Sunday, June 05, 2011
Shadow MPC votes 6-3 for rate hike
Posted by David Smith at 08:59 AM
Category: Thoughts and responses

In its most recent e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by six votes to three that Bank Rate should be raised in June. Five of the rate hawks wanted to raise Bank Rate by ˝% to 1%, while one member (who had previously worked as a central banker in Hungary) wanted an increase of 1% to give a Bank Rate of 1˝%.

The other three members of the shadow committee voted to hold Bank Rate at the ˝% originally set in March 2009. There were several reasons why a majority of SMPC members wanted to see a rate hike in June. One was concern that the persistent overshooting of the inflation target – and the Bank of England’s less than convincing response – was undermining the credibility of the monetary framework. Another was the worry that the increasingly negative real interest rate paid on UK money holdings would induce further downward pressure on sterling, and that this would be fully reflected in domestic prices in the long run.

A third reason for a rate increase was the belief that the monetary authorities would have more flexibility in both directions if Bank Rate was raised to 1% or 1˝% in June and, perhaps, 2% to 2˝% in the longer term. This would allow the use of rate cuts as a stimulus in the future, if the economy turned out to be weaker than anticipated.

The main reason that three SMPC members wanted to hold Bank Rate at ˝% was the concern that the UK recovery was not firmly established. There was also a 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 further limit the scope for recovery. This meant that the current negative real interest rates coexisted with abnormally tight money and credit conditions.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold.
Bias: To increase Quantitative Easing (QE).

The economy remains very weak and there are serious doubts as to whether even a meagre pace of expansion can be sustained. The public sector job cuts are yet to bite and recent rises in inflation without compensation in pay increases are eating into disposable income. Meanwhile, there is no sign of either inflation expectations or wage increases taking off and the government bond market is quiescent. Inflation is likely to fall sharply next year.

In the circumstances, Bank Rate should remain on hold for the foreseeable future. Although it should not be deployed yet, the Bank should be prepared to do more Quantitative Easing (QE) if the economy weakens and inflation subsides rapidly.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold.
Bias: Neutral.

The early part of 2011 has seen broadly satisfactory macroeconomic conditions in the UK. Demand, output and employment have all been growing, and unemployment is edging down, even if the official estimates for Gross Domestic Product (GDP) in the final quarter of 2010 and first quarter of this year indicate stagnation in this six-month period. As so often in the past, the data almost certainly understate growth. When the Office for National Statistics (ONS) does eventually attempt its so-called ‘triangulation’ (i.e. to reconcile data on output, income and expenditure, which theory tells us should be identical), national output could well be revised up by ˝% or so for this six-month period. Business surveys and employment numbers are the most reliable short-term guides to the economy and they argue that the economy is making steady progress.

However, inflation has been disappointing. Annual increases in retail prices of 5% plus take us back to the 1980s, as if the achievement of the so-called ‘Great Moderation’ period of low steady inflation was as nought. On the other hand, the majority view on the Monetary Policy Committee (MPC) is correct that special, non-recurring factors are responsible for the bulk of the above-target inflation number. In the year to April, the consumer price index was up by 4.5% but the ‘transport’ category was up by 9.6%, accounting for a 1.53% upwards movement in the Consumer Price Index (CPI). This means that over a third of the CPI increase was due to this one category, with the huge increase in the oil price being the main factor at work. The ONS now calculates a CPI-CT. This is a constant-tax-rate CPI, which is not quite the same thing as the more familiar CPIY, which excludes indirect taxes. As this CPI-CT index was up by 2.8% in the year to April, it is evident that – without the oil price change and increased VAT – the CPI number might well have been more or less on target. The warning here is that – if interest rates were now raised by, say, 1.5 percentage points, and oil and commodity prices were to fall sharply over the year to April 2012 (as might happen) – the annual increase in the CPI in that year might be beneath 1%. The target would be breached again, but now on the downside.

Non-oil, non-commodity-price cost pressures are weak. In the year to 2010 Q4 unit labour costs for the whole economy were up by a mere 0.7%. In a cost-accountancy sense, the underlying pressures on inflation are under good control and do not argue for strong counter-measures. Money growth is also subdued, in both the UK and elsewhere. The M4ex broad money measure rose by only 1.7% in the year to March 2011. Furthermore, there is little evidence that the last few months have seen an upturn in the growth of private sector credit. In fact, the recent withdrawal of state guarantees on some of their liabilities has obliged several UK banks and building societies to continue to shrink risk assets. Because Bank Rate is a mere ˝%, and other short-term interest rates stand at historically very low levels, negligible money growth has been compatible with the steady macroeconomic improvement noted earlier. But it is laughable to claim – as, for example, Liam Halligan did in his Sunday Telegraph columns – that the upward blip in inflation in late 2010 and early 2011 is explicable in terms of ‘the printing of money’ due to QE.

My view remains that this is not the time to tighten monetary policy. The Great Recession was caused by officialdom’s determination to punish the banks, which had the predictable - but not widely noticed or predicted - consequence of checking growth in the quantity of money. The recovery from the Great Recession is being held back by officialdom’s continued determination to punish the banks, which will constrain the growth of bank balance sheets and the quantity of money for a few years yet.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate further, and stand ready to do more QE.

To understand how to set monetary policy at the moment, it is important to distinguish between ‘quantitative’, ‘signalling’, and ‘referencing’ effects. ‘Quantitative’ effects mean those changes in monetary policy which have a more-or-less direct impact on the amount of money in circulation in the economy, or upon the speed at which it circulates. If, for example, interest rates are 10% and we cut them to 5%, then we should expect the quantity of money to increase (ceteris paribus). ‘Signalling’ effects describe the way in which changes in interest rates indicate to the market the MPC’s view about various aspects of the state of the economy, which then allow the market to update its own views. ‘Referencing’ effects denote the fact that Bank Rate is referred to in various contracts, with the prices or interest rates charged dependent on the level of Bank Rate (e.g. certain forms of tracker mortgage).

When interest rates fall below a certain level, the normal factors lying behind quantitative effects fall away. This happens for a variety of reasons, but the most important is that new constraints, that are normally loose, begin to bind. A well-known one is that, if interest rates were to become negative, so that people were charged for keeping money in the bank, some individuals might prefer to keep money in a safe at home – an option that always exists, but is not normally relevant. But, in fact, some such constraints begin to bind even before interest rates fall below zero.

The existence of such factors, and differences between countries and cultures and institutional arrangements, is an important reason why different central banks have varying ideas about what is the effective ‘minimum’ level of interest rates. For example, until the crisis of 2008 and 2009, Bank Rate had never been reduced below 2%, even in the depression of the 1930s. Nevertheless, Bank Rate was reduced to ˝% (but not to zero) in 2009. However, the European Central Bank (ECB) regards its ‘minimum’ level as 1%, and has not cut below this figure. It is now fairly clear that Bank Rate is below the level at which it has material quantitative impacts. So raising Bank Rate from ˝% to 1%, 1˝%, or perhaps even 2% would not lead to quantitative tightening.

That does not necessarily mean that Bank Rate was cut too low in 2009. It was useful to provide signals to the financial markets about the willingness of policymakers to respond, for example via QE. However, one problem with Bank Rate being at ˝% is that the ability to provide further signals by cutting rates is all-but absent. Monetary policy would provide more of a cushion if there were the capacity to cut rates if necessary. That could become highly relevant if, for example, there were to be further financial market problems triggered by a Greek default.

So, Bank Rate could be raised to 1%, 1˝%, perhaps even 2% without that involving quantitative tightening. Doing so would also allow greater scope for signalling to deal with a crisis should one arise. That leaves only referencing effects. Bank Rate serves as a reference in certain tracker mortgages and other contracts. Raising Bank Rate would thus have an impact on mortgage-holders. There are two possible observations about this. First, macroeconomic policy has spent far too long trying to spare mortgage-holders from the consequences of their own folly. It is one thing if policy smoothes an eighteen-month transition, by retarding a fall in prices in order to allow mortgage-holders to better manage themselves out of short-term cash-flow problems. However, UK macroeconomic policy has been fixated on avoiding house price falls and mortgage defaults since 2004. Seven years, and no apparent end! Such interventions create losers as well as winners. People that did not over-extend themselves by borrowing absurd sums to pay inflated prices in 2004 and thereafter have been the unsung victims. It is morally wrong to indefinitely punish the prudent to aid the profligate. Even setting this point aside, however, the reality is that those most closely tied to Bank Rate are typically on extremely low interest rates – such as 2.5%, 0.99%, or even less. Those on mortgages of 4.5%, 5%, and so on, that would be most exposed to even modest rises in mortgage rates, are those least likely to be impacted by the referencing effects of a rise in Bank Rate.

We should be aiming to get Bank Rate up to a more natural ‘minimum’ level at which quantitative effects start to bind. It is not proposed that Bank Rate should be raised relative to inflation. The CPI figure is headed for 5%, at least, now. In November 2010, the possibility that CPI inflation could reach 5% was at the outer envelope of the Bank of England’s fan charts. Now it is the main case, whilst 7% is the outer envelope. On even the most hawkish of (credible) proposals, interest rates will not rise as rapidly as inflation. So, interest rates will be falling, not rising, in inflation-adjusted terms. Insofar as there is a signalling effect from rate increases, such signals will be useful. They would indicate (mirabile dictu!) that the Bank of England still had some vague fleeting interest in keeping down inflation, even if it long ago lost all interest in keeping to the official inflation target.

Some argue that the quantity of money is not rising rapidly enough. The backlog of extremely rapid monetary growth in 2005 to 2007, and the quadrupling of the monetary base since 2007, both suggest there is ample monetary room for prices to grow. Nevertheless, in the event that further pathologies arise in the financial sector – which is by no means implausible, they could indeed happen any time, and very probably will happen shortly after Greece’s impending default – the correct monetary policy responses will be: 1) relaxation (not tightening) of regulatory capital adequacy requirements; and 2) more QE. Interest rates are not the tool for all problems. We need to try to restore a little focus of interest rates on what they can affect: the quantity of money, inflation, and - if there were a credible monetary policy framework, which there is not - macroeconomic stability.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again, and for QE to be held with a bias towards reversal.

Inflation is now taking hold across the world economy. Western central banks still have their official interest rates at close to zero and are printing money as demanded at this cost. The demand for this money is growing very fast in the developing world, mainly in Asia; so money is being borrowed at this very low rate in the West and lent in the East in virtually unlimited quantities. Because the Asian economies do not want their exchange rates to go up against the US$ and other western currencies, their central banks buy the US$s, Euros, pounds etc and swap them for their own currency as fast as this money flows in. This means that the expansion of money and credit in the Eastern world is fast and furious. This is fuelling rapid credit-fed growth, in turn.

Much the same is true of other emerging market countries. All of them are enjoying a credit boom, fed by western money. This worldwide boom has renewed the upsurge in commodity prices evident in 2006 to 2008, before the Lehman crash. Since these economies are also short of labour, the boom has led to a general inflation, with prices and wages rising generally, and not just a pass-through of higher commodity prices.

How will this all end? This ‘carry trade’ (whereby dollars at low interest rates are ‘carried’ and lent in higher interest rate economies) is very low risk in the sense that the dollar is being systematically kept down by the emerging market countries’ central banks, with only a few central banks allowing a little bit of appreciation of their currencies. To stop this flow entirely would require these emerging currencies to float upwards until they were too expensive to lend to. However this will not be allowed to happen, so nervous are their governments of the chilling this might bring to growth, particularly of their exports.

At the same time the paradoxical thing is the weakness - or sluggish growth, at best - of the western economies whose interest rates are so low. Hence, commodity price increases have so far produced no sympathetic rise in wages in these countries, as labour is in excess supply and job growth is weak; high unemployment is forcing labour to take big real wage cuts. Profits growth is strong however since capital is in short supply, because it is needed for growth in the emerging world. So we observe growing western profits, and rising stock markets, falling real wages, and limited western inflation. One could describe this as rising world inflation accompanied by lagging wage settlements which are currently holding down western inflation. However once this terms-of-trade/real-wage correction has run its course, inflation in the West will equal world inflation. Already in some countries such as the UK inflation is substantially higher than it has been and closer to this equality than elsewhere. However both Euro-zone and US inflation is now rising. The ECB has now raised interest rates for the first time since the crisis. The US Federal Reserve has not yet done so; but it cannot be far off. As for the UK, a rise is surely imminent if the Bank of England is not to become a laughing stock.

Meanwhile emerging country central banks are trying all sorts of controls to prevent this tide of money from coursing through their economies. However, these efforts are futile in the end; as fast as the last tide has been ‘controlled’, the next one is rolling in and the operation has to be repeated. In the end, the controls cannot restrict the huge availability of money by back door or front. Corruption becomes rife as opportunities for massive profits from lending this money illegally become irresistible.

So far the main actors in this drama, western central banks, have been complacent about worldwide inflation because they think it is not their problem. However this must stop within the next year, it would seem, if inflation is not once more going to become embedded in expectations in the West as it has already in the East. As labour markets tighten, real wage cuts could well be reversed and this would temporarily add to future western inflation as the terms of trade losses are also reversed. Furthermore, these central banks must be concerned about the inflation they are indirectly causing in the East. They may complain that eastern central banks ‘ought’ to allow currency appreciation; but the fact is they do not. In these circumstances, western central banks are creating world inflation, which must spill over back to their own economies in time.

Accordingly, it is reasonable to look for a tightening of western monetary policy, and rising interest rates over the next two years. By the end of 2012, this ought to get world inflation under control. During 2012, there should be a general world slowdown. Growth in developed countries will therefore be slower even than now. Commodity prices will keep rising until the end of 2012 when they should start to level off; commodities are in short supply after the massive world growth of the 1990s and 2000s. Their shortage was the main factor in triggering the crisis of 2007 to 2009 and this shortage remains the underlying factor limiting world productivity growth. My recommendation for UK monetary policy is to raise Bank Rate at once by ˝%, with a bias to further rises, and for QE to stop, with a bias to reversal (i.e. sales of the Bank’s portfolio of bonds).

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 in repeated small steps until it reaches 2˝%.

Recent newspaper interviews given by its officials suggest that the Bank of England has been so traumatised by the financial crash – and its consistent underestimation of future inflation – that it has lost its intellectual self confidence. Like Mr Micawber in Charles Dickens’s novel, the Old Lady of Threadneedle Street appears to be simply waiting for something to turn up – or rather, in this case, for CPI inflation to turn down spontaneously, without any action on the part of the Bank. Since the first duty of a Doctor is not to exacerbate the patient’s condition by inappropriate treatment, monetary inaction can be defended using the argument that the uncertainties are so great that anything that the MPC does risks doing more harm than good. One can sympathise with this view. However, if one looks back to the 1998 Bank of England Act, which established its operational independence, the Bank was given three specific responsibilities:
1) to hit the inflation target; 2) to maintain the stability of the banking system (in conjunction with HM Treasury and the Financial Services Authority), including acting as an effective lender of last resort, and 3) to nurture the wellbeing of the financial sector in order to maximise its contribution to the wider economy.

It is hard to avoid the conclusion that the Bank of England has significantly underachieved with respect to all three objectives. It is also time the ‘greedy bankers’ alibi for this underachievement was squashed on two grounds. First, bankers have always been ‘greedy’. However, this does not explain why the greed was allowed to get so out of hand in the first decade of the 21st Century, and why monetary policy was not tightened then – perhaps by a call for special deposits if the Bank was concerned that a rate increase would unduly strengthen sterling. Second, only some 5% of the 186 members of the International Monetary Fund (IMF) – or the 192 members of the United Nations (UN) – suffered from the incipient banking sector meltdown experienced by the UK and the US. Many comparable countries – including Canada and Australia – emerged virtually unscathed. An important reason for the inept British response to the 2008 global financial crisis was the tripartite dismemberment of the Bank that resulted from the 1997 settlement. This faulty institutional structure meant that no one was properly ‘minding the store’ and must take a large share of the blame. A concerted attempt is now being made to remedy the institutional problems caused by the 1998 Bank of England Act. However, people will need convincing that the UK monetary authorities: 1) now know what they are trying to do from an intellectual perspective, and 2) are in effective control of the situation.

One aspect of the general loss of nerve on the part of media and other commentators since the financial crash has been the tendency to over-interpret highly fallible official economic statistics and to react in a manic-depressive mode to random wobbles in the data. This is particularly true of the GDP figures where revisions are large, and there often appears to be no close predictive relationship between the official estimate of GDP on one base year and on another. This year, also, the ONS have announced that the annual ‘Blue Book’ changes to the national accounts will be so major that a breakdown of the expenditure and income measures of GDP in 2011 Q2 will not be available until 5th October. This will cause huge problems for anyone trying to monitor, let alone model or forecast, the UK economy during the intervening period. It may also be significant that, while the annual increase in the CPI fell from 4.4% in February to 4.0% in March before rebounding to 4.5% in April, the ‘double-core’ retail price index – which excludes both mortgage interest payments and house prices – has shown a far steadier course, going up by 5.8% in the year to February and the same 5.6% in the twelve months to March and April. This suggests that the reported CPI inflation rate has suffered from chance fluctuations, which should not be taken too seriously.

The UK’s fundamental problem is that the massive increase in the socialisation of the economy between 2000 and 2010, and Mr Osborne’s misguided decisions to raise VAT and implement Labour’s 50p income tax rate and higher national insurance contributions have severely damaged the supply side of the British economy. Pouring monetary stimulus into a supply-debilitated economy is a recipe for stagflation not growth. Britain’s economic openness also means that sterling has a far greater impact on the domestic price level than the MPC, with its over-reliance on an ‘output-gap’ model of inflation, has appreciated.

In contrast to the official approach, the properties of the author’s Beacon Economic Forecasting (BEF) macroeconomic model imply that a 1% decline in the exchange rate is associated with a 1% increase in domestic prices in the very long run. Furthermore, each 1 percentage point drop in the real interest rate differential in favour of sterling is associated with a 5.2% decline in the sterling index. This means that the Bank’s decision to ignore the reduction in the real rate of interest caused by rising inflation is placing downwards pressure on sterling and adding to the price level in the long run.

Fortunately, having shown a peak-to-trough contraction of 16% in the recession, the volume of UK private domestic expenditure, which is the subset of the economy on which monetary policy predominantly operates, had recovered by 5.6% from its 2009 Q4 trough by 2011 Q1. There are also encouraging signs that UK exports are benefitting from the marked recovery in the volume of world trade since its collapse in the Great Recession. My recommendation remains that Bank Rate should go up by ˝% immediately and that it should then be raised in a series of small steps until a figure of 2˝% or so is achieved. After which, there should be a pause for breath. If the economy does turn out to be weaker than expected, there would then be scope to use rate cuts once more to provide a monetary stimulus to the wider economy.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by 100 basis points to 1˝%.
Bias: To raise Bank Rate again.

The British economy is slowly, but steadily, recovering from the Great Recession. Output and employment are growing. Private business investment in manufacturing has been growing in the last two quarters faster than at any time since the 1990s. Similarly, private business investment in distribution services has been growing strongly since the second quarter of 2010. Investments in non-manufacturing production sectors and non-distribution service sectors are weaker. However, investment activity overall suggests that companies expect the demand for their product to grow in the future. The recovery is underway, and it is less fragile than many may claim.

Inflation is a cause for serious concern. The annual monthly inflation measured by the target CPI reached 4.5% in April. The picture is even darker if we consider the change is 1.1 percentage points higher now than it was in May 2010. Moreover, if we calculate a three-month moving average of the CPI, we then find that this figure has not only been rising since October 2010, but that it has been above target since December 2009.

It is also useful to look at the twelve CPI categories. Eight out of these twelve categories have higher annualised monthly inflation now than they did in May 2010. In contrast, only six out of these twelve categories had higher inflation in April 2010 relative to May 2009. Inflation is picking up speed and it does so in more and more CPI categories. Inflation is driven by expectations. The pattern of the UK inflation indicates that inflation expectations are picking up slowly. Once they do so, they will be very costly to break.

In my opinion, monetary policy should be tightened. My vote is for a 100 basis points rise in the official interest rate to give a Bank Rate of 1˝%. Given the excess liquidity in the economy, this hike is unlikely to have significant implication for the real economic activity. It would signal that the policy maker takes inflation seriously, and would keep inflation expectations anchored. Experience shows that successful monetary policy requires a ‘conservative’ central banker, who never takes undue risks with inflation. Given the dynamics of inflation, a conservative central banker would now raise rates in Britain.

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

The thrust of the argument presented in the author’s earlier SMPC submissions for some time now has been that a delayed economic reaction to extremely favourable monetary conditions should not to be mistaken for a weak or insignificant reaction. Real short-term interest rates have plunged over the past year as inflation outcomes have greatly exceeded expectations. The UK forecasting consensus has been chasing the game on inflation for more than a year now. The average forecast for calendar 2011 CPI inflation has shifted from 1.7% in April 2010 to 4.1% in May 2011, according to Consensus Forecasts Inc. The Bank of England’s MPC has conceded, little by little, that the annual increase in CPI is unlikely to drop back into its 1% to 3% target range until 2013 at the earliest.

The materialisation of noticeable headline inflation this year has been common to all the seven leading industrial (G-7) economies. However, the UK strain of this particular virus remains more vigorous. While the UK has at least a greater potential for inflation to recede into 2013, this extended aberration translates into a steeper fall in real interest rates this year and next than elsewhere. This is one potential source of domestic economic stimulus. A second potential stimulatory factor for the UK is its high broad money to GDP ratio. While recent broad money growth trends have been weak, this correction leaves the trend growth of money, in relation to nominal GDP, on the same underlying growth path as the one that has been observed since 2005. A third source of potential stimulus is that the UK continues to derive competitive advantage from the depreciation of sterling in 2008-09. A phase of rapid unit labour cost growth eroded part of the advantage in 2009, but latterly these costs have moderated. Over the past year, the annual inflation rates of UK unit labour costs contrast favourably with those of other major economies.

The impact of unexpectedly high consumer price inflation on the purchasing power of employee remuneration has been progressive. Real average weekly earnings growth has declined from 2% in 2008 to minus 2% currently. It is anticipated that average earnings inflation will narrow the shortfall with the retail price inflation measure next year. However, for 2011, the employer has the upper hand, enjoying profit margin protection. This means that the final item on the list of potential stimuli is the fact that the financial surplus of private non-financial corporations (PNFCs) is running at an extraordinary and possibly unprecedented rate, equivalent to almost 5% of nominal GDP. Notwithstanding the poor terms on which small- and medium-sized enterprises can finance themselves externally, there is a plenitude of free cash flow in the wake of the fixed investment recession. Our relatively upbeat assessment of the prospects for the economy rests on the progressive disbursement of this surplus in higher corporate expenditures on equipment, labour and bought-in services.

It is a measure of the fear that the credit crisis has engendered that every ‘soft patch’ in the real economy data is greeted with predictions of gloomy relapse towards the deflationary abyss. This fear also plays a key role in maintaining the extraordinary laxity of economic policy. Rather than dwelling on the risks of a near-term relapse, it is more sensible to weigh the impact of the protracted engagement of extremely favourable policy settings. There are minimal risks to the UK economic recovery from a staged increase in Bank Rate. It is high time for the MPC to take its inflation mandate seriously.

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

Over the last few months - including the last month - the dilemma for monetary policy has steadily worsened: inflation has continued to increase and is now more than double the target rate, while output has fallen, if anything. To make matters worse, the MPC has forecast that inflation will rise further and the OECD has recently revised downwards its growth forecast for the UK. With inflation driven by rising costs and demand stagnant, this is a classic stagflation.

The MPC, however, does not appear to see it this way. Each month it forecasts that inflation is about to fall and so a tighter monetary policy is deemed unnecessary. The government – which appears more concerned with output than inflation and is, perhaps, conscious that the VAT increase has caused prices to rise and the expenditure cuts are about to come through - has not objected to the MPC’s persistent reluctance to tackle inflation despite its mandate. The MPC has claimed that much of the higher inflation is imported as a result of higher world food and fuel costs and so there is little that the MPC can do about it. It is therefore striking that other European countries have had lower inflation and higher growth despite facing the same world prices for commodities.

A possible explanation for the difference is that while the euro has got stronger, sterling has got weaker. This contrast is likely to widen as the ECB has decided to tighten monetary policy even though it would worsen the fiscal stances of the heavily indebted nations in the Euro-zone by raising debt-service costs. If the MPC takes its mandate seriously, there seems to be no alternative to raising rates in the UK too in order to strengthen sterling and reduce the domestic price of imported goods and services. The dilemma for macroeconomic policy more generally is that this would hit exports the hardest, which has been the best performing sector due to sterling’s weakness. In the absence of a clear guideline from the government on how to resolve this dilemma, one can only presume that the Chancellor of the Exchequer is content to live with the higher inflation. The Chief Economist at the Bank of England has hinted at higher interest rates in the not too distant future. The danger is that this is left so long that much higher interest rates will then be required than if there were a timely, but small, increase immediately.

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

The revised ONS figures show that UK economic growth in the first quarter was 0.5%, the same as the previous estimate. Over the six months to March 2011, however, the economy was flat. Given the severity of the downturn – when output fell by over 6% peak to trough – this is a pretty poor performance. There was some good news in the data: rebalancing away from domestic demand might finally be underway. Growth was driven by a 1.7 percentage point contribution from net exports, the largest single quarter boost post war. Volume exports rose by 3.7% in total, while volume imports fell by 2.3%. Now, this might not be repeated in the second quarter but it took the goods and services deficit to its lowest level since 2001. And exports are rising faster than at any time since the export boom post the UK’s expulsion from the European Monetary System in 1992.

However, the rebalancing of the economy should also mean that investment rises with net exports, and this is not happening yet. Instead, investment fell by 4.4% in 2011 Q1, after a fall of 1.8% in the final quarter of 2010. Moreover, government spending contributed 1% to growth in the first quarter. With the cuts in spending just about to kick in, the prospects for strong economic growth are still poor. Growth this year is now on track for 1.5%, little different from the 1.4% recorded last year. For 2012, a combination of weak consumer spending, held back by continued private sector balance sheet restructuring, and public sector debt reduction, suggest little more than 2% or so economic growth at best.

Hence, the overriding message from UK data in the last few months is that the pace of the recovery is slowing. This is why financial market expectations of interest rate hikes have fallen back so sharply, despite the rise in inflation in the interim. In the year to April, CPI inflation was 4.5%, up from 4% in March and well above the 2% target. In this weak growth environment, higher prices are not translating into higher pay, so unit labour costs are low, keeping price pressure weak in the medium term and helping export competitiveness.

Looking at other inflation indicators – such as pay settlements, the level of unemployment and demand for skilled workers – suggests that wage inflation pressure will remain low for some time. Add in the recent data for broad money expansion – a fall of 1.1% in the headline rate of M4 in the year to March and growth of just 1% in the three month annualised rate of M4ex excluding other financial institutions – and the picture is one of severe constraints on the ability of the economy to generate inflation in the true sense. That is, continually rising prices led by demand or wider profit margins, rather than once-and-for-all shifts in the price levels caused by changes in excise duties, VAT and commodity prices. Without these influences, CPI inflation would be close to the 2% target.

For these reasons, my vote is to keep rates on hold at 0.5% for now. If the Bank of England's preferred measure of M4ex money supply turns negative, the MPC may even have to do more QE. However, the risk is that inflation two years ahead becomes an issue later on this year. This prospect could then mean a rate rise will be necessary, but only if the economy is recovering in a sustainable way by then.

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.), 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.