weakened household living standards.

The 23rd March Budget measures were no big deal when viewed superficially, largely because the main strategic decisions had already been taken in the June 2010 ‘emergency’ budget and the 22nd November 2010 government spending review. However, there were two aspects of the 2011 budget that give rise to longer-term concern. One was the upgrading of the projected Budget deficit in 2011-12 and subsequent years, which looks rather like the continual borrowing slippage observed under the previous government. The international bond markets have given the Coalition the benefit of the doubt so far. However, they may not be prepared to do so in a year or eighteen month’s time if public borrowing is not palpably falling in line with the official forecasts. In that case, the incipient sovereign-debt crisis that would have hit the UK financial markets last summer if a Labour government or Liberal-Labour coalition had been the electoral outcome will have been postponed, not averted, and the Conservatives and Liberals will take the blame.

The second negative aspect of Mr Osborne’s March 2011 Budget was the resort to Gordon Brown style populist fiscal attacks on North Sea oil producers and the banks, including overseas banks operating in London who have received no financial support from the British taxpayer. Such arbitrary imposts are inconsistent with due process and the rule of law and exacerbate the perceived political risk for people who are contemplating investing in Britain. It is also odd, from an energy self-sufficiency perspective, to take measures that will reduce the supply of home-produced oil and natural gas, while increasing the demand for fuel by squashing the planned duty increase, when the Middle East is in turmoil and nuclear power looks less attractive because of events in Japan. The present coalition seems to have a tin-ear for the effects that its policies are having on the incentives to supply goods and services in Britain, just as the monetary authorities appear to be blissfully unaware of the adverse impact that their regulatory proposals are likely to have on the supplies of money and credit to the non-bank private sector.

The Coalition government has been strongly criticised by the political opposition and state spending lobbies for the alleged excessive speed and size of the so-called public expenditure cuts, even if the cash value of total general government spending is still officially predicted to increase from £665bn in 2009-10 to £763bn in 2015-16. This means that these are not cuts as this term would be understood by a private-sector manager facing a normal cash-constrained Budget. However, the question that no-one has dared ask is whether the public spending retrenchment over the next few years will be sufficient to maintain fiscal credibility at a time when UK monetary policy credibility has been badly compromised by persistent inflation overshoots, if not lost entirely.

Having run the March Budget measures and the 29th March UK national accounts and balance of payments data through the Beacon Economic Forecasting (BEF) model, it is hard to see how the Coalition can achieve its borrowing intentions over the next few years, even if the economy grows broadly in line with the official predictions. On a ten-year view, it is possible to foresee a broad balance emerging on the Public Sector Net Borrowing (PSNB) definition by 2017-18, with growing surpluses emerging thereafter. However, the PSNB is expected to come in slightly worse in 2011-12 than the £145.9bn officially projected for 2010-11 before it starts falling away from 2012-13 onwards. This fall is also noticeably slower than the one shown in the official forecasts. This is partly because of a disagreement about the taxable capacity of such a highly-socialised economy as Britain’s. In logic, the government cannot tax itself. With general government expenditure amounting to 53% of the factor-cost measure of GDP in 2010-11 – albeit, officially projected to drop to 45% by 2015-15 – the private sector tax base is simply too small to generate the tax receipts that Mr Osborne is relying upon. Furthermore, many of his tax initiatives, such as the hike in VAT, appear to have made the public finances worse not better. However, it is also not obvious that the cash expenditure projections in the official OBR projections are realisable, even if one takes the volume projections – which are given up to 2016 Q1 on the OBR website – as given. This is partly because the official projections appear to assume a much smaller cumulated increase in the cost of general government consumption by 2015-16 than one would expect on the basis of historic relationships.

Finally, and having consistently voted for an increase in Bank Rate to 1% since February 2010, there seems to be no point in changing this recommendation now, even if there seems very little likelihood of a rate hike in April. The longer the required monetary normalisation is delayed, the greater the risk that, when Bank Rate does go up, it will do so dramatically and in a way that does far more collateral damage than if the Bank had acted in good time. The outcome of the current official approach to both fiscal discipline and monetary rigour – which looks uncannily like the ‘establishment Keynesianism’ of the 1960s and early 1970s – will presumably be the same mix of weak growth and disappointing inflation that got to be called stagflation. It will be instructive to see the financial market’s verdict on this policy mix in a year or two’s time.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%; no extension of QE at present.
Bias: To raise Bank Rate to 2% by end-2011.

Measured either in terms of the current or the expected rate of inflation, UK real interest rates have fallen in recent months to leave this aspect of the policy stance even looser than before. The commencement of nominal interest rate increases up to around 100 basis points would merely reset the policy stance to where it was six months ago. The argument over MPC policy is between those who desire an even looser stance and those who desire, at a minimum, the reversal of recent policy loosening.

Notwithstanding some gradual improvement in the growth of the adjusted monetary aggregates, the UK has one of the weakest private sector credit and money recoveries in the world. In a recent comparison for fifty countries, only Ireland displayed weaker bank credit growth. It has been obvious for some time that the overall stance of the Bank of England towards the credit and capital markets is much tighter than could be inferred from the level of interest rates. In 2004-05, prior to the final, dramatic expansion of Value-at-Risk (VAR) in the UK financial system, monetary financial institutions (MFIs) issued £50bn of net capital per annum and other financial corporations another £50bn. The current rates of annual net issuance are £14bn and minus £24bn.

Without going into detail regarding the timetables for the adoption of Basel III, the Financial Services Authority’s Liquidity Directive and the withdrawal of Special Liquidity Scheme and Credit Guarantee Scheme funds, it is becoming clear that the complex messages contained in these policies and directives have strangled the effectiveness of low interest rates for the UK economy. Bank Rate is merely one element of the UK monetary policy stance and probably the least significant at present. Quite simply, the Bank of England is operating a policy of credit rationing towards the banking and other financial sector. The only reason that the UK has any prospect of economic growth in 2011-12 is that the corporate sector is able to finance its own capital requirements from internal sources.

Mortgage approvals have slackened off over the past year; the house price recovery has petered out and prices are softening. Despite the lowest effective mortgage rates in modern history and a first-time buyer mortgage repayments ratio back to its long-run average, few deals are going through. The Bank has taken us back to the credit policies of the 1970s prior to financial de-regulation. Until this mutually conflicting policy mess is resolved, the Bank Rate vote has huge psychological, but little operational, significance. Nevertheless, my vote is for an immediate increase of ½% to 1.0%.

Comment by Mike Wickens
(Cardiff Business School)
Vote: Raise Bank Rate to 1%.
Bias: To hold after the ½% rise.

In recent months, I have argued several times that interest rates must be increased if the inflation target of the MPC is to be taken seriously. The immediate aim should be to reverse the depreciation of sterling in order to reduce imported inflation, which is the main reason why UK inflation has been above target. In other words, the transmission mechanism is via the exchange rate, and not output or the cost of capital. Over this period, CPI inflation has steadily increased and now stands at 4.4%. As a result, the public’s inflation expectations are naturally rising and indexed contracts will soon cause costs to increase. Yet the MPC has done nothing about this, on the grounds that the additional inflation is temporary and is outside their control.

To add to the confusion, the Chancellor has just confirmed that the inflation target will remain at 2%. What are we to make of this? The obvious answer is that either the MPC is mistaken about the temporary nature of inflation – which is what the evidence shows - or that the monetary framework has changed but this has not been announced publically. Why else would the Chancellor be content to receive without serious comment the series of letters received from the Governor explaining why inflation is above target, and still confirm that the target is 2%?

If we assume that the objectives of monetary policy are changed, then the whole debate about what interest rate to set is changed too. The new aim seems to be to subordinate targeting inflation in favour of economic growth. The Government and the Bank seem to be hoping that the public have not yet realised that the change has taken place and so will not affect inflation expectations. The de facto new policy objective is not unreasonable in the current circumstances. It is similar to that of the US Federal Reserve, but not the European Central Bank which is still a strict inflation targeter. It does, however, raise an old question: is it better for the wider economy if the government distorts prices – in this case, the real interest rate – rather than allow market forces to set the correct prices? This is a re-run of the Hayek-Keynes debate of the 1930s.

Government intervention is expected to result in a misallocation of resources. In particular, a low interest rate generates little incentive to save as real interest rates are currently negative at around minus 4%, but investment – if the finance were available – would be stimulated and the cost of government debt finance is kept low. According to the interventionist position, this is an argument for the long run whereas the policy problem is to stimulate the economy in the short run.

The problem with adopting a new flexible inflation targeting remit in the current circumstances is that, whatever view one takes about the effectiveness of government intervention, it would have to take the form of fiscal, and not monetary policy measures, as interest rates are near the zero lower bound and QE has proved not to increase lending to the private sector. Hence, even if the Bank were given a new remit to be a flexible inflation targeter, monetary policy would be ineffective as a way of stimulating the economy. To summarise, the MPC refuses to try to control inflation and is powerless to assist in stimulating a recovery. It therefore does nothing. It might be better if the MPC stuck to its original remit of controlling inflation via the exchange rate by raising interest rates.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: To tighten.

What are we to make of the message for interest rates in the latest UK data? On the surface, the evidence is clear and unequivocal, inflation is rising and so interest rates should rise. After all, the reason that Bank Rate was cut to ½% two years ago was because the economy was faced with the prospect of a contraction of at least 5% and, possibly, double that. Now, price inflation for February was up by 4.4% on the year and RPI was rising by 5.5%, some of the fastest increases since the early 1990s. In the meantime, the international economy is recovering, with the US growing by 3% currently, Germany by 3.6% in 2010 and the emerging markets expanding once again by between 4% and 10% per annum. In addition, the UK economy expanded by 1.3% last year, ending one of the worst recessions since the Second World War.

Underneath the recovery, however, all is not well. Domestic demand in the UK is still very weak, with real consumer disposable income set to drop again this year, after falling in 2010. Unemployment is likely to start to rise as government cut backs - confirmed in the March Budget - start to bite. Indeed, the Budget growth rate forecast of 1.7% for this year was mainly generated by a net trade contribution of 1%, something that seems highly implausible against the small positive contribution of just 0.2% in the end quarter of last year and more recent trends. It is not that manufacturing exports are not rising, they are, and boosting manufacturing output by 6% year on year in January. It is just that imports are rising even faster. With manufacturing accounting for some 13% of output, its expansion is not fast enough to pull the whole economy along, as consumers are retrenching and government spending is set to fall. Money supply growth is rising on the government's preferred measure, but is still at the lower end of the 4% to 6% range judged necessary to ensure growth of at least 2% a year.

Historically, one of the risks of price inflation is that it leads to a spiral in wages as workers demand, and get, higher nominal wages to compensate them for rising consumer prices, this is then paid for by firms raising their prices, which in turn leads to workers demanding more pay, thus setting off a vicious inflation spiral that can only be ended at great cost in employment by swingeing rises in interest rates. If that is the risk, then the earlier interest rates start to rise, the lower they may then end up. But this does not seem to be what is happening at the moment. With pay roughly stagnant, higher prices are instead reducing spending power and so slowing the recovery. If the economy was buoyant and demand was strong, then there would be a real threat that higher inflation would result as firms paid workers more. However, the evidence is that this is not happening and, moreover, seems unlikely to happen in the near future.

Taken together with the uncertainty around the impact of the Middles East, Japan, and ahead of fiscal tightening, I think rates should be left at ½%. Once it is clear what is happening to demand, then I believe that rates should go up – probably, later on this year. For now, the recovery is not secure enough and there are too many deflationary forces at work at this delicate stage of the recovery cycle.

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.

Current 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 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.

Forthcoming membership changes

Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School) and Akos Valentinyi (Cardiff Business School) will be joining the SMPC in April 2011 while Peter Spencer will be retiring after fourteen years as an active member.