Sunday, February 05, 2012
Shadow MPC unanimous again on unchanged rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its most recent quarterly gathering on 17th January, the Shadow Monetary Policy Committee (SMPC) voted unanimously that UK Bank Rate should be held at ½% on Thursday 9th February. The main reason why SMPC members again voted without any dissension to hold the official interest rate in February was their concern about the potential adverse consequences of the crisis in the euro-zone for UK banks and exporters. Indeed, more time was devoted to a discussion of the situation in the euro-zone at the SMPC meeting than it was to British policy issues.

The general view was that the UK monetary authorities were in the position of doctors attempting to treat a patient with a life threatening medical condition that was incapable of diagnosis. Any aggressive treatment was more likely to prove fatal than to provide a cure. However, relying on a spontaneous recovery did not necessarily provide much hope either.

Two things that the SMPC generally agreed on were that a Greek default was unlikely to be averted and that there was a serious inconsistency in British monetary policy between the official hard-line approach to financial regulation and the need to maintain the supplies of money and credit to the private sector in order to sustain job-creating activity and the tax base.

The official intention to raise bank capital and liquidity requirements represented a perverse, business-cycle exacerbating, regulatory shock. The UK monetary authorities would be better advised to re-instate the Special Liquidity Scheme, whose premature withdrawal had badly damaged the credit creation process, if they wanted to succour Britain’s economic recovery.

Attendance: Philip Booth (IEA-Observer), Roger Bootle, Jamie Dannhauser,
Anthony J Evans, Andrew Lilico, Kent Matthews (Secretary), Patrick Minford,
David B Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.

Apologies: Tim Congdon, John Greenwood, Ruth Lea, David H Smith (Sunday
Times observer), Mike Wickens.

Chairman’s Comment

The Chairman started by saying that Gordon Pepper had confirmed his intention
to stand down from the SMPC in January 2012 in order to make way for the
new younger members of the committee who had recently been recruited. The
Chairman expressed his sincere thanks to Gordon Pepper for his consistent
loyal service to the SMPC since its foundation in July 1997. He added that
Gordon Pepper would be remembered among his numerous other contributions
for his pioneering advocacy of Quantitative Easing (QE) where he was well
ahead of the consensus and the Bank of England in understanding the need
for such measures. The Chairman then called upon Trevor Williams to give his
assessment of the global and domestic monetary situation.

UK Economic Situation

Trevor Williams said that he would reverse the usual order and discuss the
domestic monetary situation first and then go on to analyse the global scene. He
referred to his prepared charts on the monetary situation. The domestic scene
was set by events that had weakened global growth in 2011. The euro-zone
crisis, the deepening credit crunch, faltering trade and confidence effects were
joined by spending cuts in the US, tightened monetary policy in the emerging
economies and continued rising oil and commodity prices. The present year had
started with weak growth compounded by political risks from the Middle East,
regulatory risks for banks in advanced economies, and sovereign risk and bank
default risk. The only positive sign was the overweight holdings of cash on the
balance sheets of large companies. However, the exposure to a potential euro-
zone collapse was the major threat facing the British economy.

For the UK, the contraction in credit growth posed a major obstacle to recovery.
While credit availability had improved a little, it was still insufficient to meet
the latent demand from small companies. Defaults were rising and spreads
remained too tight. Survey evidence suggested that the UK was currently in
recession. The Lloyds Business Barometer indicated that the probability of a
renewed recession was well above 50%.

Secured borrowing by households had remained flat and unsecured borrowing
had picked up only marginally. Total personal borrowing had peaked but high
debt levels were holding back the recovery as household sector de-leveraging
continued. Net repayments dominated the actions of the corporate sector, with
credit growth having remained negative since mid-2009. The company sector
financial surplus had continued to rise while investment had declined. Overall,
the weakness in broad money growth signalled interest rates would remain low
for the foreseeable future. QE had boosted nominal income growth but had
demonstrated little ability to stimulate real GDP. However, underlying inflation
pressure was likely to be subdued although the inflation target was not likely to
be met until 2013.

The current downturn may not be as deep as the 1930s but it appeared to be
more protracted. The forecast for GDP had greater downside risk.

World Economy

Prospects for the world economy depended on whether the expected Greek
default was orderly or disorderly, according to Trevor Williams. The baseline
assumption was that there would be a Greek default. A 50% haircut was
expected around the turn of the year. If the default was orderly, contagion could
be avoided. However, the world would be adversely impacted by a disorderly
default. Structural shifts within the euro-zone had opened up wide gaps in
competitiveness between Germany and many of the other members, so any new currencies would face significant depreciation risk. A euro-zone break-up would impact on the UK through a liquidity squeeze, a tightening of the credit market, a contraction in domestic spending and an appreciation of sterling.

Globally, credit conditions were tightening and capital markets were under
pressure with widening emerging market bond spreads. A global recovery had
been underway at different speeds for the emerging markets and the developed
markets but with signs that growth was faltering in 2012. The quicker the euro-
zone crisis was resolved the better for the world economy.

Discussion

The Chairman thanked Trevor Williams for his presentation before asking both
Roger Bootle and Patrick Minford to make their respective comments forthwith,
since he knew that both had to leave by 6pm and time was pressing. As there
were ten members present, the Chairman also ruled that the last person to
physically join the meeting (Patrick Minford) would have his views recorded but
his vote discounted. Roger Bootle’s comment and vote appears with the other
votes below while Patrick Minford’s comments follow immediately.

Patrick Minford started by stating that monetary policy was in suspense while
the euro crisis continued and that voting for a policy was a pointless exercise.
That meant his immediate rate recommendation could only have been for a
hold where the 9th February decision was concerned. Unfortunately, the euro
crisis might continue for some time and QE was not having any effect other than
filling the government’s coffers by financing gilt sales. Meanwhile, regulatory
noises of a super-Basle nature had scared the banks into not lending. This was
similar to a situation of financial repression which was affecting small companies
particularly badly. Patrick Minford said that it was appropriate to be tough on the
commercial banks in a boom but not in a slump. He called for the reversal of
the current drive towards excessive bank regulation from the Financial Services
Authority and the Vickers Report. Patrick Minford then left the gathering.

The Chairman then opened up the meeting for general discussion. He proposed
that, rather than concentrate on the purely domestic situation, the meeting
should apply its monetary expertise to discussing the situation in Continental
Europe, since the uncertainties in the euro-zone dominated all other factors
and he strongly suspected that everybody present would be voting for a Bank
Rate ‘hold’ in any case. He suggested that they should begin with a discussion
about the technical feasibility of the break-up of a currency union, particularly as
Akos Valentinyi, as a Hungarian, knew a lot more than most people about the
collapse of the currency union between Hungary and Austria after World War 1
and Ukraine and Russia after the collapse of the Soviet Union. Akos Valentinyi
commented that the integration of financial markets made it difficult to compare
the break-up of the euro with the historical precedent of over-stamping a former
imperial currency to create a new national one. Peter Warburton added that
the web of interconnectedness went deeper than people imagined, particularly
through the leverage created by derivatives contracts.

Andrew Lilico said that the British banks had been instructed to make
contingency plans in case of a euro-area break-up. Trevor Williams said that Greek banks were effectively bankrupt with the haemorrhage of deposits from
Greece. He said that the draw-down of euro deposits in Greece matched the rise
in euro deposits in Germany. Andrew Lilico said that he was concerned with the
cascade effect of a Greek exit on the UK money supply. David B Smith said that,
under such extreme circumstances, the government should stabilise the stock
of bank deposits by allowing the budget deficit to be directly monetised until
the crisis was over. The UK budget deficit was so large that direct monetisation
would be a powerful weapon under these specific circumstances. Jamie
Dannhauser said that the Bank of England could switch from being a liquidity
provider to being a funder - like the ECB - by buying bonds from the commercial
banks.

The discussion went on to include the implications for bank balance sheets
of rating downgrades of government bonds. David B Smith said that financial
regulators almost universally demanded that banks hold government bonds on
alleged prudential grounds. However, there was now a greater probability of
major losses on sovereign debt than there was on lending to households and
businesses. This meant that such officially imposed balance sheet constraints
served no socially useful purpose and mainly served to allow fiscally profligate
governments to crowd out potential private-sector borrowers without having
to pay the normal interest rate penalty. David B Smith added that the banking
sector (and pension funds) would suffer large capital losses if real interest rates
simply returned to more normal levels, or inflation premiums rose, causing
nominal bond yields to rise and capital values to fall. However, such losses
would happen far more dramatically if governments substantially defaulted by
haircutting their debt obligations.

Jamie Dannhauser added that the difficulty of measuring financial services
and the possible overweighting of bank services in the official measure of GDP
in the base year of 2008 may have been giving a false picture of where the
economy currently was situated. Trevor Williams said that the political climate
had created perverse policy reactions that lead to credit tightening when the
crying economic need was for a loosening. He said that regulators had to accept
that the current situation was partly of their own making through the creation of
perverse incentives. Further tightening of the regulatory framework at this stage
would make things worse not better.

David B Smith concluded the discussion by suggesting that the uncertainties
discussed in the meeting were such that the committee were in the position
of a panel of doctors confronted with a patient with a life-threatening but
undiagnosable condition. His concern was not so much that the patient would
not recover if left well alone, but that ill-advised medical interventions carried
out by quack doctors would definitely prove fatal. The sight of politicians and
regulators crowding round the British economy with their metaphorical leaches,
bleeding cups, and trepanning drills did not inspire confidence, to put it mildly.
The Chairman then called on the committee to cast their votes and make their
comments on monetary policy. Kent Matthews suggested that they should
expand on their views on unconventional monetary policy since no one was
calling for a rise in interest rates.

Comment by Roger Bootle

(Capital Economics)
Vote: Hold Bank Rate.
Bias: Increase Quantitative Easing and carry on increasing it as necessary.

Before he left the meeting, Roger Bootle had stated that he largely agreed with
the assessment of Trevor Williams. The global economy was approaching an
existential crisis. Greece and possibly Portugal would have to exit the euro. The
worst of all outcomes for the world economy was for the euro crisis to drag on. A quick break-up would create immense damage in the short run but the recovery would be faster and, correspondingly, the better option for the world economy.

The potential for a banking crisis that was several times worse than the Lehman
one could not be excluded. One ray of sunshine was that inflation would fall
below 2% by the end of this year. Those in work would benefit from this. The
housing sector could still create problems and a weak economy would continue
for two or more years. Since inflation expectations were down, QE could be
used more effectively. He therefore voted to maintain the rate of interest and to
increase QE

Comment by Jamie Dannhauser

(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: Aggressive QE as the euro-zone situation worsens.

Jamie Dannhauser said that QE had been the correct policy response at the
beginning of the crisis and that it remained the correct response now. QE had
to be used to offset the effects of tighter conditions in the bank funding markets.
Greece was likely to exit the euro-zone within twelve months and could well be
followed by Portugal, in his opinion. The responsibility of the British government
was to insulate the UK banks from the seemingly inevitable break up. Unless
conditions in financial markets improved markedly, additional asset purchases
could be needed soon. If the euro area situation worsened, the Bank of England,
possibly in co-ordination with HM Treasury, should expand its QE programme
dramatically, going beyond gilts to bank debt (including covered bonds and
ABS) and potentially even riskier assets. In the event of a disorderly Greek exit
from monetary union, preventing a rapid appreciation of sterling would also be
important.

Comment by Anthony Evans

(ESCP Europe)
Vote: Hold Bank Rate.
Bias: Use QE to stabilise money supply to target nominal GDP.

Anthony Evans said that the problem facing the British monetary authorities
was the necessity to make policy decisions based on predictions of what was
going to happen to the euro-zone. Policy should not be based on pre-empting
disaster, although the Bank of England should be on standby to respond to
clear signals of financial distress. He said that he was hesitant to engage in
further QE especially when inflation was above target and the money supply
was rising. Indeed, he did not think that QE was compatible with the Bank
of England’s attempt to keep popular inflation expectations at 2%, and that
forecasts of CPI returning to target by the end of 2012 constrained its impact.
The fact that inflation targets had been more honoured in their breaching than
their observance in recent quarters suggested a need to re-examine the whole
monetary regime. The policy focus should be to buttress the broad money
supply to prevent nominal GDP from falling.

Comment by Andrew Lilico

(Europe Economics)
Vote: Hold Bank Rate; hold QE.
Bias: To raise rates.

Andrew Lilico said that he was mystified as to the purpose of monetary policy
since there appeared to be no robust inflation target to speak off. The policy
discussion was about what to do in the case of a euro-zone collapse. Greek
default could occur in the next two months, in which case QE should not be
viewed as last resort lending. The Bank of England should not stop banks from
going bust. It was likely that monetary policy had gone as far as it could. We
may be close to the point where the interest rate had to revert to a Wicksellian norm - i.e. a real rate of something over 2%. The rate of interest could not stay
at the current level forever. The interest rate could remain where it was in the
short term. However, a rise was appropriate if the crisis remained unresolved.

Comment by Kent Matthews

(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To raise; QE to be used only if euro crisis signals danger of UK recession.

Kent Matthews said that the problem for monetary policy was the need to know
whether the recent contraction in output was permanent or temporary. The
credit crunch that followed the banking crisis had led to considerable capacity
destruction in the Bernanke-Gertler sense. However, a permanent contraction
in output meant that GDP would not grow back to a ‘potential’ level defined by
some pre-crisis trend but rather grow at the historic trend rate from the low level reached in 2008 and 2009. Maintaining interest rates at their current low level was playing fast and loose with longer term inflation expectations.

Admittedly, the Bank of England’s prediction that inflation would fall in 2012 looked plausible. However, there remained room for doubt as to whether inflation would reach the target by the year end. Part of the uncertainty was to do with where interest rates will be in the second half of this year. We would have a better idea of whether the economy was close to capacity, or if the Bank was correct in its assessment that there was sufficient capacity in the system to continue to exert downward pressure on inflation, towards the year end. If there was little spare capacity, monetary policy was not just ineffective, it was inappropriate. Currently, we did not know where the economy was.

QE was good at stopping a downturn in the economy from turning into a
disaster, in the opinion of Kent Matthews. However, there was little evidence that
QE worked to reverse the direction into an upturn. Therefore QE should be used
sparingly and held in reserve. He was also not as sanguine about the likelihood
of a quick resolution of the euro crisis. The crisis could carry on for another
year or longer. In which case, interest rates would need to signal a movement
towards a level where real interest rates were positive. There was always the
possibility that a Greek exit became a reality in the next few months. In which
case, QE could be deployed to counter the liquidity squeeze and the ensuing
asset price deflation. In the mean time, we had to wait and see.

Comment by David B Smith

(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate, until the euro-zone situation clarifies.

David B Smith said that the decade of extreme tax-and-spend policies in the
UK between 2000 and 2010 had generated the mother of all supply withdrawals
and that the Coalition were in a state of psychological denial about the scale
of the structural fiscal problem that they had inherited. As a result, there was
a danger that policy could over-stimulate home demand relative to the supply
base, leading to chronic inflation and a worsening trade gap. If European
monetary union genuinely could not be saved, a rapid break-up was the least
bad outcome, regardless of how much political ‘loss of face’ this caused. This
was unambiguously preferable to a crisis that dragged on for several years,
leading to chronic economic uncertainty and rising social and political tensions
across the Continent. The European Central Bank had argued that a major
cause of the euro crisis was the inconsistency between the relative fiscal rigour
that had been maintained in Germany since monetary union in 2000 and the far
more profligate policies that had been adopted elsewhere. He broadly agreed
with this view and suspected that Greece, Cyprus and Portugal would all have to
quit the euro-zone during the course of 2012. However, he was more sanguine about Spain and Ireland which could regain favourable supply-side flexibility if
they returned to their earlier more disciplined fiscal stances.

The problems within the euro-zone had distracted market attention from the
issues of the long-term viability of UK sovereign debt, in David B Smith’s view.
The Coalition had inherited a dreadful fiscal mess but it had also chickened out
of taking the measures needed to stabilise the fiscal situation in the long run
and to improve the supply-side of the British economy. He was also profoundly
concerned that the domestic financial regulators had got the bit between their
teeth and were attempting to gold plate the already excessively tight regulations
stemming from Basle III and the European Union. The solution to the ‘too big
to fail problem’ was to break up the large banking groups using the normal
tools of anti-monopoly policy, not to strangle money and credit creation through
excessive regulation. Public choice theory suggested that bureaucracies always
tended to over-regulate financial institutions – regardless of the social costs and
benefits involved – because this minimised the apparent risk of embarrassing
institutional failures, even if officials were half-asleep on the job as they had
been before the crisis, and also maximised the extent of the bureaucratic
empires concerned. Monetary policy in the immediate future should be to
hold Bank Rate and to stop M4ex from falling, using the full range of monetary
tools including QE when appropriate. However, he thought that QE was best
employed when the Central Bank had to act as a lender of last resort and was
not convinced that it was an appropriate implement for demand management
purposes on a day to day basis. One reason was that it probably was not as
effective as the Bank of England appeared to believe. Another was the political
moral hazard it engendered because it allowed fiscal profligacy to become a free
good where the political and bureaucratic interests were concerned.

Comment by Akos Valentinyi

(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To tighten, unless inflation eases sharply.

Akos Valentinyi said that there remained significant inflation risks. The Bank
of England had consistently under predicted inflation in the past three years.
As a result its credibility was weak. It was difficult to see how the euro-zone
crisis would play out. It could turn out to be worse than a sovereign debt crisis.
The imbalances in the euro-zone went well beyond fiscal policy. There were
deep structural problems. The exit of Greece and Portugal from the Euro was
possible. However, and until the uncertainty in the euro-zone was resolved, the
Bank of England’s priority should be the inflation target. The inflation figures
were more transparent and better understood that nominal income, given the
delays and uncertainty of the Office for National Statistics (ONS) figures. He said
that QE should be put on hold for the moment.

Comment by Peter Warburton

(Economic Perspectives Ltd)
Vote: Hold Bank Rate; no extension of QE; reinstate the Special Liquidity Scheme.
Bias: To raise Bank Rate before the end of 2012.

Peter Warburton said that, on a global basis, the pace of private sector credit
growth had not slowed, despite the numerous surveys showing a tightening
of credit conditions. Overall, there had been no deceleration of global credit
aggregates and hence no strong expectation that the global economy would
slide into anything worse than an inventory downturn. This was not shaping
up as a repeat of the experience of 2008 and 2009. The UK was perfectly
capable of generating 1% to 2% GDP growth in 2012, even after accepting
that the Euro crisis could knock growth back by an indeterminate amount. The
Bank of England had effectively killed off the wholesale money markets and it should support collateralised alternative to the moribund inter-bank market. It
was wrong to think that UK banks could be weaned off their dependence on
wholesale markets, including securitisations, completely. There was a need to
widen the range of eligible collateral to provide greater flexibility for the banking
sector in meeting its funding requirements.

QE had induced some positive effects but these were diminishing, in Peter
Warburton’s opinion. The case for additional QE was unconvincing. The road of
pre-commitment to emergency low levels of policy interest rates was ill-advised;
the US Federal Reserve’s recent willingness to do so should not be copied in the
UK. Rather, by revitalising the wholesale markets, the Bank of England should
be looking to re-engage Bank Rate with the structure of market interest rates
later in the year with at least one token Bank Rate increase.

Comment by Trevor Williams

(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: To loosen via QE.

Trevor Williams said that the rate of interest had to remain on hold until the
situation had normalised. European Central Bank type lending could be followed
by the Bank of England but QE was probably more workable in the UK context.
QE did have an effect on ten-year gilt rates and it also minimised defaults. He
said that he was sympathetic to those banks that had responded to regulation
by increasing reserves with the central bank, because they were fearful of being
caught short of capital. However, central banks had sent the wrong message to
the commercial banks and households creating a moral hazard problem of their
own making. QE could be deployed effectively in the context of the euro crisis.
He said that QE should be extended by £75bn from its current position and even
increased up to a total stock of £500bn in case of serious fallout from the euro
crisis.

Policy response

1. There was unanimity that Bank rate should remain on hold in February and
probably until the outcome of the euro crisis was clarified.

2. There was general acceptance that the euro crisis would come to a head
in the first half of 2012 with the likely exit of Greece from the euro-zone.
However, two members of the committee felt that the crisis could continue to
be unresolved for longer.

3. Several SMPC members indicated a bias to raise Bank Rate in the future,
while accepting that this was not appropriate at the moment when QE
was a superior monetary tool. However, there was a bias to get back to a
more ‘normal’ rate of interest as soon as this became practical.

Date of next meeting Tuesday, 17th April 2012.

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 (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), 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.