Sunday, May 01, 2011
Shadow MPC votes 5-4 to raise rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its latest quarterly gathering on 13th April, the Shadow Monetary Policy Committee (SMPC) voted by five votes to four to raise Bank Rate to 1% in May.

All four dissenting members voted to hold the official interest rate at its present ½%. There were various reasons why a majority of SMPC members wanted to raise Bank Rate. One was concern that the overshooting of the inflation target – when combined with the fact that the annual increase in the target consumer price index (CPI) was running 1.4 percentage points below the previous RPIX target measure rather than the 0.5 percentage points gap claimed at the time of the official changeover – was undermining the credibility of the monetary framework.

There was also concern that the present negative real interest rate was leading to a serious misallocation of capital, as well as doing injustice to savers. A third reason for wanting a rate hike was the belief that the monetary authorities would have more flexibility in both directions if Bank Rate was raised to 1% immediately and perhaps 2% to 2½% in the longer term.

There was also concern that high levels of public borrowing would prove more intractable than was predicted in the Budget, and that this could test the patience of the global bond markets at a time when sovereign risk concerns were escalating.

The main reasons that four SMPC members wanted to hold Bank Rate at ½% was the fear that the UK economic recovery was not yet firmly established together with the belief that the banking system remained so weak that there would be a long period of sluggish money and credit growth ahead and that this would seriously limit the scope for recovery. This meant that low interest rates currently existed alongside abnormally tight money and credit conditions, not just in Britain but in many other developed economies as well.

Minutes of the Meeting of 13th April 2011

Philip Booth (IEA-Observer), Jamie Dannhauser, Anthony J Evans, John Greenwood, Andrew Lilico, Kent Matthews (Secretary), Gordon Pepper, David Brian Smith (Chairman), David Henry Smith (Sunday Times-Observer), Akos Valentinyi, Peter Warburton, Robert Watts (Sunday Times-Observer), Trevor Williams.

Apologies: Roger Bootle, Tim Congdon, Ruth Lea, Patrick Minford, Mike Wickens.

Chairman’s comments

David B Smith opened the meeting by formally proposing a vote of thanks for Peter Spencer who had kindly stepped down to make way for the three new members who were attending that evening’s meeting for the first time. Peter Spencer had been one of the SMPC’s founder members in July 1997 and his many contributions were much appreciated. David B Smith then welcomed the three new SMPC members: Jamie Dannhauser (Lombard Street Research); Anthony J Evans (ESCP Europe), and Akos Valentinyi (formerly of the Hungarian Central Bank and now at the Cardiff Business School).

As there were more than nine potential voting members present at the meeting, the Chairman suggested that the discussion of everybody should be recorded but that only two votes should be taken from the three new members. He also suggested that this should be done in alphabetical order, since any method of choice was essentially arbitrary. This meant that Professor Valentinyi’s vote would not be counted on this occasion but that a slot would be reserved for him in the June SMPC poll. This would be conducted on the usual ‘first come, first served’ basis otherwise. The Chairman then invited Peter Warburton to give his assessment of the world and domestic economy.

The Monetary Situation
The International Situation
– Tentative recovery in global monetary growth
Peter Warburton referred to his previously prepared charts and began his assessment of the international economy. The global recession had resulted in some rebalancing of current account imbalances, but the revival of capital flows to emerging markets in 2010 had propelled global gold and foreign exchange reserves to exceed US$10trn. The second phase of the US Federal Reserve’s Quantitative Easing (QE) policy – commonly referred to as QE2 – would continue through to end-June. However, the big news was the events in Japan, with the Bank of Japan making a huge liquidity response to the earthquake disaster. The growth of the Bank of Japan’s balance sheet was the magnitude of a QE3, with particular purchases of short maturities. On a superficial comparison, there had been a strikingly strong correlation between total US Treasury purchases by the Federal Reserve and global commodity prices. Calculations of US inflation expectations derived from the break-even rates on inflation-protected Treasury bonds (TIPs) show a sharp increase to 2.6%. However, world trade volumes had apparently extended their strong recovery from their 2009 lows. This was indicated by the growth in international freight volumes.

After a delay, a new global private sector credit cycle had begun in 2010 and seemed to be continuing. Nominal global GDP growth had waned but was still growing in the region of 7%. Global de-leveraging had continued, but at a slower pace. Most countries had reported a healthy growth of bank credit. However, there was a split between size and growth and between developed and emerging markets. The largest economies had shown the weakest credit growth and credit growth had been slower in the developed countries than in the emerging markets. Global money supply growth had shown signs of a modest recovery. De-leveraging had continued but the incipient threat from higher oil and other commodity prices was materialising. There was a strong perception that the US would be the last economy to raise interest rates, while the ECB appeared ready to move faster. However, this perception could easily be overturned: the ‘doves’ in the US Federal Reserve could not ignore the import-led inflation pressures indefinitely.

In response to Peter Warburton’s comments, Andrew Lilico and Philip Booth both questioned why the strong correlation that was obvious from the chart of QE2 and global commodity prices should be so widely ignored. There followed a short discussion about global monetarism and the transmission mechanism involved. This suggested that it was normal for financial markets and then commodity prices to respond to monetary ease well before consumer price measures. However, Peter Warburton felt that it would be difficult to draw statistical inferences from only two years of data. David B Smith said that it was widely accepted that investors went long of commodities when interest rates were below inflation. This was because the so-called ‘cost of carry’ of investing in commodities rather than holding cash became negative under these circumstances.

The UK Economy – Blame the weather for Q4 weakness Turning to the domestic economy, Peter Warburton noted that the severity of the cold weather spell last December might have subtracted as much as 1% from the level of GDP in the final quarter of 2010, rather than the official estimate of 0.5%. Since then, there had been a rebound in service sector output. Peter Warburton said that he expected a 1% rebound in growth in the first quarter of this year. David Henry Smith (Sunday Times-Observer) said that the monthly figures for construction had led to some down grading of activity in 2011 Q1. David B Smith said that he had done a lot of work on the quality of the national accounts data produced by the Office for National Statistics (ONS).The historic data contained what looked like clerical errors. He suspected that the ONS numbers were a highly unreliable guide to what was happening in the real-world economy and that it was necessary to treat them with a large pinch of salt.

Peter Warburton argued that the conventional monetary transmission mechanism remained dysfunctional. He said that the expectation of the Office for Budgetary Responsibility (OBR) in June 2010 – and that of many other economists – was that the pace of mortgage lending would quicken in 2011. However, despite a fall in the cost of fixed rate mortgages, mortgage approvals had sagged in recent months. Mortgage lending appeared disconnected from the price of credit, implying that other factors were rationing the supply of credit. More broadly, the UK has one of the weakest private sector credit recoveries in the world, despite record low interest rates. Trevor Williams said that borrowers that met the conditions of higher deposits were getting loans at low rates.

Akos Valentinyi and Andrew Lilico discussed the meaning of credit rationing and commented that combinations of deposits and mortgage rates constituted the price of credit and did not reflect credit rationing. Trevor Williams added that as a result of the crisis both borrowers and lenders had altered their respective risk preferences. Peter Warburton countered that more people were entering the labour force and employment had grown but first-time buyers had been frozen out of the market. Akos Valentinyi said that the backdrop of robust mortgage borrowing in the past had been one of rising house prices. It should not be a surprise that mortgage demand had not recovered as no one expected house prices to grow as rapidly as in the recent past. There was a brief discussion between David H Smith, Jamie Dannhauser, Andrew Lilico, and Phillip Booth about the driving factors and the dynamics of the housing market. Peter Warburton said that a combination of altered bank management objectives, the Basle III accord, and a plethora of other interventions by the Financial Services Authority (FSA) and the Independent Commission on Banking (ICB) had acted to constrain bank behaviour. Peter Warburton referred to the chart of the decomposition of the retail price index. This showed that the inflation rate of private sector goods and services had left its normal channel and was settling at a much higher level. Weakness in broad money growth showed no sign of reversing. This, again, was consistent with dysfunctionality in the monetary transmission system.

Peter Warburton summed up by saying that the stagnating monetary aggregates remained a concern, but that the UK economy was continuing to recover from the 2009 slump. UK visible trade figures for the first two months of the year showed an acceleration, which may signal the long-awaited boost from currency depreciation. Kent Matthews said that the basic story was that, because credit rationing existed and monetary conditions had been sluggish, a rise in Bank Rate would not have any effect on monetary conditions anyway. He said that you did not have to buy the credit-rationing story to argue for a rate rise. Andrew Lilico then asked Peter Warburton for his assessment of growth prospects in 2011, Would UK economic growth stagnate or accelerate? Peter Warburton said that he expected growth to be in the range of 1½% to 2% with capital expenditure and inventory rebuilding leading the way.

Bank’s hopes of inflation falling back to target are misplaced
Andrew Lilico said that business cycle research suggested that one should expect a one quarter downturn in any recovery phase and by mid-year there should be signs of a normalisation of markets. He expected that the main driver of growth would be capital expenditure and that the prevailing doctrine that inflation would tend to fall back to target was simply wrong. Trevor Williams said that the global output gap was negative but small. Peter Warburton added that the gap argument was misleading. The output gap in most of Asia was closed. The way world prices had developed in the context of the supply-side means that inflation could persist even in the face of a negative output gap elsewhere. The Chairman, David B Smith, then expressed his worries about the British government’s fiscal position and questioned the patience of the global bond markets if the UK budget deficit overshot the official projections by as much as he expected. The Sunday Times observer, David H Smith, said that it was right to be concerned. It was less than a year into the coalition and already expenditures on defence and the NHS were being revisited. However, he did not foresee any immediate problems with the international bond markets.

The Chairman then asked each SMPC member present to make a vote on the appropriate monetary policy response. The votes are traditionally listed alphabetically rather than in the order they were cast, since the latter simply reflected the arbitrary seating arrangements at the meeting.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold.
Bias: To tighten.

Jamie Dannhauser stated that he voted for no change. The analogy he used was taking the foot off the accelerator rather than applying the brake. The real short rate may not be the best monetary indicator. All measures of liquidity in the UK, USA and Euro-zone pointed in the same direction. They were not consistent with the above trend nominal spending growth needed to hit the inflation target over the medium term. He added that the idea of a mechanical link between bank reserves and lending was inaccurate. The Bank will have plenty of warning of a rise in the money multiplier. Regarding the output gap, he suggested that there was a huge gulf between where the economy was and where it could have been had the crisis not come along. On the likely pace of global recovery, the forecasts produced by the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) appeared overly optimistic. He said that he was not confident that the recovery, both at home and abroad, had entered a self-sustaining phase. The legacy of the financial crisis would mean a long drawn out recovery.

Comment by Anthony J Evans
(ESCP Europe)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Anthony J Evans said that the Consumer Price Index (CPI) inflation target was not the only appropriate measure to look at. He said that he was uneasy about the shift in the target measure from the Retail Price Index (RPI) to the CPI. He added that monetary policy should not be too accommodative of fiscal policy. Spending cuts could spur growth. Low interest rates had resulted in a serious misallocation of capital. He said that he had no confidence in the exit plan from QE. This may not provide enough early warning to absorb the bank reserves that would otherwise feed into broad money growth.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate. Reactivate QE if negative monetary growth continues.
Bias: Neutral.

John Greenwood said that the key distinction to be observed in Peter Warburton’s charts was the difference between the emerging economies where broad money growth was accelerating and now reaching 14% to 16% on average (e.g. in Asia and Latin America), and the developed economies where broad money and credit growth was at historically low rates. Consequently, the revival in the emerging economies had been strong, with monetary expansion flowing from property and stock markets through to strong domestic demand and now rising inflationary pressures. Inflation in these economies was therefore likely to be much more embedded.

In developed economies, by contrast, deleveraging continued with the repair of balance sheets, resulting in historically low rates of broad money and credit growth. In these economies the inflation problem was mainly confined to imported commodities, or was due to the imposition of higher indirect taxes. Reported inflation would therefore diminish once commodity prices stabilised. Rising headline inflation in the UK did not imply any easing of monetary policy since interest rates were an unreliable signal of the tightness or ease of monetary policy. Currently, low interest rates existed alongside tight monetary and credit conditions. This was mainly because the demand for credit had fallen so much, but also because banks were reluctant to lend. While the process of deleveraging continued, there would be low growth. These conditions did not justify any increase in Bank Rate.

Comment by Andrew Lilico
(Policy Exchange and Europe Economics)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Andrew Lilico said that press commentary suggested that the Bank of England would need a reason to raise Bank Rate but, in fact, it needed a justification for keeping rates at a three-hundred year low. Over time, the automatic tendency should be for Bank Rate to revert to some ‘Wicksellian’ notion of a natural position. A small rise in rates will not make a big difference in the short term. However, it was better to raise rates now so that the jump will not be so great when the monetary authorities were forced to raise Bank Rate in 2012. He said that he expected quarterly growth to be in the order of 1% to 1½% by 2011 Q4, driven by an aggressive rise in investment spending. The Bank should have raised rates earlier and did not do so in February only because of the weak 2010 Q4 output figure. He said that the Bank of England would regret waiting too long. As it was, inflation targeting now had little credibility as a policy.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold.
Bias: Neutral.

Gordon Pepper said that Peter Warburton’s commentary had barely touched on the monetary situation. Although the current margin of spare capacity in the economy should be sufficient to stop the current increase in the price level from becoming inflation, money-supply policy should be in support. Given the risks involved, the current supply of money should not significantly exceed the current demand for money. Sluggish data for the money supply suggest that there is at present a monetary squeeze. However, this was misleading because the demand for money as a home for savings had collapsed. This saving demand for money depended on wealth and the rate of interest on bank deposits relative to the expected return on other assets, for example on equities, after allowing for perceived risk of loss. The current rate of interest on bank deposits was abysmal. The overall demand for money had fallen, possibly faster than the supply of money. The position was not clear. Additional evidence was needed.

Generalising, Gordon Pepper suggested that the gathering should suppose that the supply of money currently exceeded demand. Some of the excess would be spent on goods and services – which would stimulate economic activity – and some would be spent on assets, the prices of which would rise. Because financial markets reacted more quickly than the economy, a rise in the stock market preceded an economic recovery. The rise in equity prices was a necessary but not sufficient condition for economic recovery. (In the opposite case of a monetary squeeze, similar reasoning explained why the equity market had predicted five out of the last ten recessions!) Currently, the stock market had risen; it had bounced back nicely from bad news. If it had carried on falling, this would have been clear evidence of a monetary squeeze but the rise was insufficient evidence to argue that money supply should be tightened. The case has not been made for money supply to be either tightened or eased. The conclusion was that it should not be changed.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Kent Matthews agreed with the comment by David B Smith (see below) that uncertainty about the nature of the disequilibrium in the monetary sector was not a reason for doing nothing. The argument could be equally applied to the do something camp if policy is thought to be out pushing the economy in the wrong direction. He said that you did not have to buy Peter Warburton’s argument of credit rationing to agree with the policy conclusion of raising rates.

An indicator of where the market believes the economy was going could be gleaned from measures of inflation expectations. Both the short measure of inflation expectations collected in the Bank’s own survey and the longer term measures got from bond yields and indexed linked of equivalent maturities, suggest an edging upwards of inflation expectations. The reason why these measures were rising but lagging behind actual inflation measures was because the markets faced a ‘signal extraction’ problem. The Bank had not persuaded markets of the view that the rise in actual inflation was purely temporary. The probabilities that above target inflation was temporary rather than permanent were an indicator of the credibility of the inflation target. Kent Matthews agreed with Andrew Lilico that the credibility of the policy was under question. Creeping inflation expectations measured the loss of credibility. A series of small rises in interest rates starting now might restore credibility and circumvent the need to raise interest rates more sharply in the future. He voted to raise rates now with a bias to rise further.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%. Hold QE stock at present level.
Bias: To tighten gradually until Bank Rate is at 2% or 2½%.

David B Smith said that Gordon Pepper’s comments about disequilibrium money were most interesting. However, while he did not disagree with Gordon Pepper’s analytical framework he did disagree with the conclusion that Gordon drew from it. In particular, if there is no confidence on which side any disequilibrium between the supply of, and demand for, money existed, policy makers had two options - either to do nothing or, alternatively, move towards a neutral position. If the economy needed to be stabilised in either direction again, it was easier to do so from a position where Bank Rate was, say, 2½% than from the current ½%. There was scope for a strong global recovery because of the nature of the preceding crash – which was the result of a collapse in global supply chains and intermediate demand that was now being rapidly reversed. Britain’s small trade-dependent economy meant that the country would benefit strongly from the upswing in global activity. Britain’s real problem was its sclerotic supply-side. This supply-side problem had been made worse by excessive government spending and over-regulation during the past decade. Applying undue monetary stimulus to a supply-constrained economy would cause stagflation, not growth. Unfortunately, this was the situation that we were now in.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Peter Warburton said that the prevailing structure of retail interest rates continued to bypass Bank Rate and that a reconnection might not occur until Bank Rate reaches 1½% to 2%. Hence, raising rates into this range should not have a detrimental effect on economic growth. The restoration of wholesale markets to their former health is an urgent priority if Bank Rate is to play a key role in the monetary transmission process again. The failure to normalise interest rates last year had cost the Bank of England its inflation-fighting credibility. The Bank had misjudged the inflationary climate and lacked the tools to restrain inflation expectations.

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

Trevor Williams said that the depreciation in the exchange rate had not had stimulated the desired response from external demand but that it had generated inflation. In addition to the regions John Greenwood had referred to, Latin America and Africa were also growing more rapidly. World growth was rising. Although doing well, UK exports had not grown as fast as other countries. The effects of the crisis would take a long time to wear off and the recovery was a long process. There was still a negative output gap and wage inflation remained low. Monetary policy had to act as an offset. Commodity prices would come off the boil in time.

Further Comments by non-voting participants

The chairman then asked Akos Valentinyi, Philip Booth, and his near namesake from the Sunday Times if they had anything that they wished to add to the written record. David H Smith declined the offer but the other two contributed as follows.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise bank Rate to 1%.
Bias: To raise Bank Rate again.

Akos Valentinyi said that he had three points to make. First, strong investment spending with some contribution from exports would be the drivers for growth. Second, it was unclear how monetary data could be interpreted when massive deleveraging was going on. Third, inflation expectations were crucial. It signalled the serious intent of policy to influence private sector behaviour. It was also the case that central bankers have to signal their ‘conservativeness’. The main task of central banks was to defend the value of the currency.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)

Phillip Booth said that, while he did not wish to cast a vote, he did want to comment about the measure of inflation in the inflation target. Going back ten years, there were many technical and economic debates about how inflation should be measured. The Bank was then given the CPI inflation target and since then we have seen the increased politicisation of the inflation measure. The government has endorsed the CPI measure particularly for purposes that suited the government rather than taking explicit decisions to, for example, ‘under-index’ benefits. Furthermore, direct taxes allowances are to be indexed to the CPI whilst indirect taxes will be indexed to the RPI.

Policy response

1. A five to four majority of the shadow committee felt that Bank Rate should be raised by ½% to 1% on Thursday 5th May.

2. Of the five members who voted to raise rates, four had a bias to tighten further.

3. Of the four members that voted to hold Bank Rate in May, two indicated a bias to raise Bank Rate in the future.

Date of next meeting

Monday 18th July 2011.

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 members of the Committee include: Roger Bootle (Deloitte and Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Akos Valentinyi (Cardiff Business School, Cardiff University), 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 exactly nine votes are always cast.