Sunday, September 04, 2011
Shadow MPC votes 5-4 to hike rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by a knife-edged five votes to four that Bank Rate should be raised when the official rate setters meet on 8th September. All five members who voted for an increase wanted to raise Bank Rate by ˝% to 1%.

There were two main reasons why a narrow majority of the SMPC wished to see a Bank Rate increase in September. The first was the suspicion that Britain’s weak growth and limited job creation were predominantly supply-side problems caused by excessive government spending, populist political interventions and perverse regulatory shocks, which could not be alleviated by a lax monetary policy.

There was also concern that the UK monetary framework risked losing popular credibility if the persistent overshoots of the inflation target continued to be ignored. One risk associated with the current policy mix, in the view of the SMPC hawks, was that it could embed a ‘stagflationary’ bias into the UK economy, which could only be countered by painful measures in the longer run.

The reason that four SMPC members wanted to hold Bank Rate was a belief that the UK economy was weak for predominantly demand-side reasons, and that the recent data suggested that activity was palpably faltering.

Both hawks and doves agreed, however, that the present crisis in the Euro-zone posed a serious risk to Britain because of the damage it might do to our export markets and to UK banks’ capital and reserves if there was a chain of defaults. There was a consensus that Quantitative Easing (QE) might need to be revived if the situation in the Euro-zone got out of hand.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and keep QE at present level.
Bias: Neutral, except in case of Euro-zone disaster.

Over the last month, investors’ risk appetite seems to have deteriorated markedly. Equity markets have been on a roller-coaster ride, bank shares in particular. Most notably, dislocation in bank-funding markets has become more acute. Lenders in Europe’s periphery and beyond have found it more difficult to roll-over short-term funding. US money market funds, key providers of short-term finance to European banks, reportedly cut their exposure to Spanish and Italian banks to practically zero in July. Data from the US Federal Reserve suggest their difficulties may have intensified in August, with US offices of foreign institutions losing over $100bn of deposits in the last month. This could help to explain the extra premium that European banks are now paying to swap Euros into dollars.

The major UK banks have been insulated from these tensions somewhat. Furthermore, sizeable term-debt issuance in the first half of this year means they are relatively well placed to cope with disruption in funding markets. They are not, however, completely unscathed by recent developments. The risk premia on UK banks’ Credit Default Swaps (CDS) have risen sharply. To the extent that these are a proxy for lenders’ marginal funding costs, and that market disruption is not short-lived, there could be further upward pressure on banks’ lending rates.

Tighter than expected monetary conditions are one downside growth risk that may be materialising. The other is the timing of the global slowdown. Next year was always going to be a difficult one for the world economy, with the advanced economies undertaking the largest, co-ordinated fiscal consolidation in the post-war period. Weak monetary growth in the West and inflation-fighting in the East meant there would be little demand offset. Although there is scant reason to expect the magnitude of the growth slowdown to be any greater, recent data suggest it may already have started. Indicators of manufacturing activity in Asia, for instance, far from rebounding after the Japanese disasters, have softened further in 2011 Q3.

The chances of a renewed UK recession would still appear slim; but the recovery could remain subdued until the second half of next year. UK export prospects are less bright than anticipated a few months ago; and there are concerns for UK consumer demand given the soon-to-be-felt energy price hikes. Despite this, the case for more Quantitative Easing (QE) at this stage is hard to make. Consumer Price Index (CPI) inflation could hit 5% in coming months and there is considerable uncertainty about how consumers and firms will react to such a prolonged period of upside-inflation surprises. It is also important that one gets a clearer picture of global developments: to assess how much of the apparent weakness of the world economy is due to Japan-related supply-chain disruption and the spike in oil prices; and how much reflects more persistent factors.

Looming over any forecast of the UK economy is the debacle in the Euro-zone. The ‘unmentionable and unimaginable’ risks, which Mervyn King spoke about, cannot be quantified. It is unclear how one factors in such a low-probability tail-risk with such damaging consequences to forward-looking monetary policy. The best one can do is to build in an expectation of very weak European Area output growth and ongoing disruption to parts of the funding markets. If the crisis in Europe were to intensify significantly from here, the Bank of England has to stand ready to deploy whichever tools it deems necessary to shield the UK banking sector.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate and to keep further QE in reserve.

Economic growth is faltering. The revised estimate of second quarter GDP from the Office for National Statistics (ONS) suggested a modest 0.2% quarterly increase, which implied the economy had barely grown since the third quarter of 2010. The ONS, perhaps encouraged by HM Treasury, offered many reasons - one is tempted to use the word ‘excuses’ - for the weak figure. These included the Royal Wedding, the sale of Olympic tickets and the weather (an old favourite). Whilst it can be expected that the third quarter may ‘bounce back’ a tad, the omens for growth in the near-term do not look encouraging.

The last set of labour market data was also disappointing. Unemployment on the International Labour Office (ILO) definition was up 38,000 in the second quarter and the unemployment rate inched up to 7.9%. Higher unemployment can only undermine consumer sentiment and, on cue, the Nationwide’s consumer confidence index, released the following day, slipped further.

But the really worrying economic developments in recent weeks have concerned Britain’s main export markets. It is on these markets, and the potential for ‘export led growth’ as projected by the Office for Budget Responsibility (OBR) in March, that so much of Britain’s near-term prospects depend. The recovery in the US, one of Britain’s biggest export markets, is running out of steam to a worrying extent. The Euro-zone is not just experiencing an existential crisis, its ‘powerhouses’ look to be faltering too. After buoyant first quarter GDP figures for Germany and France, the second quarter data were especially disappointing. A measly 0.1% quarterly increase was recorded for Germany whilst France flat-lined. Granted that the quarterly patterns may be distorted by the effects of rogue seasonal factors over the winter, the underlying trends are not encouraging. Recent business surveys have been almost uniformly pessimistic.

CPI inflation was 4.4% in July and looks set to reach 5%, before declining. The Monetary Policy Committee (MPC) is clearly resigned to this probability. However, it has, rightly in my view, resisted the temptation to raise rates and undermine the economy further. Given all the downside risks, not least of all the increasing probability of a car crash in the Euro-zone, my vote is for no change in interest rates, with a bias to keeping interest rates at their present level. Further QE should be kept in reserve.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again; QE should not be resumed.

The world has been through a sharp recovery from the Great Recession. However, this immediately triggered a return of the commodity price peak that itself was, in turn, the underlying reason for the slowdown that precipitated recent US house price falls, mortgage losses and bank losses on property. The renewed upturn in commodity prices was, therefore, the underlying reason for the whole crisis. The available supply of world raw materials cannot accommodate world growth on its recent scale. We will have to see how much growth it can tolerate as monetary policy continues to tighten and brings down world inflation from its current 5% or so. Inflation has now become worryingly embedded in a number of major economies, as the July CPI figures reveal. These show that annual inflation was: 3.6% in the US; 4.4% in Britain, 2.5% in the Euro-zone, 6.5% in China, 8.6% in India, and 9.7% in Argentina.

It seems likely that economic growth in the developed countries will continue to be slow. Commodity prices will continue to be kept high by the continuing fast growth of productivity and GDP in the emerging market economies. This will go on restraining western growth, in turn. Commodities are in short supply after the massive world growth of the 1990s and the 2000s. Their shortage remains the underlying factor limiting world productivity growth, especially in the developed world which relies on innovation rather than the transfer of people from low- to high-productivity sectors to power its productivity growth. It is hard to innovate when raw materials are so costly. This is because raw materials are complementary to many new products – for example, the rare earths which are widely required as parts in electronic products and now in seriously short supply. Furthermore these high commodity prices act to reduce developed country real living standards directly.

The instinct of many leading macroeconomic commentators – for example, recent statements by Professor Kenneth Rogoff – is to demand ‘a final bullet’ to jumpstart growth again. In his case he wants inflation to be raised for a long stretch to eliminate ‘asset deflation’. However this misses the point about supply limitation. After all, it is unlikely that the world economy could be ‘short of demand’ as such people claim, over a long period. The International Monetary Fund (IMF) is predicting 4% world growth for 2011; this hardly rates as ‘slow’. It is developed countries that are growing slowly; clearly not because of some global demand shortage. If it were a local shortage of demand, how come that record fiscal deficits combined with near-zero interest rates do not revive it? How come that QE stimulated a huge flow of money into emerging markets via the carry trade and hence a sharp world inflation?

In short, it is rather astonishing that so many macro commentators have forgotten the basic lessons of macroeconomics: that repeated ‘stimuli’ only create inflation once economies have settled down after major shocks. It is one thing to inject money in the immediate aftermath of an emergency like the 2008 Lehman collapse; it must be quite another to keep on doing so long after the initial injection has worked to revive the patient from the emergency. Fortunately most developed-country central banks have been more prudent than this. Indeed, while central bank interest rates have remained close to zero in most countries, the interest rates charged by banks have been much higher. In addition, there is plenty of evidence that banks are still lending slowly, and charging high commitment fees in addition to the overt interest rate charged on loans. This tightening has been enhanced by the recent crisis in the Euro-zone, which has made it much harder for most European banks exposed to the crisis to raise money to lend. Furthermore the aggressive printing of money via QE has ended in the UK and now also in the US. Finally the European Central Bank (ECB) has raised its lending rate to 1.5%.

In these circumstances the Bank of England has decided to take no action at all on interest rates and not to restart QE. Some are now urging it on to more QE because growth is weak. This is true. However, QE will not change the facts of supply. Instead it will embed inflation in the UK via a falling exchange rate and rising inflation expectations. The anchor of the inflation target regime is its credibility; this has been seriously undermined by the Bank’s weakness in the face of persistent inflation.

It has now become routine for commentators to stress the dangers to growth of the Euro-zone crisis, of weak jobs growth in the US, or tightening monetary policy among key emerging market economies. Indeed, all this is true. However, it does not alter the necessary monetary stance because these are the result of supply problems. The implication is that an easy monetary policy will have little effect on growth but will create inflation through the undermining of the target regime. That regime sets inflation as the unique target; only if it is satisfied can the Bank pay attention to growth. Yet the Bank is ignoring this. True, it tells us that if it tightened it could create ‘deflation’; tell that to the marines when inflation is climbing to 5%!

In conclusion, my view is that the Bank should return to its inflation-targeting regime. Under present information, and if it does not start to tighten policy soon, it will undermine the prospect of inflation falling that it constantly predicts, simply because people will stop believing that it will ever act to ensure this. This scepticism will be reinforced by the prospect that growth will remain weak, which is now the dominant probability. If the Bank has covertly switched to a growth targeting regime, then it is likely not only to avoid raising interest rates indefinitely but also to embark on more rounds of QE. It is hard to imagine a more certain way of creating renewed and embedded future inflation. Therefore, I reiterate my call for a rise in interest rates, of ˝% with a bias towards further increases subsequently. QE should not be resumed.

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

The author of this submission has been monitoring the behaviour of the money supply for more than forty years. This experience shows that the current stance of monetary policy should be judged by whether the supply of money is greater or less than the demand for money. Further, the stance during the last year or so is a powerful indication of whether the economy is developing expansionary or recessionary tendencies. In the former case the current stance should not be easy. In the latter case it should not be tight.

About this time last year, it was possible to argue that the negative growth of the stock of money that was occurring in real terms was not necessarily an indication of shortage of supply, because the demand for money was possibly falling even faster. The explanation of this unusual situation was that the demand for money as a home for savings had collapsed due to the abysmally low rates of interest on bank deposits. This was, however, an argument that would not be tenable for very long. The fall in the stock of savings money in the economy could not go on forever. It would eventually come to an end. When it did, monetary policy would be too tight if sluggish monetary growth continued. This has now happened.

During the first three quarters of the past year the conclusion that monetary policy was not too tight was supported by the behaviour of the stock market. If the supply of money is inadequate expenditure on goods and services falls as does expenditure on financial assets. Because financial markets react much more quickly than the real economy the effect on asset prices comes first. The equity market has, for example, always fallen prior to a recession. The fact that it was not falling until recently suggested that monetary growth was adequate and that a second leg of the recession was not imminent. That has now changed.

Elaborating, when unexpected bad news occurs the reaction of the equity market depends on the amount of money about. If there is a lot people will bargain hunt, taking advantage of falling prices, and the market will tend to bounce back. If there is little there will be less bargain hunting and the fall in the market is more likely to continue. One thing is clear at the moment. The existing stock of money being held as a home for savings is very low because of the fall in the savings demand for money during past months. This suggests that bargain hunters will have little ammunition. An important conclusion for investors is that the market is likely to be susceptible to further bouts of bad news (but see below about QE).

Reverting to the main theme, policy needs easing. Fiscal policy, which is one of the main drivers of monetary growth, is out of play because of the debt overhang. Interest rates cannot be used either because they have been lowered as much as they can be. Only two types of measure remain, namely, supply-side and direct action to boost the money supply. Without any question all types of supply-side measures to boost economic growth should be employed. The trouble is that they are slow acting and can take several years to have a full impact.

Bank lending is another of the main drivers of monetary growth. (After Geoffrey Howe’s budget in 1981 buoyant bank lending was the main offset to the dramatic fall in the central government borrowing requirement.) The difficulty here is illustrated only too clearly by the behaviour of one of the UK’s largest banks which is charging an absurd APR of 19% for personal overdrafts even when credit worthiness is impeccable. Even then, credit is not freely available. Banks have to strengthen their balance sheets before they will again lend freely. So, bank lending to boost the money supply is not in play either. Another way in which the money supply can be boosted is for the Bank of England to intervene in the foreign exchange market to stop sterling from rising if it becomes firm. This process was the main offset in 1976, after the IMF had insisted that the UK should tighten fiscal policy. This depends on sterling becoming stronger, which may be wishful thinking.

QE remains. In my judgement, the case for case for additional QE is stronger than it has been for more than a year. Nevertheless, it should still be only held it in reserve, for three reasons. Firstly, it would be wise to wait until there is definite evidence that inflation in the UK is falling, particularly as QE2 in the US was one of the causes of the damaging rise in commodity prices as people switched out of dollars into commodities. Secondly, the case for additional QE is nothing like as strong as it was in the winter of late 2008 and early 2009 and our knowledge is insufficient to attempt to fine tune the economy. Thirdly, it takes time to repay debt and restore balance sheets and there is a case for wanting sluggish economic growth rather than rapid recovery.

Finally, after a financial bubble bursts, asset prices fall and a downward spiral starts symmetrically with the previous upward spiral. The process becomes asymmetrical during the downswing when the value of asset prices falls to a level at which the value of collateral in general is no longer sufficient to cover the bank loans being secured. Borrowers then become forced sellers of assets. The laws of supply and demand then reverse with a fall in prices forcing more selling rather than encouraging buying. Confidence in markets becomes shot to hell. QE’s most important role is to stop the forced selling and avoid the asymmetry.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%.
Bias: To ‘normalise’ Bank Rate in small steps until it reaches 2˝%.

The international financial markets had a severe fit of the collywobbles during August. However, it is still not clear whether this was primarily the result of erratic trading in thin summer-holiday markets or the harbinger of something nasty affecting the global economy. The FTSE World Share Price Index measured in local currency dropped by 12.6% between 1st August and its low point on 10th August but had recovered by 5.5% by 30th August, the latest available figure, to give a net decline of 7.8% since the start of the month. The US Standard and Poor’s composite index of US Share prices was 5.8% down on its level on 1st August on 30th August, while the British FTSE All-Share index was down by 9%. Possibly surprisingly, neither short-term money market rates nor the trade-weighted exchange rates for the major currencies showed any major changes beyond the usual wobbles through the course of August as a whole. This was despite occasional marked movements within the month, especially where the Swiss Franc was concerned. There was, however, a noticeable easing in government bond yields. The US ten-year yield fell from 2.75% to 2.18% between 1st and 30th August, while the equivalent UK and German yields eased from 2.82% to 2.50% and from 2.47% to 2.15%, respectively. In theory, lower bond yields, after allowing for inflation, should boost equity valuations because they lower the rate at which future profits are discounted. This clearly did not happen in August 2011.

Hypothesising without data is always a dangerous activity. However, one plausible explanation of what is happening in the developed economies is a collapse in the ‘animal spirits’ of businessmen and entrepreneurs caused by a sharp increase in the perceived political uncertainty of doing business, recruiting or investing in new plant and equipment. The initial increase in uncertainty resulted from the collapse of Lehman Brothers on 15th September 2008, after which businessmen became obsessed with avoiding counter-party risk. This reaction caused a collapse in trade credit, supply chains and intermediate demand. However, this initial panic had burned itself out by 2009 Q2 – when industrial production in the aggregate OECD area was 15.9% down on its peak a year earlier – and by the first quarter of this year industrial output was 13% up on its trough. The problem now is that misguided political and regulatory initiatives, and the threat of large populist-inspired increases in the taxes levied on wealth creation, have increased business uncertainty to the point that the entrepreneurial classes are again withdrawing into their shells. This, politically-induced, increase in uncertainty explains why businesses are de-gearing, sitting on abnormally high levels of liquid assets, and have become reluctant to recruit workers and invest in long-term assets.

This situation cannot be cured by monetary stimulus or conventional Keynesian fiscal stimuli, if that is interpreted to mean further increases in public spending as distinct from supply-side friendly tax cuts. Indeed, the first thing that the fiscal authorities need to do is to convince economic agents that they will not be clobbered by even higher taxes every time that the official projections for public borrowing are overshot. The next thing that the political class needs to do is stop engaging in lynch-mob rhetoric against wealth creators, something that US President Obama, some UK Liberal-Democrats and many Continental politicians are unduly prone to do. Such rhetoric undermines confidence and leads to less aggregate supply and fewer employment opportunities than if the politicians concerned had kept their mouths shut. The third thing that the monetary authorities, specifically, need to do is to be aware of the danger that excessive financial regulation will lead to a reduction in bank balance sheets and a collapse in the supplies of money and credit. It is probably necessary to employ public-choice theory to understand what international and domestic bureaucrats are up to in the area of financial regulation. Bureaucrats like a massively over-regulated banking system because that minimises the risks that: a) they will have to do too much hard detailed work concerning the situation of individual financial institutions; and 2) reduces the risk of embarrassing regulatory failures. There is also the consideration that regulatory activity may be becoming something of a gravy train for the bureaucrats concerned, many of whom are highly articulate economists, who might be less employable elsewhere.

While on the subject of bureaucrats, it is worth noting that the ONS decided not to publish the normal breakdown of the income and expenditure measures of GDP when they published the revised estimate of UK GDP on 26th August. The reason was to allow sufficient time for the major changes to the national accounts to be introduced in the 2011 ‘Blue Book’. It will not be until 5th October that a more detailed analysis will be available, and that will be on a different set of base-year weights and probably on a noticeably different set of definitions. Since most conventional macroeconomic forecasting models make extensive use of the expenditure breakdown of GDP, the effect is to ‘un-sight’ official and private sector forecasters at a critical time. As it is, the recent official data show a mixed picture of sluggish – but not collapsing – home demand, persistently stubborn inflation at both the producer-price and consumer and retail-price levels, and somewhat disappointing figures for the government accounts and international trade. The annual increase in the ‘double-core’ retail price index – which excludes all housing costs and appears to be somewhat less skittish than the CPI – increased from 5.4% to 5.5% between June and July, when CPI inflation accelerated from 4.2% to 4.4%, and both the old RPIX target measure and all-items RPI showed inflation unchanged at 5%. The current monetary background is completely different to that observed in earlier inflation episodes and the M4ex broad money measure rose by a relatively modest 2.2% in the year to July 2011, compared with the 1.6% recorded in June. However, it took only seven quarters in the early 1970s for RPI inflation to proceed from breaking through 5% to going through the 10% barrier and eight quarters for the same thing to occur in the early 1990s. Neither of these inflationary upsurges was widely anticipated in advance.

The main conclusions are as follows. First, in the US, Euro-zone and Britain the political and bureaucratic classes have behaved like gigantic wrecking machines as far as the non-socialised sectors of their respective economies are concerned. This needs to stop if animal spirits are to recover and the private sector is to start investing and employing on the scale that should be expected, given the high liquidity and reasonable profitability enjoyed by many companies. Second, financial regulators must consider the macroeconomic consequences of their regulatory initiatives and allow capital and liquidity cushions to be squeezed at present. Mandatory capital and/or liquidity requirements should only be raised later, and if recovery threatens to be excessively fast. This was well comprehended by earlier generations of monetary economists, who understood that liquidity ratios should be run down in a financial panic and rebuilt afterwards. The same applies to the capital-ratios that are preferred by modern regulators. Third, the main problems facing the UK, US and much of Continental Europe are to do with their supply sides and cannot be cured by further monetary easing. A recent example is the lunatic decision by the British government to implement the ‘European Union’s Temporary Agency Workers Directive’. This can only price the more vulnerable workers out of employment, inducing a rise in structural unemployment that cannot be compensated for by monetary easing. The final conclusion is that Bank Rate should be raised immediately to 1% and cautiously to 2˝% or so in the longer run. Additional QE should be held in reserve – in case there is another run on the banks, possibly caused by sovereign default on the Continent – but not implemented at this stage. The recent collapse in bond yields has rendered further QE otiose. However, QE remains a potentially useful tool that should be employed without inhibition if the Bank has to act again as a lender of last resort in a financial crisis.

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

The recovery in the industrialized countries after the Great Recession has been weak. The UK economy is no exception. The 0.2% growth in the second quarter was disappointing. It is noteworthy, also, that the growth of value added across the various productive sectors of the economy has been uneven. Manufacturing growth has slowed and construction and agriculture have contracted. However, services overall showed a higher than 1% growth in the second quarter.

Inflation is a cause of serious concern. The annualized monthly inflation measured by the CPI reached 4.4% in July, and it has been above 4% in every month since the beginning of the year. We can get a better idea about inflation dynamics if we calculate a three-month moving average of the CPI. Nine out of the twelve CPI categories had higher annualized monthly inflation in July than they did in December 2010. Inflation shows no signs of slowing down at the more disaggregated level. Rather, it is picking up speed and doing so in more and more CPI categories. The longer the current pattern prevails the more likely it will be that the public’s expectations of future inflation lose their anchor. Then inflation will speed up further.

The key question is whether one thinks that the weak growth of the British economy and the other members of the group of seven leading industrial countries (G-7) is primarily due to weak demand – implying a negative output gap – or due to supply constraints (indicating a close to zero output gap). If demand is weak, then observed inflation is temporary, and there is no need for monetary tightening. If supply is weak, then inflation is not temporary and without monetary tightening, it will not get back to its target. The output gap is notoriously difficult to measure. Current estimates suggest the existence of a significant negative output gap. That would indicate spare capacity, and no need for monetary tightening. On the other hand, survey evidence suggests that capacity utilization is not particularly low in the UK suggesting little excess capacity. This would call for monetary tightening. In addition, there were several factors prior to the crises that would distort any estimates of the output gap based on past time-series regularities. Hence, it is more likely that there is little excess capacity in the British economy at the moment. This implies that monetary policy should be tightened. My vote is for a ˝% rise in the official interest rate. It would signal that the policy maker takes inflation seriously, and would keep inflation expectations anchored. However, there is no need to signal further tightening, thus, no case for a bias where future rate changes are concerned.

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

Since the global credit and financial crisis erupted over four years ago, the path of quarterly real GDP growth has become much more erratic. Beyond the understandable foibles of the weather and the UK’s royal occasions, the increased volatility of quarterly GDP is an international phenomenon. The standard deviation of the contribution of net trade to GDP has risen by around 50% in Germany, France and the UK and by 70% in the US, when the period 2007 to 2011 is compared with 1997 to 2007. Hence, the task of extracting the signal (the underlying pace of real growth) from the quarterly GDP data has become much more difficult. Crisis-crazed media commentators have seized upon these erratic deviations to amplify their impact on the public psyche. The result is that timely survey indicators have also become prone to wild and meaningless swings.

Worse still, in an environment of sub-par, post-slump, economic growth, policymakers appear to have lost confidence in their own economic judgements. In the past, they might well have looked past an erratically weak quarterly GDP report but, fearful of a media storm, they now use it to justify a postponement of any tightening. The Bank of England’s MPC has retracted its modest inclination towards a Bank Rate increase despite a sizable body of evidence to suggest that the UK economy has gathered steam during the course of 2011 and that inflationary expectations are shifting higher. The ‘lower-for-longer’ message that emerged from the latest US Federal Open Markets Committee (FOMC) meeting, and was echoed by the body language of the Governor’s briefing after the August MPC meeting, translates as ‘be careful, we’re still in crisis’ to the business and household sectors. Instead of a word of encouragement, this policy sends the opposite message: to hold back and brace for another downturn.

The conclusion that we reached earlier in the year still stands: that the complex messages contained in the policies and directives such as Basel III, the Financial Services Authority (FSA) Liquidity Directive and Project Merlin and the planned withdrawal of Special Liquidity Scheme and Credit Guarantee Scheme funds have strangled the effectiveness of low interest rates for the UK economy. Bank Rate is merely one element of the UK monetary policy mix and probably the least significant at present. As the Euro-zone’s banks have recently discovered, the wholesale funds markets have not healed since the initial crisis in 2007 and remain a source of fragility for the global financial system. The continuation and even extension of central bank insurance schemes and money market initiatives would improve the transmission of Bank Rate and promote economic recovery.

The case for additional QE is even weaker than before, given the extraordinary plunge in gilt yields. The Bank of England’s MPC has the primary responsibility of inflation control and the secondary responsibility of promoting the government’s other economic objectives, notably output growth and high employment. The first demands, at least, a token response to inflationary outcomes and threats; the second requires the design of practical plumbing solutions that will revitalise the money markets transmission mechanism and widen access to cheap credit. My vote is for an immediate Bank Rate increase of ˝% to 1.0%.

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

Nothing much has changed in the UK economy in the last few weeks: inflation remains over twice its target level and the real economy is flat-lining. In other words, the economy is still in the grip of a large negative supply shock. Meanwhile, the Bank has continued to ignore the UK’s inflation rate and agonises ineffectually over its rate of growth. The Bank is likely to continue in this mode for some time, but is it the best it can do?

Since the recession, UK inflation has been largely imported. This limits the ability of the Bank to do much about it, but it does not entirely remove its room for manoeuvre. Prior to 2007, inflation was close to its target value of 2%. This was almost entirely the result of the average of two components of the CPI. Services had an inflation rate that fluctuated around 4% and goods had an inflation rate between zero and minus 1%. Since 2007, services inflation has continued as before, while goods inflation has climbed to 4%. The latter development has been due largely to the steady increase in commodity and energy prices; the Economist commodity price index increased 23% in the last year. The change in the UK’s inflation since 2007 is therefore almost entirely imported.

What are the options for the Bank? There are two channels open to the Bank. Both involve an increase in interest rates. One channel is domestic: it can reduce service inflation by inducing lower wages. However, with the economy stagnant, unemployment high and little sign of wage inflation, this would be politically unpopular and would probably not be very effective. The second channel is to offset imported inflation via a sterling appreciation. This would reverse the contribution to inflation of the depreciation of sterling since 2007. The effectiveness of this depends on the strength of the US$ and the Euro. Recently the US$ has been weak. As most commodities are priced in US$’s, this may have contributed to the commodity price rise but it has also offset sterling’s depreciation. Due to an interest rate increase by the ECB, the Euro has been strong. This does not greatly affect commodity prices but it has made UK exports more competitive in Europe. Nonetheless, exports have been weak recently. A sterling appreciation may therefore reduce imported inflation but it has the downside of making exporting more difficult. Further support for the exchange rate strategy is a finding of mine made some years ago from simulations of the Bank of England model. In the first year, 80% of the effect of an interest-rate increase on inflation comes via the exchange rate; this erodes rapidly thereafter as the other transmission channels, such as the costs of borrowing and capital, take over.

If the Bank of England appears to have given up on controlling inflation, how well is it doing in its alternative policy objective of stimulating the real economy? With interest rates close to the zero-rate lower bound, interest rate policy is impotent to stimulate the real economy. Furthermore, and with private sector borrowing stagnant despite the available liquidity in the banking system, even a further round of QE would be futile. Although, as noted already, a near zero interest rate has caused a depreciation of sterling and added to imported UK inflation, this increased competitiveness has not brought about an increase in exports. These have fallen recently despite a growth rate in excess of 4% in the non-western world. It appears, therefore, that foregoing the inflation target has had little or no benefit for the real economy.

With the economy stagnant, raising interest rates in order to reduce imported inflation is a difficult call for the Bank as it may also harm the real economy. This is always the case when inflation is due to a negative supply shock. The current monetary policy framework was, of course, designed to deal with inflation due to positive demand shocks when demand would be strong. Although there is a case for adopting a flexible inflation target rather than the current strict inflation target, officially the Bank does not have this option even though it has acted as though it did. The main danger in the Bank’s current policy is that it threatens to throw away the main benefit of its past success in presiding over low inflation, namely, anchoring inflation expectations at the target rate of inflation. Once this is lost we may expect considerable inflationary pressure from wages and prices. This would more or less complete the return to the disastrous conditions to the 1970s. There should be a small increase in interest rates now and, in the longer term, further increases in order to provide a sensible real rate of return. In the short term, it is the change in interest rates rather than their level that is more important as this affects expectations. A value of 1% rather than ˝% would otherwise probably have little effect.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: To hold Bank Rate and be prepared to undertake further QE if money supply growth turns more negative and the economy slumps into recession.

A weaker global economy, especially in our main export markets, and the recent market turmoil in the financial markets indicate that a wait-and-see approach to monetary policy is the most appropriate response. That having been said, long-term nominal interest rates have become even lower and so real, inflation adjusted, rates are even more negative. This implies a monetary loosening. Also, it is becoming clear that loose monetary and fiscal policy are becoming part of the problem through inadequate returns to savers and the crowding out of the private investment necessary to help drive supply-side growth. The cut-backs in public sector investment in infrastructure are another minus where future growth prospects are concerned. However, rates will have to stay low until the economy has recovered sufficiently to be able to withstand a tighter – or, more accurately, a less loose – policy stance.

Unfortunately, the situation in the advanced economies is not getting better fast. The earlier monetary policy and regulatory mistakes are going to be reverberating for some time to come. It has to be hoped that any fiscal and other policy errors being made now do not compound the earlier ones. The revised data for UK GDP in 2011 Q2, released on 26th July, suggests that the economy is weak but not heading for recession. Manufacturing activity has turned the corner and seems to be holding up, albeit at a lower level than earlier in the year. With revisions likely to the level of output for the last few years, a rise in Bank Rate seems more likely to be the next policy move rather than further easing via QE. The immediate problem is that with so many uncertainties, moving rates up now would be counterproductive with recovery still so weak.

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.