Sunday, October 02, 2011
Shadow MPC votes 7-2 to hold Bank rate
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by seven votes to two that Bank Rate should be held at its existing ½% when the official rate setters make their next announcement on Thursday 6th October. The two dissenting SMPC members wanted to raise Bank Rate by ½% to 1%.

The main reason why most SMPC members wished to hold Bank Rate in October was concern over the potential adverse consequences of the turmoil in the Euro-zone for Britain’s exports together with the potential risks to UK banks if their Continental counterparties were destabilised by a sovereign debt default.

Two of the holds regretted that Bank Rate had not been raised around the middle of last year, when there was the opportunity to do so. This would have allowed the Bank of England to achieve a greater psychological impact now with an overt rate cut, than is achievable with another hold.

A rate hike last year would have also strengthened sterling and meant that inflation would have been less of a concern than it has now become.

The main reasons that two SMPC members wanted to raise Bank Rate was a belief that the UK economy was weak for predominantly supply-side reasons – a number of the ‘holds’ shared this view to a greater or lesser extent – and that the sustained period of high and accelerating inflation had already destroyed so much of the Bank’s credibility that it risked the development of a wage-price spiral. There was a consensus that further Quantitative Easing (QE) should be on standby in case the situation in the Euro-zone worsened, but no great enthusiasm for implementing it immediately.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: More QE, possibly as early as November.

UK inflation is set to hit 5% in coming months. Over the medium-term, however, inflation is set to fall below the Bank’s 2% inflation target. Downside risks have increased markedly since the summer. The debacle in the Euro-zone continues. The meeting of international leaders at the International Monetary Fund (IMF) over the weekend of 24th/25th September suggests bold ideas are being placed on the table; but it is far from obvious that there is the political stomach for such action in the places where it is most needed – Berlin and Frankfurt. Since our last vote, the Fed announced a sequel to ‘Operation Twist’, buying $400bn of medium and long-dated US Treasuries (USTs) with the proceeds of sales of its short-dated USTs by mid-2012. Its actions may have some effect in pulling down the US yield curve; but it is hard to believe this will have much effect on US demand growth, given the limited boost it will offer to broad money and the state of US household balance sheets. Some 23% of mortgagors – around 12½% of all US households – now find themselves in negative equity.

The biggest worries for the UK are external. First, the rate of demand growth in Britain’s trading partners is set to be weak in coming quarters. A recession in the Euro-zone now looks increasingly probable. Second, there is a growing risk that UK banks are adversely affected by wider financial market developments. Bank stocks have taken a battering in recent weeks. The senior unsecured bank bond market in Europe has effectively been closed since mid-July. Marginal funding costs for UK banks have increased by 150 basis points (bps) since the end of May and by 50bps in the last month alone. To the extent this leads to even tighter credit supply in the UK, it poses downside risks to already weak monetary growth. The Bank’s latest Credit Conditions Survey, due to be released on the 28th September, could be particularly telling.

While considerable uncertainty persists about the degree of spare capacity in the economy, a good amount of slack should remain for some time. Recent developments suggest downward pressure on inflation from this source could be greater than previously anticipated over coming quarters. In the light of the gloomy outlook for global demand, commodity prices should decline further as we move into 2012. Brent crude oil at $105 per barrel looks particularly expensive. Moreover, it is hard to detect any real sign that recent upside inflation surprises are feeding through to wage settlements or medium-term inflation expectations. Headline Consumer Price Index (CPI) inflation could be below 2% by the end of next year. Unless there is a meaningful improvement in financial conditions, especially in bank funding markets, soon, additional Bank of England asset purchases will be desirable.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Hold Bank Rate, expand QE only if M4ex broad money declines.

The weakness of recent economic data releases among the developed economies, the on-going crisis in the Euro-zone, and the sharp declines in equity and commodity markets are all symptoms of a shared malaise: excessive indebtedness in the household, financial and government sectors. To gain proper perspective we need to step back for and consider some history. Looking across the world over the sixty-five years since the ‘Bretton Woods’ system of pegged currencies was implemented after World War II, there have been hundreds of recessions and dozens of more serious crises for individual economies, currencies and sovereign states, both among developed and emerging economies. In most cases, the underlying causes included the excessive growth of private-sector credit or government debt in the period prior to the crisis. These episodes were often – but not always – accompanied by excessively rapid growth of the quantity of money and hence inflation.

Time and again, the preferred solution by politicians and central bankers was either to spend their way out of these recessions, or to devalue the currency to regain competitiveness and enable growth to revive. In the case of private sector debt crises, this meant transferring, not paying down or restructuring, the debt from the banks or firms or households that had over-borrowed and overspent to the government through some kind of bail-out mechanism. The result has been a persistent rise in the ratios of public and private sector debt to GDP in one economy after another. In the US case, the combined debt-to-GDP ratio for the combined private and public sectors increased modestly from around 140% in the late 1950s to nearly 170% by 1980 (based on annual flow-of-funds data), but then soared over the next three decades to reach a peak of 375% in 2009. If the financial sector is excluded, US total sectoral debt was 268% of GDP in 2010. On the same basis, the UK’s total sectoral debt-to-GDP ratio increased from 203% in 1990 to 321% in 2010. Numerous countries in Europe have seen similar increases.

Since the credit crisis of 2008-09, the US and UK private sectors have de-leveraged modestly. However, this has been offset by the government leveraging up to finance fiscal spending stimulus, and to recapitalise the banks and other financial institutions. Since the depths of the recession in early 2009, US household debt has declined from 101% of GDP to 92%, while in the UK it has declined from 111% to 103%. At the same time, UK net government debt (excluding temporary financial interventions) has increased from 35% to 61.4% of GDP, or 151% including those interventions. In the US net government debt has risen to 74.8% of GDP. In their efforts to solve the 2008-09 crisis, politicians and policy-makers of US and European governments are grasping at the same old solutions again: borrow and spend more money in the hope that private sector growth will pick up, GDP will revive, and government tax revenues will recover. In the past, central banks stood ready to create the money needed to finance the spending. This Keynesian solution always seemed to work.

The problem is that there is a flaw in the Keynesian solution. It ignores the underlying deterioration in private and public sector balance sheets. The recovery formula was focused on flows of spending and only worked as long as private and government debt levels were relatively low in relation to annual incomes, or the debt could be devalued or forgiven. Now that both the private sector and governments are overburdened with debt and neither the US nor the UK nor the Euro-zone can overtly devalue, the mechanism is seizing up. On one side, households and firms are reluctant to borrow from banks and spend, while banks are unwilling to lend until they have repaired their balance sheets. On the other side, incontinent governments are looking less and less creditworthy – even to those who have funds to lend or invest. So the economic recovery is stalling, and investors are demanding bigger risk premiums (i.e. higher bond yields) for lending to financially weak governments.

In effect, the British, US and European governments have maxed out their credit cards. The Keynesian formula has reached the end of the road. It is time to turn to a different, more durable solution. For the UK this means that if a ‘quick solution’ is sought, it must come from accelerating balance sheet repair – for example through relieving households and banks of debt – not through additional fiscal spending or inflationary money creation. This implies no change in Bank Rate, and activating asset purchases only if the M4ex broad money continues to decline.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate and raise QE.

To state the obvious, the economic situation is dark and difficult. The British domestic recovery – albeit inflationary and unsustainable – appears to have been derailed by international events. British inflation remains high. The Bank of England’s credibility is totally gone. The government’s deficit reduction programme – always overly dependent on tax rises early and thus always at risk of experiencing slow growth early on – appears unlikely to deliver on its targets without further spending cuts. Some British banks are exposed to further downturns in the US, others to developments in the Euro-zone, yet others to a downturn in the East. Another banking crisis appears imminent, with the government forced to consider whether to cast even more good taxpayers’ money after bad in recapitalising the banks yet again.

The most severe and imminent issue is in the Euro-zone, where a Greek default appears imminent at the time of writing and certainly inevitable by March 2012. Euro-zone policy-makers appear resolved to continue in their apparent attempt to turn crisis into catastrophe, with ever-more exotic and expensive schemes – e.g. debt pooling, Eurobonds, a €2 trillion European Financial Stability Fund (EFSF), mass European Central Bank (ECB) purchases of distressed debt – that serve little purpose other than to undermine German popular confidence and which risk eventually inducing a German withdrawal. The longer a Greek default is delayed, the worse the banking sector contagion will ultimately be. Since the Euro can function only with large fiscal transfers between member states in the long-term and no such long-term transfers will be offered to Greece, the longer the pretence is upheld that the Euro can continue with Greece as a member, the greater the ultimate risk of disorderly collapse of the whole arrangement, dragging down the Single Market in the process and inducing a Euro-zone-wide recession on a scale unprecedented in modern Western democracies.

The disaster sketched above is by no means inevitable yet. Greece might default reasonably soon, exiting the Euro (presumably accompanied by Cyprus), and a longer-term solution for the Euro might be implemented with the loss of no more than a couple of other members, perhaps even none. Even if an EU collapse does occur, the slump scenario of a 20% to 25% first-year contraction in GDP even of countries such as Germany, recently put forward by the Union Bank of Switzerland (UBS), seems hysterical to put it bluntly. However, the scenario of Euro-zone and consequent European Union (EU) collapse, though not yet the most likely outcome, is definitely now on the table. Policy-makers should have contingency plans in place.

For the UK, the key contingency plans fall outside monetary policy, albeit within the Bank of England’s new remit. There must be no more bank bailouts, no more taxing of the poor to keep the rich wealthy. ‘Recapitalisation’ – a strategy that would have been immoral and economically destructive even had it worked in its own terms – has manifestly failed. The error must not be repeated, or else Britain risks going the way of Ireland. Governments must not recapitalise failed banks. Indeed, even the insistence on private sector recapitalisations to meet new higher capital adequacy thresholds is misplaced and risks making matters much worse. Capital exists as a buffer against a rainy day. Insisting that banks have adequate capital at the moment makes no more sense than insisting that a man must be wearing a dry raincoat during a storm.

Instead, if banks become distressed this time, then: if they are solvent and viable long-term, they should be provided with Bank of England funding (which is not a form of bailout); if they are insolvent but viable long-term, they should have bail-ins (swapping bank bonds for equity) imposed in Special Administration; if they are unviable, value-destroying entities, their assets should be sold off or wound up. To manage the risk of bank depositor runs, a Deposit Access Fund should be created with newly-created Bank of England money, servicing depositors, repaid from the assets of the banks. This will have short-term money supply implications, and thus is a clear monetary policy issue. QE should be held back for this purpose, for the purpose of offsetting any contraction in the money stock if British banks should actually collapse and – if push really comes to shove – standing ready to fund the British government’s deficit if bond markets panic totally.

QE should have been introduced more than a year ago, when many members of the Shadow MPC were calling for it. Not having done that can now be seen to have been a serious policy error. However, it should not now be introduced for purely UK domestic purposes. Doing so would be chasing the problem. If international events settle down quickly following a Greek default, then only a minor liquidity injection – no formal QE at all – might be sufficient. Complaints about slow British growth miss the point. The sustainable growth rate for the UK economy is currently very low – perhaps only 1% to1.5% per annum; it is potentially even lower. There is probably much less output gap than official government figures have suggested – after all, even the growth we have had has been associated with rising inflation. So growth is not ‘slow’ in the sense of being ‘slower than possible’. Growth is slow because potential growth is slow. That problem can only be addressed by raising the potential growth rate: household deleveraging; government spending reduction; increasing public sector productivity growth (through more use of quasi-markets) and increasing the pension age.

There are no instant solutions here. There is simply working the problem through. Monetary policy can only help so much. The main alternative strategy would be a form of ‘cleansing’ – raising rates rapidly back to some neutral level, forcing rapid deleveraging and rapid structural change. This is a much less stupid or unthinkable idea than is often implied, and if matters were to drag out into a Japanese-style quiescence, then cleansing might become attractive – a couple of years of minus 5% growth followed by 2% or 3% growth thereafter could be much more attractive than two decades of no growth at all, interspersed with occasional recession. Even now it is a judgement call that is becoming more balanced. However, we are not there yet. For now, we should await the storm. Hold interest rates. Hold QE. And hope…

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To raise Bank Rate; QE should be held in reserve.

The global stock markets have reacted with their usual alarm at recognising that the economic fundamentals are not as rosy as was originally thought. Capacity destruction coming from a mixture of over-investment, credit crunch, oil price rises and, in the case of the UK, a decade of tax and business-unfriendly regulatory policies have produced adverse supply-side effects that cannot be rectified by radical or unconventional monetary policy. Granted that a wave of asset price deflation, particularly that of bank stocks, following a sovereign debt default, could be averted by providing emergency liquidity to the money markets and through a further bout of QE; but all that QE can do is to arrest the natural decline in stock values that must eventually occur with the recognition that the returns from investment have diminished. However, nobody wants what should be a stock market correction to turn into a stock market melt-down. QE is not going to revive domestic demand at a time when households remain over-leveraged and investment pessimism dominates corporate expectations. Household and company borrowing were based on the expectation of positive returns on investment and productivity growth which looks naïve in retrospect. There is nothing for it but to recognise that households have to rebuild assets and repay debt and that could take some years. There is no magic bullet available to the government and any policy that can be done such as supply-side innovations will not yield immediate returns.

QE is an option, but one that should be held in reserve if (or when) the Greek default and inevitable exit from the Euro results in a deluge of asset price deflation. Until that happens, the Bank of England needs to focus on monetary policy. It is clear that the Bank is in no hurry to stem the rise in inflation. Inflation expectations have crept up and it appears that the policy of inflation targeting is all but abandoned. So, should we therefore recognise the inevitable and simply allow inflation to devalue the debt? Inflation will redistribute the burden of adjustment from borrowers to savers which is good news for the borrowers in the short term (government and indebted households). However, the long term damage in terms of the reputation loss to the Bank and the pain of disinflation and restoration of credibility that must inevitably follow, has to be weighed against the gains of the short-term fix. It is tempting to put off pain today for pain tomorrow. Even so, those of us who remember the inflationary 1970s and the hard path of credibility built during the 1980s would prefer pain now to a longer pain in the future. It’s a tough call asking for a rise in Bank Rate at time when financial markets are in such turmoil. If rates had been raised earlier, we could be talking about a cut in Bank Rate to help boost financial markets. However, and like a stopped clock that is always right twice in the day, rates have now to stay where they are until the financial storm has passed.

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.

To read some of the pronouncements from Madame Christine Lagarde at the IMF and Olivier Blanchard, her chief economist, one could be forgiven for thinking the world was on the brink of recession. Yet world growth is likely to be around 4% this year, after over 5% last year, with an IMF forecast of another 4% in 2012. So, all the fuss is about the West and in particular the threat to it from the Euro-zone crisis. There has been a (deliberate) slowdown in the East and other emerging countries because monetary policy has been tightened in the face of serious world inflation, including 8.4% in India and 6.2% in China. This in turn has taken the sheen off manufacturing growth worldwide, assisted by the earthquake-related problems in Japan. Nevertheless, growth in these emerging market countries remains robust and will be allowed to rebuild as soon as world inflation drops back.

The underlying problem of the West-East imbalance that is driving slow western growth is an imbalance of productivity against a world shortage of raw materials. With eastern productivity growth fast, fuelled by inter-sectoral transfers of people and capital, supplies of raw materials are pre-empted by the East, and their prices driven up. This, in turn, undermines western productivity growth, which relies on ever-rising computer power and cheap raw materials. While it is hard to get exact estimates, western total factor productivity seems to have slowed down, capital installed on the assumption of low raw material prices has been written off – while estimates of excess capacity are likely to be revised down correspondingly – and investment in new projects and the uptake of new labour is being slowed by low marginal profitability. Another factor is the sharp decline in western terms of trade due to these high raw material prices; this has lowered permanent income. Similar things occurred in the oil and raw material crisis of the 1970s. At that time, western governments estimated excess capacity at high levels and called for large-scale coordinated stimulus in the face of the ‘oil producer surpluses’. However, this essentially Keynesian analysis turned out to be seriously wrong and precipitated massive world inflation.

It is incomprehensible that the IMF of all bodies should be demanding coordinated stimulus from western governments coping with sovereign debt problems. More understandable is the IMF’s demand that the Euro-zone come up with a plan to deal with its sovereign debt problems and the knock-on effects on banks. But is the Euro-zone crisis a threat that requires the UK to abandon inflation targets and fiscal stabilisation? Certainly not at this stage, at least. In aggregate, the Euro-zone is not growing any more slowly than the UK. A Greek and, say, Portuguese default accompanied by exit (no doubt temporary) from the Euro could actually restore some growth on the periphery. Bank problems have been well trailed and their sponsoring governments must be ready to support them, one would assume. Also, the ECB seems to have been licensed to be active in support operations of sovereign bonds) – even if German Board members are not happy, they cannot seem to stop it.

If UK growth is slow because of slow productivity and excess capacity, as is now generally being agreed, much lower than previously thought, then we are facing a ‘supply-side’ problem that cannot be cured by demand stimulus, whether fiscal or monetary. Additional fiscal stimulus is essentially out of the question now that the existing plans will most likely overshoot the Chancellor’s public sector borrowing targets. So what of monetary policy? It seems rather clear that the Bank of England has seriously underestimated UK inflationary pressure. This has come about in two main ways. First, they have overestimated excess capacity and firms have accordingly been pushing up prices faster than expected, with no dampening of the ‘pass-through’ of massive input price rises. Second, by treating sterling as an exogenous variable over which money has no power, the Bank has disregarded a major transmission channel of its policy. This has led to inflation breaching the 2% target for much longer and by bigger amounts than the Bank has successively forecast for the past two years; there seems no prospect of the Bank reaching its target in 2012 either. This breaching of the target has led to doubt about the Bank of England’s seriousness in pursuit of the target.

So far, wage settlements have been quiescent as the weak labour market - which now has a fair degree of competition and union power only in a beleaguered public sector - has pulled wage growth down. However, were inflation expectations to climb to 4%, which is a not incredible prospect, and should unemployment continue to be roughly level, then real wages would start to level off or rise a bit and nominal wages start to grow by 4% to 5%. With UK labour productivity growth stalling (or even negative) this would threaten to raise steady state inflation to around the same rate. Then we would go into 2013 with continued inflation of over twice the target. At this point, either the target will be abandoned or raised or there will have to be a drastic monetary tightening to get inflation back under control. As an election might then be approaching, it is too easy to see the target’s abandonment as the most likely course.

For all the discomfort of the UK economic prospect at present, the fact seems to be that there is little we can do about it without sacrificing control of inflation. Furthermore, even if inflation were to be sacrificed in this way, it could not alter the gloomy supply-side ‘fundamentals’ and might not have even have much of a temporary effect on growth. Therefore, any resumption of QE should be opposed. The Bank needs to signal its serious intention to bring down inflation by raising Bank Rate to 1% at once – with a bias to raise it again in due course. This will not have much short-run practical effect on costs of funds which are well above Bank Rate now. However, it would be a powerful signal in this environment. It is really about time that the Bank of England rediscovered its role as the guardian of the currency, and ceased to be its debaucher.

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

Other things being equal the effectiveness of fiscal policy depends critically on whether the consequential alteration in government borrowing is from banks or non-banks. Suppose that fiscal policy is eased by a cut in the rate of VAT, the government’s borrowing requirement will increase because of the loss of revenue. The additional funds can be obtained from either the banks, for example, by issuing treasury bills, or from non-banks, by issuing medium and long-dated gilt-edged stock. In the former case, banks’ liabilities rise in line with their assets. The private sector’s bank deposits rise and these can be spent either on goods and services or on assets. Money, that is, purchasing power, will be injected directly into the economy. In the latter case, the private sector’s holdings of assets, rather than money, will rise and the direct effect on economic activity will be much less. Easing fiscal policy is not really effective if the government replaces the lost finance by borrowing from non-banks.

How about the opposite case of fiscal policy being tightened? If the government uses the additional revenue to repay borrowing from banks, bank deposits will fall. There will be a direct impact on economic growth as less money is spent on goods and services. If the government uses the additional revenue to repay borrowing from non-banks, for example, by buying gilt-edged stock from non-banks, the sellers of the gilt-edged stock will receive bank deposits in return for their stock. Initially, however, much of the money is likely to be spent on assets, as the funds are reinvested. Asset prices will rise but the direct effect on economic activity will be delayed. Money normally stays in the system as one person passes it to another, rather like the ‘hot potato’ in the children’s game, in which case a direct effect will still occur but will be delayed whilst the money percolates through to being spent on goods and services.

QE is the name now given to government buying gilt-edged stock from non-banks. Since QE started in March 2009, money has been injected directly into the economy. However, only a small amount has stayed in the system. The bulk of it was absorbed by banks raising new capital and large companies issuing bonds the proceeds of which were used to repay bank borrowing. Such restructuring of balance sheets was highly desirable. Even so, most of the continuing impact of the money created by QE was lost.

If current fiscal tightening is not to slow economic activity, monetary growth must be adequate. QE is however not the only way in which the money supply may be boosted. Other things may not be equal. For example, after the UK borrowed from the IMF in 1976 and fiscal policy was tightened, confidence in sterling returned and the Bank of England intervened in the foreign exchange market to stop sterling from rising. The result was that the money supply was boosted by money flowing in from abroad. Further, after Geoffrey Howe’s budget in 1981 buoyant bank lending was the main offset to a dramatic fall in the central government borrowing requirement. Neither appears likely to occur this time. The conclusion is that additional QE may become vitally necessary during the coming months.

In February, it was argued that a distinction should be drawn between a jump in the price level caused by external factors and inflation and, further, that it was certainly the job of the MPC to stop the former from turning into the latter. Inflationary expectations must be stopped from rising. There is a strong case for the MPC standing firm and not easing in the face of trade union militancy and until there is clear evidence that inflation is falling back towards target.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: To ‘normalise’ Bank Rate in small steps until it reaches 2½%, while holding QE in reserve.

It has become increasingly hard to avoid the conclusion that both the fiscal and the monetary authorities in the US, Japan, the Euro-zone and Britain have largely lost their control over events. This can be seen from the widespread failure of the public finances to improve as intended, the continued weakness of output and international trade, and the failure of the attempts to bail out the weaker members of the Euro-zone to gain bond-market credibility. The seeds of the present crisis were sown by the remarkable expansion in the size of the state during the present century in countries such as Britain, where the government spending ratio went up by 14.4 percentage points of GDP between 2000 and 2010, and the US where the increase was 8.4 percentage points. The developed countries that have escaped most lightly from the post-2008 Global Financial Crash have, by-and-large, tended to be nations where the share of government spending was relatively low to start with in 2000 and has remained low subsequently – examples, would include Switzerland, Australia and Canada – or, alternatively, where spending has been falling noticeably as a share of GDP, Sweden would be the prime contender here.

Germany is especially significant. This is because it has broadly held its government spending ratio, which was 46.7 % of GDP last year, over a decade in which many other Euro-zone members have seen substantial increases from distinctly higher starting bases. People used to contrast Germany’s ‘Rhineland’ social-market capitalism with the more aggressively pro-capitalist approach of the US and Lady Thatcher’s Britain. However, Britain has had a higher government spending ratio than Germany since 2007. The British government spending ratio was 51.0% last year, according to the Organisation for Economic Co-operation and Development (OECD). The US, at 42.3%, is also catching up rapidly, having had a spending ratio 11.2 percentage points below that of Germany in 2000. The ‘old’ Bundesbank was as hostile to European Monetary Union (EMU) as it dared to be in public ahead of the event. Recent developments have confirmed the prescience of the EMU reservations that it was advancing in the late 1980s and early 1990s. One crucial concern, which was brushed aside by Continental politicians, was that it would not be possible to hold a monetary union together in the absence of a single over-arching legal authority. This was partly because central banks could only operate effectively if they had a clear legal right to regulate commercial banks’ activities. However, it was also because the Bundesbank anticipated the fiscal free-rider problem that would arise if irresponsible countries could borrow at better terms within the currency union than they would have been as stand-alone entities.

This is why the Maastricht criteria were introduced as a second-best solution to the problems posed by the absence of a unitary legal authority. These criteria, including the 3% of GDP government borrowing limit, were deliberately made simple for political-economy reasons. The mainly German officials concerned wanted the convergence criteria to be so simple that a media furore would be provoked if the fiscal limits were breached. The intention was to embarrass the politicians into responsible fiscal behaviour. The officials who designed the fiscal criteria were well aware of the case for automatic stabilisers and cyclical swings in the deficit. They just did not want to allow the politicians ‘wriggle room’ to get out of the Maastricht commitments. However, the fatal weakness of the criteria is that they did not include a limit on the acceptable ratio of government spending to GDP. If that had been set somewhere around 40% to 45%, it would still have been too high from the perspective of maximising social welfare but it is unlikely that the present crisis would have escalated to the extent that it has.

It is in nobody’s interest to have your neighbour’s house on fire. The events in the Euro-zone pose a major threat to the UK, because it is our largest export market and because of the risk of financial contagion affecting UK banks. However, it is hard to see a resolution that can be implemented from a political viewpoint. The most likely long-term outcome seems to be a process of the EU’s political class attempting to postpone the inevitable, followed by one or more sovereign defaults, ending up in the probable Balkanisation of EMU. In pure logic, it should be possible to move towards the single legal authority for the Euro-zone, which was a necessary condition for a stable monetary union in the Bundesbank’s eyes. This appears to be the path that the EU elites wish to adopt. Indeed, such people are trying to use the crisis to ratchet up fiscal and political integration several more notches. The stumbling block is that the German people – who never wanted EMU in the first place – will not wear it, and will probably bring down any government that takes this path. Fundamentally, the Germans are being asked to accept open-ended taxation without representation, while the more fiscally-challenged Euro-zone members are asking for representation without taxation. This prospect is untenable as well as unjust and the situation in Continental Europe is only likely to deteriorate. This imposes a massive constraint on policy makers in the UK, because of its potential adverse fall out effects.

Another background concern is the growing evidence that the UK’s fiscal position is not coming right as rapidly as Mr Osborne had intended, despite a recent £5.9bn downwards revision to estimated Public Sector Net Borrowing in 2010-11. It has been argued previously that the Coalition would not achieve its borrowing targets as a result of the adverse ‘Laffer-curve’ effects arising from the hikes in VAT and employers’ National Insurance Contributions. (Editorial Note: see also Chapter 2 of the recent IEA publication Sharper Axes, Lower Taxes: Big Steps to a Smaller State, edited by Philip Booth.) However, the questions that now arise are how long the UK can maintain fiscal credibility, if its borrowing plans are not achieved, and what will be the consequences if fiscal credibility is lost, especially where debt servicing costs are concerned? The 29th November Autumn Statement and the new Office for Budget Responsibility (OBR) forecasts released alongside it will be important here. It is fortunate for Britain that financial markets can only concentrate on one thing at a time and that they are currently pre-occupied with the Euro-zone. The danger point for Britain is likely to come when – or if – there is a resolution to the Euro-zone crisis and the financial markets’ attention becomes directed elsewhere.

The 2011 Q3 Bank of England Quarterly Bulletin has an article on the effects of the earlier QE operation, which may be intended to soften up public opinion for a further tranche of QE (see: The United Kingdom’s Quantitative Easing Policy: Design, Operation and Impact, by Michael Joyce, Matthew Tong, and Robert Woods). The article uses a variety of techniques to assess the effects of the £200bn QE implemented earlier and suggests that QE may have raised GDP by 1½% to 2% and increased inflation by some ¾ to 1½ percentage points, while admitting that a high margin of uncertainty is attached to these estimates. These are rather stronger gains from QE than the author found in his article on the subject published in the June 2010 IEA Economic Affairs. However, another thing that comes out of the Bank’s research is the poor output/inflation mix that has accompanied QE, although this probably applies to other potential stimulatory measures also. Between one third and one half of any boost to money GDP from QE seems to have been dissipated in higher inflation. This suggests that there are supply-side constraints present, and not just a simple deficiency in demand. Moreover, bond yields have recently fallen so low that it is hard to see that QE would be anything other than otiose at present.

The Office for National Statistics (ONS) will be introducing major changes to the methodology used to compile the national accounts on 5th October, after this note has gone to print. Past form suggests that these revisions might be large enough to alter views about the current situation and the future outlook. Recent data show a downbeat picture of sluggish home demand, stubborn inflation and disappointing figures for the government accounts and international trade. The annual increase in the ‘double-core’ Retail Price Index (RPI) – which excludes all housing costs – went from 5.5% to 5.7% between July and August, while target CPI inflation accelerated from 4.4% to 4.5%. The RPIX ‘old’ target measure and the all-items RPI showed inflation rising from 5% in July to 5.3% and 5.2%, respectively, in August. This suggests that Bank Rate remains too low from a strategic perspective and should have been raised some time ago.

Finally, the issue of whether a low Bank Rate stimulates the economy or not is more open than most people assume and essentially a quantitative one. A low Bank Rate compared to other countries lowers sterling and increases export competitiveness. However, it also leads to higher inflation, reduced living standards and increased precautionary savings. These two sets of factors counterbalance each other. It is only if one knows the relative sizes of the effects involved that it is possible to estimate which will dominate. The evidence suggests that the demand for imports into the UK is now largely insensitive to the exchange rate and that exports are only weakly sensitive. Furthermore, a lower pound appears to be eventually completely reflected in a raised price level, reduced living standards and less home demand. The higher inflation that appears during the adjustment period also has adverse effects on activity for both supply-side and demand-side reasons. The MPC has taken another view of the quantitative effects concerned – which it is entitled to do – but it would be useful to have a fuller debate on the subject. Meanwhile, the uncertainties are such that holding Bank Rate for purely tactical reasons seems the most appropriate policy decision where October is concerned. Raising rates now will bring little immediate benefit and could have a nasty impact on shaky confidence. The pity is that we are not starting from a 2½% Bank Rate already, as some of us have long advocated. Then there could have been a modest cut from a more sensible base and a greater psychological impact on ‘animal spirits’ than yet another business-as usual ‘hold’ decision.

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

There have been few new macroeconomic figures coming available since last month. This means that there has been very little change in sentiment concerning the evolution of the economies of Britain and the other industrialised countries. Recovery in the industrialized countries is weak, and so it is also in the UK. One new piece of information, which has become available, is the August inflation data. Inflation is a cause for serious concern. The annual monthly inflation rate measured with the CPI reached 4.5% in August, 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 have higher annualised monthly inflation in August than they did in December 2010. Inflation shows no signs of slowing down at the more disaggregated level. It is picking up speed and it does so in more and more CPI categories. The inflation in the prices of alcohol, clothing, household equipments, and housing has risen by more than 2 percentage point since December 2010. The longer the current pattern prevails, the more likely it is that expectations of future inflation lose their anchor. Then inflation will speed up further.

The key question remains the same as in previous months; is the weak growth of the British economy and the leading seven industrialised countries (G-7) primarily due to: 1) weak demand and the associated negative output gap; or 2) supply constraints in a situation in which the output gap is close to zero? If demand is weak, then observed inflation is temporary, and there is no need for monetary tightening. If supply is inadequate, then inflation is not temporary and without monetary tightening, it will not get back to its target. In particular, if there is spare capacity resulting from weak demand, monetary stimulus could help to lift the economy out of recession. Current output-gap estimates suggest there is a significant negative output gap. That would indicate the existence of spare capacity and no need for monetary tightening as a corollary. On the other hand, survey evidence suggests that capacity utilisation is not particularly low in the UK suggesting that there is little excess capacity. This would imply a need for monetary tightening. However, there were several factors prior to the crisis that would distort estimates of the margin of available capacity. In particular, the long period of time in which government expenditure grew rapidly makes it particularly hard to estimate the output gap during the present period, when there is very little room to increase government expenditures. Therefore, it is more likely that there is little or no excess capacity in the British economy at the moment. Hence monetary policy should be tightened by means of a ½% rise in Bank Rate. This increase would signal that the UK monetary-policy makers take inflation seriously, and would keep inflation expectations anchored. However, there is no requirement to signal further tightening. Thus, there is no bias where future rate changes in November and beyond are concerned.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: Hold Bank Rate and stand by to ease via QE but only if there is a recession.

Financial markets are in turmoil at present. Evidence of tepid growth in the advanced economies and growing indications that Greece will default is leading to renewed volatility. After a very difficult August, September has turned out to be worse. The greater volume of trading, as people returned from holiday, has not brought the calm that was expected, but a greater storm. Now, the focus is on what the ECB and the politicians in Europe can do to manage the impact of any default by Greece, in terms of financial markets support for affected banks and a long term solution that answers the question of what might happen after Greece to the members at risk from a similar outcome.

The reason why this is so very important to the UK is the implied direct economic impact of disruption to key export markets, and the impact (direct and indirect) on our banking sector. This has added to pressure to keep interest rates low and perhaps to embark on further QE, as a consequence. There is little domestic economic reason for QE2 at present. This is because the economy is growing, albeit by just 0.7% in the year to 2011 Q2. There is little that interest rates or QE can do to speed up the recovery pace. For one thing, there is a process of deleveraging underway in the private sector, amongst households and companies. Of necessity, this is a slow process. No matter how low interest rates are consumers and business will not be encouraged to spend more than at present. Savings are being built up and financial balance sheets are being strengthened. Paradoxically, low interest rates are inimical to this as they mean savers are getting little or nothing on their money in nominal terms and, indeed, returns are falling in real, inflation adjusted, terms.

Yet another effect keeping down the pace of economic recovery in the real economy is the high rate of price inflation. This is eroding the real spending power of households as wages are well below price inflation, which is running at 5.2% on the RPI and 4.5% on the CPI basis. Lower real wages may help corporate profitability. However, they are serving to keep a lid on real household income growth, which is experiencing one of its worst performances for decades. On some measures, this represents the longest run of negative income growth since the 1920s. Hence, the problem is that high price inflation is exerting a negative effect on real incomes and so spending and the rate of growth. It has helped nominal GDP but not volume growth. This is why QE is not yet appropriate, especially since price inflation is higher now than when it was last enacted. Of course, if the economy started to contract that would be a different scenario. However, and at present, it is growing at the sort of rate that is to be expected from a debt-constrained economy at this point in a recovery phase that could last for up to eight years.

Of course, there was also the shock from higher oil prices earlier in the year. This oil price shock, together with the impact of the Tsunami and nuclear meltdown in Japan, as well as the crisis in the Middle East, also need to be taken into account. These events have all conspired to weaken global growth and so UK exports. Slower manufacturing activity has flowed from this and this has weakened the overall rate of growth in 2011. However, with spare capacity likely to have been damaged by the long period of weak investment spending, the trend rate of growth of the UK economy is likely to be down to some 1% to 2% a year for some time to come. In this context, Bank Rate should remain at ½% at the moment. In addition, QE should only be used if the economy enters recession, perhaps as a result of Euro-zone issues. With inflation still high, monetary policy should not be loosened. This is because it will only artificially boost asset prices which will fall back once the QE is stopped.

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.