Sunday, July 31, 2011
IEA's shadow MPC votes 5-4 to hike Bank rate
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its latest quarterly gathering on 18th July, the Shadow Monetary Policy Committee (SMPC) voted by five votes to four that Bank Rate should be raised when the Bank of England’s rate setters next meet on 4th August. All five SMPC members who voted for an increase wanted to raise Bank Rate by ½% to 1%.

The main reason why a narrow majority of the shadow committee wished to see Bank Rate increased in August was concern that the UK monetary framework risked losing credibility if the Bank ignored the persistent overshoots of the inflation target. There was also a view that the current Bank Rate was appropriate when the global financial crisis was at its worst. However, things had now settled sufficiently to justify some element of interest-rate ‘normalisation’.

Another factor influencing the hawks was the belief that there had been a serious loss of aggregate supply stemming from the tax-and-spend policies of the post 2000 period, as well as the 2008 global financial crash.

The two main reasons that four SMPC members wanted to hold Bank Rate were their beliefs that: 1) the UK economy was weak for demand-side reasons, and 2) continued de-leveraging meant that present money and credit growth were inadequate to support real activity.

Two issues on which most people agreed were: first, that excessively heavy-handed financial regulation was in danger of causing a contraction in banks’ balance sheets and a renewed fall in economic activity, and, second, that the Euro-zone crisis posed a serious risk to Britain. There was a consensus that Quantitative Easing (QE) might need to be revived if the Euro-zone’s problems got out of hand.

Minutes of the Meeting of 18th July 2011

Attendance: Philip Booth (IEA-Observer), Tim Congdon, Jamie Dannhauser, Anthony J Evans, John Greenwood, Ruth Lea, Kent Matthews (Secretary), Patrick Minford, David Brian Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.

Apologies: Andrew Lilico, Gordon Pepper, David Henry Smith (Sunday Times Observer), Mike Wickens.

Chairman’s comments

David B Smith discussed the element of ‘flip-flopping’ that had appeared in some recent monthly votes of the SMPC. He suggested that, following the introduction of three new younger members, the membership of the committee had expanded to the point that the interest-rate recommendations made each month were unduly dependent on the random process of who got their commentary in first. He said that he believed ‘first come, first served’ remained the fairest method for deciding who voted. This was because it precluded any possibility of the Chairman swinging the poll by selecting whose votes were included. It also had the incidental benefit of incentivising members to get their votes in on schedule, facilitating the production process.

However, he suggested that the committee needed to consider reducing the number of members marginally – perhaps, by one or two of the older members standing down – if flip-flopping was to be reduced in future. The alternative was to devise a system that produced greater consistency but that would require people to commit themselves to voting several consecutive months in advance. The fundamental problems were that the SMPC was an unpaid voluntary body and that many members had extensive travel commitments. This meant that it was simply impractical to have a nine person committee in which every member voted every month.

He then asked John Greenwood to give his assessment of the global and UK monetary background.

The Monetary Situation
The International Situation – Developed versus Emerging economies

John Greenwood referred to the handout of charts he circulated to the committee. He began his presentation by asserting that the standard relationships in economics did not hold in times of severe balance-sheet repair. In particular, interest-rate policy was unable to gain traction. This was the scenario in those developed economies which had also seen credit and housing bubbles. In contrast, the emerging economies had not participated in the recent credit and housing bubbles but they had a more embedded inflation. In the past, these economies had linked their currencies to the US$. However, they were now engaged in a process of de-linking from the US$ and raising interest rates independently of the USA for the first time.

In the developed economies, there was little growth in lending or money despite the fact that interest rates had remained low. Asset prices and money growth had been supported by Quantitative Easing (QE). Deleveraging continued both in the US and in Europe, but the question was whether the US economy was going through a temporary soft patch or a more permanent slowdown. European broad money had recovered from its earlier negative growth, but the pick-up was mainly due to lending to the household sector in Germany and France, not to the corporate sector. Elsewhere in Europe, money-supply growth had been weak or the level of the money stock had been contracting. Monetary growth in the core economies of Germany, France, and the Netherlands had been positive whereas in the peripheral economies of Ireland, Greece, Spain and Portugal, money growth had been negative. In Italy, M3 had also turned negative. The Euro crisis was dominating the European scene. It was clear that Greece was insolvent, and therefore the only issues were the timing of its exit from monetary union and whether the exit would be orderly or disorderly.

China and the East Asia had avoided the credit bubbles of the 2000 to 2008 period and therefore had not participated in the excessive leveraging seen in the West. However, and partly as a consequence, there had been rapid money growth in China since November 2008 and in some other East Asian economies more recently.

The UK Economy – Balance sheet shrinkage
As far as the UK was concerned, weak domestic demand indicated the continuance of de-leveraging. The growth of M4 broad money and total lending was too low. Even the Bank’s preferred M4ex money measure showed little increase. There was little sign of exports or corporate investment offsetting the weakness in household spending. While inflation remained a worry for the MPC, the constant-tax consumer price index (CPIY) was only up 2.7% on the year in June. Bank lending to the private sector had been very weak but the corporate sector had been borrowing from the capital markets. Mortgage lending had recovered a little but still remained weak overall. All the various competing measures showed a flattening out of house prices. The slump in personal lending continued. However, and despite surprisingly good employment figures and unemployment indicators, earnings growth had been weak with household incomes being eroded by inflation.

QE had been successful in offsetting what would have been an even more catastrophic fall in the money supply. Bank of England assets have fallen back to £235bn from £250bn since July 2010 following the cessation of QE. This could have been brought about by the natural maturation and redemption of some shorter-term assets purchased by the Bank, rather than a deliberate policy decision.

Some parts of the economy such as manufacturing were doing better with the Confederation of British Industry (CBI) output expectations indicator having shown a rise. Order book volumes were also improving. However, as this development was largely driven by exports, domestic investment remained sluggish. On the domestic side there was a discrepancy between the CBI survey-based indicators of retail sales and the official figures from the Office for National Statistics (ONS) which showed negative growth in recent months. Given the weakness in GDP growth, the Coalition government was likely to have difficulty in meeting its budgetary targets.

Consumer price inflation remained well above target but CPI inflation excluding indirect taxes had fallen below 3%. Furthermore, calculations of inflation expectations derived from a comparison of five-year nominal and indexed-linked gilt yields produced a figure of below 1.5%. Inflation was likely to fall sharply, if and when commodity price inflation eased. Because of the state of the economy and the prospects for inflation in the near future, the rate of interest should remain on hold in John Greenwood’s view.

Euro problems will dominate policy in short term

The Chairman thanked John Greenwood for his presentation and opened up the meeting to discussion. Philip Booth started the ball rolling by asking why depositors in Greek banks continue to hold Euro deposits, given the possibility of Greece exiting the Euro. He also questioned the measure of inflation expectations derived from the five-year nominal and indexed-linked gilt yields, which seemed counter to other measures. John Greenwood replied that there had been a capital outflow from Greece to other Euro-zone countries, especially Cyprus. Ruth Lea next enquired how close Portugal and Ireland were to the Greek situation. John Greenwood replied that unit labour costs in Ireland had reduced sharply, indicating flexibility in wages and increased productivity, but this favourable development had not happened in Portugal or Spain.

Patrick Minford said that the convulsions in the Euro-zone would inevitably impinge on the Bank of England’s interest-rate decisions. However, an orderly exit might be positive for financial markets as it would remove a source of uncertainty. Tim Congdon said that he broadly agreed with Patrick Minford. If Greece and Portugal were to exit, the banks in the remaining Euro-zone could cope with this through write-offs. The risk was that the regulators would wreck the whole business by demanding higher capital ratios. Trevor Williams said that there was no mechanism for an exit from the Euro and that there needed to be one. Philip Booth said that the chaos resulting from the problems of southern Europe might continue to reverberate even after a Greek exit from the Euro-zone. Akos Valentinyi said that there were historical precedents for the break-up of currencies. It could be done provided that there was sufficient political will; an example was Hungary after the First World War. Peter Warburton said that the European Central Bank (ECB) was prone to compromise in the use of its balance sheet as it had no desire to bring the curtain down on the Euro project. Despite its protestations, a further expansion of its loan and bond purchase programmes should be expected, perhaps to the extent of a 25% asset expansion. However, the ECB would also be reluctant to see an expansion of its assets by 25%, because that would lead to a devaluation of the euro. Tim Congdon said that if Italian deposits end up in Germany, then the Italian banks will go to the ECB as the only option available.

The Chairman then stated that, because there were two more than the obligatory nine voting SMPC members present, he would again apply the principal of ‘first come, first served’. Unfortunately, this meant that neither the votes of Jamie Dannhauser or Peter Warburton could be included. In compensation, he suggested that their views should be noted down and included in the discussion under alphabetical order.

Jamie Dannhauser said that he was most concerned about events in the Euro-zone and how to stop contagion spreading to Spain and Italy. He said that he was relatively dovish on interest rate policy. He said that he did not believe that the trend in global commodity prices would be sustained as the global environment would remain generally weak. While CPI inflation is the Bank’s official target, there was a danger of placing too much weight by it at this juncture. A broader measure of UK inflation, the annual increase in the market-sector deflator, was in the region of 1%. Taking out the VAT effect and government-sector inflation shows that actual inflation was very low. As a result, Jamie Dannhauser believed that Bank Rate should be left unaltered in August. Where later months were concerned, he had no bias

Peter Warburton said that the latest Bank for International Settlements (BIS) quarterly publication contained an important paper on the global output gap. While the OECD and most of its member central banks were clinging to the notion of a substantial negative output gap, there was a credible case to be made that the global output gap was small or had already closed. Inflation expectations were trending up in many countries, including the US and UK. Supply-side inflation was showing up to an increasing extent in import prices, which had reached double-digits for a number of Western economies. He was not so bearish on the UK economy. Household income growth had begun to recover and should now take an increasing share of national income. While employee income growth remains subdued, self-employment and property incomes were recovering strongly. He expected the pace of wage inflation to increase next year and for the pressure on real after-tax incomes to ease. As a consequence, he thought that Bank Rate should rise immediately to 1% in August and had a bias to tighten further in subsequent months.

The Chairman then asked each of the other nine SMPC members present to make a vote on the appropriate monetary policy response. The votes are listed alphabetically, in line with the customary SMPC practice. However, Patrick Minford had been obliged to make his submission part way through the meeting as he then had to rush off to the airport.

Comment by Tim Congdon
(International Monetary Research)

Vote: Hold Bank Rate. Reactivate QE if euro crisis deepens.
Bias: Neutral.

Tim Congdon said that idiotic supply-side policies of higher taxes had resulted in a lower trend rate of growth of capacity. Nevertheless, output was still below trend. The headline inflation figures had been exaggerated by the Arab Spring uprising. Stripping out oil effects, actual inflation was in the region of 1½% and this would fall further. Money-supply growth was very weak and credit availability from the commercial banks was not what it should be. He said that interest rates should stay on hold but QE should be resurrected if there were further shocks from an impending collapse of the European Monetary Union (EMU).

Comment by Anthony J Evans
(ESCP Europe)

Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Anthony J Evans said that he wanted to distinguish between an already loose monetary policy and the even looser monetary policy that resulted from accelerating inflation reducing the real rate of interest when the nominal rate was constant. He said that current monetary policy was getting looser and that there would still be a loose monetary policy even after a rate rise. The annual report from the Bank for International Settlement (BIS) had warned that negative real interest rates delayed adjustments and magnified risk, and the latest Organisation for Economic Cooperation and Development (OECD) survey warned of embedded inflation expectations. The balance of risks for the Bank was between falling inflation now and being able to exit quickly from QE and future inflation. The Bank needs to reclaim its independence. He said there was scope in the UK for an ‘expansionary fiscal contraction’, but monetary policy should not attempt to accommodate fiscal policy. The magnitude of the rate rise he was calling for should not have a serious adverse effect on the real economy but would influence expectations and future inflation prospects. The fact that the ECB had begun moderate rate rises had set a precedent that reduced the fear that any rate rise would cause a new downturn. He said that with hindsight the Bank of England should have raised interest rates earlier but, given that rates would need to rise, it was better to do it too soon than too late.

Comment by John Greenwood
(Invesco Asset Management)

Vote: Hold Bank Rate. Reactivate QE if monetary conditions tighten further.
Bias: Neutral.

John Greenwood said that it was not possible to judge the stance of monetary policy by interest rates alone. Japan had experienced a history of zero interest rates but effectively tight monetary policy. The shrinkage in commercial bank balance sheets had led to limited growth and low underlying inflation. Current inflation was largely transitory and imported. Rates should not change. A rise in Bank Rate would squeeze monetary conditions further. QE should be reused if the supply of money contracted.

Comment by Ruth Lea
(Arbuthnot Banking Group)

Vote: Hold Bank Rate.
Bias: Neutral.

Ruth Lea said that the economy was in a very weak state and, although the ONS figures were not perfect, the GDP numbers due out on Tuesday 26th July would probably confirm this. (Editorial Note: the ONS data released after this comment was taken down showed a rise of 0.2% on the first quarter and 0.7% on the year, while non-oil GDP demonstrated equivalent increases of 0.3% and 1.1%). Ruth Lea added that she was bearish on the economy. The latest figures on net trade were not encouraging and household consumption was weak. She said that she did not buy the view that commodity prices were on a secular upward trend. The Bank’s measure of Inflation expectations had moved up but there was no runaway inflation and wage growth remained weak. Commercial bank lending had been muted with the pressure to raise capital. She voted to hold Bank Rate and keep QE in the wings in case of further economic problems.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)

Vote: Raise Bank Rate to 1%. Keep QE available in case the fallout from the Euro-zone crisis adversely affects the British economy.
Bias: Neutral.

Kent Matthews said that he accepted that there was considerable uncertainty about the output gap and he took the point made by John Greenwood that the level of the interest rate was not a good indicator of the monetary stance. He interpreted this as meaning that interest rates were so low that the demand for money was unresponsive to small changes to it. Yet, a small rise in rates may signal to the market a change in direction in policy and influence expectations, particularly in the market for foreign exchange. He said that a small rise in rates now may mean that an undesirable sharp rise in the future could be averted. Like Anthony Evans, he felt that the Bank had to take steps to restore its both its own credibility and the credibility of the inflation-targeting policy. The Bank had not convinced the markets of its strategy. This meant that they faced a signal extraction problem. However, there was sufficient uncertainty to recommend that a rise in Bank Rate should be followed by a pause. This was to see what the rate increase did to market expectations. Further rises might be necessary in the future. However, this could be done in staggered stages. QE should be held in reserve in case of further fallout from the euro crisis.

Comment by Patrick Minford
(Cardiff Business School)

Vote: Raise Bank Rate to 1%.
Bias: To tighten.

Patrick Minford said that the chaos in Europe would affect the UK and the Bank had to be aware of the potential fallout. If the US went to QE3, and credit growth continued in the far-East, world liquidity would rise at an alarming rate. The ECB was raising rates and the US would shortly begin the process of rate increases. Commodity price rises would not ease off. Therefore, the threats to UK inflation should not be underestimated. However, the key focus of the Bank was to restore credibility. Clearly, the fallout from the Euro-zone crisis was an important factor that would constrain the hand of the Bank. In the end, however, it was a question of balancing the various risks involved. The Bank could not neglect the loss to its credibility and commodity price inflation was not just a special case of inflation - it was inflation. The Bank of England had shown a serious lapse in judgement. Its raison d’être was the inflation target. It had given the impression that it had some other job. He said he agreed that the increased capital demand on banks was a problem. However, it was a problem for regulators not the Bank of England.

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 the evidence from previous bank crisis was that capacity got destroyed. There was indeed a supply-side problem. Therefore, money-supply growth was not the point. He accepted that QE was helpful in the initial stages to mitigate the worst effects of the crisis. However, the present capacity constraints meant that it was no longer the principal issue. The role of the central bank was to target inflation and this was what the credibility of the policy and expectations hung on. The Bank was not supposed to target components of the CPI or alternative measures. The figures said that inflation had been rising.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)

Vote: Raise Bank Rate to 1% but be prepared to re-activate QE if the Euro-zone crisis gets out of hand.
Bias: To tighten, subject to developments on the Continent.

David B Smith said that, during the 21st Century both the USA and UK had implemented ‘big-government’ policies that seemed hand crafted to do the maximum possible damage to aggregate supply, potential output and the structural rate of unemployment. After 2008, the recession in both countries had been exacerbated by ‘crass-Keynesian’ policies that had crowded out private-sector activity, not supported it. He said that current policies were likely to lead to what the late John Flemming had described as an upwards ‘gear shift’ in inflation expectations in his 1970s book ‘Inflation’ (Oxford University Press 1976, ISBN 0 19 877086 3, Chapter VII).

The increasingly negative real rates of interest paid on bank deposits had caused a downwards movement in the demand for broad money. The disequilibrium between the ex ante supply of, and the demand for, broad money was not easy to calculate. However, one way that it could be judged was through the response in the currency markets. If the exchange rate was weak – and the global monetary background was not unreasonably tight – then the demand for money was less than the supply.

The Coalition’s fiscal policy lacked credibility and the VAT and NIC increases perversely had reduced growth and worsened the budget deficit. When neither UK monetary nor fiscal policy had any credibility remaining, it was hard to see why the international financial markets should be willing to underwrite further British budget and balance of payments deficits. Tactically, it might be hard to raise rates now that the latest data had shown that CPI inflation had blipped downwards in June. However, a comparison of the annual increase in the CPI with the much smoother course of the ‘double-core’ RPI suggested that the much-commented-upon movement in the CPI in recent months was predominantly statistical ‘noise’. He remained of the view that Bank Rate should be raised by ½% immediately. However, he was perturbed sufficiently by the developments in Continental Europe to want QE to be put on standby in case the problems in the Euro-zone led to serious capital losses for UK banks.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)

Vote: Hold and hold QE.
Bias: Neutral.

Trevor Williams said that the situation was highly complicated because of the potential sources of shocks. Risks for the British economy came from the Continent, the US and Asia. The output gap was a less important influence in a small open economy like the UK. The underlying trends in Britain were weak and economic growth of 1% to 1½% was what was expected for 2011. The financial regulators were running scared of another banking crisis in the UK. However, by asking for potentially too much capital, the regulators had risked creating shocks to demand and supply conditions that could potentially derail the recovery. Since most of the risks to the British economy were on the downside, the Bank of England had been right to hold rates. Trevor Williams voted to hold Bank Rate and to keep the option of additional QE available on a ‘wait-and-see’ basis.

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 4th August.

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 August, one indicated a bias to raise Bank Rate in the near future.

4. Four members felt that QE should be held in reserve and be activated if the Euro-zone crisis spilt over to the UK.

Date of next meeting

Monday 17th October.

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.