Sunday, July 28, 2013
Shadow MPC votes 6-3 for half-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 9th July, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 1st August. Five SMPC members wanted an increase of ½%, another voted for a ¼% increase, and three voted to hold Bank Rate.

This vote distribution implies a ½% increase on normal Bank of England voting procedures. Although opinions differed on many issues, there was broad agreement on the shadow committee that over-regulation of the financial sector was a clear and present danger to the UK economic recovery.

The six that wanted to raise rates cited a variety of reasons. Broadly, one was that monetary policy was ineffective with interest rates at these levels and a rise was required so that a cut to help ward off a future crisis, such as one in the euro area, would be possible. Another reason was that with inflation exceeding its target for so long, the Bank of England ran the risk of being seen to be not serious about the inflation objective.

This is linked to the point that inflation was the Bank’s target not growth, and if the latter was the target, then the policy had not worked since the recovery remained feeble. The third broad final point of those wanting a rate rise immediately was that monetary policy cannot solve the real problem of the economy, which is a supply side one. The three dissenters argued that the time was not yet right for a rate rise and the risk of triggering a further crisis was simply too high at this point. Forward guidance was seen by some as a target and not as policy, and there were doubts about how effective it would be without some supportive policy action from the Bank of England.

Minutes of the meeting of 9th July 2013

Attendance: Philip Booth, Jamie Dannhauser, Joanna Davies (Observer - Economic Perspectives), Anthony Evans, Graeme Leach, Tim LeFroy (Observer – IEA Intern), Andrew Lilico, Kent Matthews (Secretary), David B Smith, Peter Warburton, John Webster (Observer - IEA Intern), Trevor Williams.

Apologies: Roger Bootle, Tim Congdon, John Greenwood, Patrick Minford, David Henry Smith (Observer – Sunday Times), Akos Valentinyi

Chairman’s introductory comments

The Chairman said that he would be unavailable to help with the production of the Minutes as he was attending his son’s wedding in Vietnam and said that Trevor Williams would substitute for him in his absence. He also said that the revision to the national accounts announced shortly before the SMPC gathering had noticeably affected the value figures as well as the volume figures, and that the revised data went back to the start of 1997 only. The ONS has promised the revised historic database sometime after July 31 following the publication of the Blue book.

He then invited Peter Warburton to present his analysis of the global and domestic trends.

Economic situation

Peter Warburton distributed a pack of charts and tables for reference. He began by observing global private sector credit trends, noting that bank lending was undergoing a recovery – albeit insipid. Outstanding corporate sector bond debt was accelerating, while financial institutions were on the cusp of re-leveraging as growth in debt edged above nominal GDP growth for the first time since Q4 2009. Overall, he noted that there had been a gradual improvement in private sector debt growth, but it remained feeble enough – at just below 5% per annum – to keep central banks fully engaged. He observed that surging corporate credit issuance had not displaced bank lending.

Referring to the charts and tables of global monetary growth Peter Warburton observed a similar profile to that of global credit. Global broad money growth of just above 7% per annum reflected a mixture of modest acceleration in developed economy money and gradually decelerating emerging market money. The trends in broad money growth were sufficient to support a faltering recovery in the advanced economies. US bond yields had surged in the past month with implications for debt service and future fiscal policy. Recent US research shows that QE had positively impacted high net worth households but had not improved the net worth of other, less wealthy households. Global nominal GDP growth had slowed materially in the past two years but had steadied since the middle of 2012 and improved slightly in Q1.

Adoption of path-dependent QE in the US, QQE (quantitative and qualitative easing) in Japan, and with hints of forward guidance on interest rates by the ECB and Bank of England, meant policy imparted a reflationary bias to the global economy. However, there were three headwinds to consider. First, the difficulty the US Federal Reserve had encountered in the communication of its QE tapering message suggested that bond yields would announce actual monetary tightening long before the Fed does. Second, the deliberate liquidity squeeze and recent clampdown on shadow banking activities in China might spark a greater slowdown in economic growth than intended. Third, the disinflationary effects of Yen depreciation on other economies’ export pricing in the region.

In contrast to the stubbornly high rate of unemployment in the advanced economies, the unemployment rate in emerging market economies had been falling. This was primarily a reflection of the strength of domestic demand, since world export growth remained very subdued, even among emerging nations. Manufacturing Purchasing Managers Indices (PMIs) for Japan had seen an improvement but China and India were disappointing. World inflation, on a GDP-weighted basis, remained moderate at just over 2%, but on a population-weighted basis, which took greater account of high food weightings in populous emerging nations, inflation was much faster at 6.5%.

Turning to the UK, Monetary Financial Institutions (MFI) negative net lending growth indicated that the Funding for Lending Scheme was struggling to reach its desirable 5% to 9% growth band. All past attempts to boost the housing market had not succeeded but the latest policy, ‘Help to Buy’, appeared to be bearing fruit with housing transactions showing an encouraging rise, backed up by a rising UK construction PMI.

The revised figures for GDP showed a disturbing downturn in capital expenditure. However, on the plus side the manufacturing PMI had maintained its solid second quarter performance. Domestic market conditions had improved while overseas demand had strengthened. The PMI service sector had accelerated to its highest level since March 2011 and there was some improvement in consumer confidence.

The decomposition of retail price inflation revealed a stubborn underlying private sector inflationary trend. The labour market paradox remained with a rising employment rate and increasing weekly hours worked and yet very weak annual growth of the wage bill. There was a suggestion in the data that labour incomes were pushed forward into Q2 to benefit from the lowering of the top tax rate. The worsening of the UK’s current account deficit had continued and the outlook for Sterling remained unsettled ahead of Bank of England policy announcements in August.

Discussion

David B Smith thanked Peter Warburton and opened the meeting out to general discussion. Andrew Lilico began the discussion with a reference to Simon Ward’s work on the M1 narrow money/nominal income relationship and suggested that they should consider which monetary measure was the appropriate indicator in this economic climate. There followed a discussion as to whether M1 was a leading or coincident indicator. Jamie Dannhauser and David B Smith said that M1 was a coincident and not a leading indicator.

There was a discussion about the implications of forward guidance but Andrew Lilico said that the Bank had no credibility for sticking to targets and that forward guidance would have no effect on expectations. He said that any lenders that were making loans to borrowers conditional on interest rates this low had no business doing that. He added that the worry was that nominal income growth would raise the balance sheet of banks, which would lead to an increase in bank lending, and the cycle would restart with inflationary growth.
Graeme Leach discussed the sustaining of the higher than normal zombie companies on the commercial banks books. Andrew Lilico said that an upturn in nominal income growth would see zombie companies being wiped out, as typically more companies die off early in recoveries than during recessions.
Trevor Williams said that normally lending would rise with an improvement in balance sheets but with on-going delevering and the leverage ratios being imposed this might not happen to the same extent. Andrew Lilico was sceptical that the Bank of England would maintain its hard stance on leverage ratios in the upswing. David B Smith said that George Osborne was thinking in terms of the political business cycle not the wider public good.

Peter Warburton said that some supply side adjustments were occurring. He said that real wage growth had fallen and hours worked were growing. David B Smith said that the ONS was trying to do the impossible by measuring intangibles such as software in the process of development in the capital expenditure figures.

Andrew Lilico asked if the rise in bond yields were the result of withdrawal of QE or rising expectations of growth. Trevor Williams and Jamie Dannhauser said that the bond market in the UK was heavily influenced by the US bond market and the influence from QE was likely to be smaller than that from global capital flows.

David B Smith called on the committee to make their comments on monetary policy. Philip Booth said that since we would not get unanimity on a change in interest rates he asked if the committee would make a united stand on the negative effect of bank regulation on the ability of the banks to fuel the recovery. Jamie Dannhauser said there was an anti-commercial-bank culture within the Bank of England.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate ½%.
Bias: To raise, and neutral on QE.

Philip Booth said that inflation had been above target for four years. The Bank of England was given the task of targeting inflation. Growth being high or low was the result of other policies of the government that had affected the supply-side and which monetary policy could not address. The existing situation pointed to a tightening of monetary policy. Philip Booth said that the underlying problems were on the supply-side. He said that the productivity problem could not be solved by monetary policy and that Bank Rate should be raised by ½%, given the forecast for inflation, and that there should be no further QE.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: Monetary easing.

Jamie Danhauser said that he was encouraged by the recent data. The PMI surveys were pointing in the right direction and monetary growth was trending back towards reasonable rates. However, the revised indicators showed that output was even further below the pre-recession peak. There was considerable slack in the economy. He said that it was hard to believe the productivity collapse that the data was indicating. He said that he was also concerned about the hysteresis effects of the recession, and that euro issues were still around. With the global economy still weak, there was a strong case for the maintenance of the current monetary position.

Comment by Anthony Evans
(ESCP Europe)
Vote: Raise Bank Rate ½%.
Bias: To raise.

Anthony Evans said that he was concerned about the reverence given to the new Governor. He said that there was little scope at this point for monetary growth to generate real growth, and was disappointed that the Governor seems to have placed forward guidance as a more important issue than nominal GDP targets. He recognised the danger of early tightening but rates were too low and if it is a choice of rising rates too early or too late it was better to be too early. He acknowledged that the economy was fragile but believed that current policy was making it even more fragile. The squealing noises that came out following the Fed moves was all the more reason to start the process of normalisation. There was so much uncertainty about how markets would react to a rate rise that it was almost worth doing as a controlled experiment to test reaction.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and hold QE.
Bias:Neutral.

Graeme Leach said that he has been forecasting an L shaped recovery for some years but broad money growth and a wide range of other indicators now point to a recovery somewhere between L and V shaped. Growth in M4ex at around 5% suggested that GDP growth could be 1½% this year. M4ex was providing a tailwind, which suggested that economic prospects were better than at any time since the financial crisis began. However, significant headwinds remained. Firstly, from continued deleveraging in both public and private sector debt. Secondly, from balance sheet adjustment by the banks and tight regulatory capital controls. Thirdly, from the squeeze on household real income from inflation running ahead of earnings. The household consumption squeeze was being compounded by the relatively low savings ratio at this stage of the economic recovery. Fourthly, the ever-present threat of resumption in the euro crisis. Finally, the reality that any recovery will contain within it, the seeds of its own destruction, due to a potential normalisation of interest rates at both the short and long end – although the other headwinds meant that this threat was relatively benign at present.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate ½%; hold QE.
Bias: To raise rates.

Andrew Lilico said that he had no faith in the pronouncements of the Bank of England and that forward guidance was only a target forecast. Why should anyone believe that interest rates will stay at ½%? There was an intrinsic impetus to the UK economy caused by the timing of projects. Capital spending projects had been delayed and there was an opportunity for a catch-up. The euro crisis may well return, or some other euro crisis arise, so it was forlorn to hope for a “good moment” to raise rates. Mortgage lending to borrowers that depended on rates being so low should not be made.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate; ½%; hold QE.
Bias: To raise. QE to be used only when the euro crisis returns.

Kent Matthews said that in January he voted for a ½% rise largely because of microeconomic issues. These issues remained. The loanable funds market was not allowed to operate efficiently because of Bank Rate remaining low for so long. He reminded the committee of what he said at the previous physical meeting concerning the support of zombie companies. Risk was being ‘under-priced’ for the zombie ‘insiders’ whereas it was probably ‘overpriced’ for the outsiders who faced a bank credit crunch. The Schumpeterian process of ‘creative destruction’ only worked if credit markets were well functioning and exceptionally low interest rates for this length of time have generated a misallocation of resources to the low areas.

Unlike Andrew Lilico he did not think that forward guidance was ineffective because of the lack of credibility of the Bank. On top of the micro issues he said that there were considerable macroeconomic dangers from forward guidance which was meant to influence expectations. The potential for the building up of inflationary expectations and macroeconomic instability followed the analysis of Friedman’s critique of pegging the rate of interest. Sterling had already weakened on the prospect of interest rates remaining low for some time. Since nobody knew with any certainty the size of the output gap, and OECD and IMF estimates had been reducing it over time, the next thing we will observe is inflation rising and moving away from the target. Interest rates had to start rising now to help in the process of rebalancing the economy.

The inevitable return of the euro crisis would require a tractable monetary response in the form of an interest rate cut and additional QE. An interest rtate cut would have no effect at current levels.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate ½%. Hold QE.
Bias: To raise Bank Rate.

David B Smith said that the history of the 21st century had been about the wrong type of supply-side policy. Supply withdrawal was treated as a demand withdrawal. A tax-and-spend induced supply withdrawal could not be offset by monetary policy. Long-term interest rates were distorting monetary policy to allow the housing market to be sustained. Forward guidance was pointless because either the authorities would pursue the policies that they would have done in any case or they would have to break their commitments. The vogue for nominal GDP targets ignored the fact that nominal GDP can easily generate perverse policy signals. One reason was that just over 48% of GDP was in the public sector whose behaviour can be very different to that of the non-bank private sector on which monetary policy operates. Another was that imports were a negative item in the GDP identity whose cost rose if sterling fell, perhaps because of an unduly lax monetary policy.

Weaker sterling had not had the stimulatory effect that was expected by UK officials. The main effect had been to push up prices. However, the Tax and Price Index was only up 2.2% on the year in May and real earnings had not been squeezed quite as much as one might deduce from the CPI and RPI. It was increasingly difficult to use the data produced by the ONS for prediction, as it was so unstable.

He added that he was surprised that there had not been more discussion of the extent to which European politics will be influenced by the outcome of the September elections in Germany. The German population was already restless about the fiscal burden that was being asked of it. The ECB had been utterly politicised and the German taxpayer had every right to feel angry and misled. Angela Merkel was desperately trying to paper over the cracks in the short term but the celing could well come down in late September.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate ¼%; no extension of QE.
Bias: To raise rates conditional on growth.

Peter Warburton began by stating that he was doubtful of the efficacy of forward guidance in the UK in the context of rising US government bond yields. The impressive effect of calendar-based forward guidance in the US in the first half of last year was opportunistic and probably not replicable in the UK. Peter Warburton said that, in any case, there was a stronger case now for tightening as business and consumer economic confidence was rebuilt and output growth became more robust. He still preferred to begin with an increase in the rate of interest of ¼% as even a small rise would have a negative psychological effect. However, the UK private sector remained more vulnerable to inflationary pressures compared to other large European countries and the Bank of England could not afford to ignore persistent breaches of its inflation objective, much less embark on a new policy of monetary relaxation. There were compelling reasons to diversify some of the £375bn of existing QE into a portfolio of other assets, including securitised property, infrastructure and possibly even SME (small and medium-sized enterprises) assets as a means of lowering the regulatory burden of the banks that relates to these loans. The fact that the ‘Bad Bank’ debate had revived in recent weeks was a reminder of how little structural progress has been made to restore health to the UK banking system.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold.
Bias: Neutral.

Trevor Williams said that the revised data of the economy showed how risky it was to draw firm policy conclusions from recent data. The latest figures could therefore prove to be a ‘false’ positive in terms of the pace of the recovery, despite the bigger output gap indicated by revised figures. The underlying picture was of a ‘wrong’ type of growth, unsustainable at the H1 pace. Household gearing was going up again after dropping to just above 142% of annual disposable income in Q4 last year, at a time that real wage growth was negative. The expenditure mix could be wrong for a sustainable upturn in the economy, as consumer spending was driving growth at a time that household budgets were under pressure. Continued slow European growth would be a drag on UK exports in 2013. As such, the state of the real economy did not justify a rise in the rate of interest. A real risk was that a rise in the Bank Rate would increase the frequency of household defaults and corporate failures, hitting confidence, one of the bedrocks of the recovery.

Policy response

1. On a six to three split the committee voted to raise Bank Rate in August.

2. Five of the SMPC members voted to raise rates by ½% and one voted to raise it by ¼%.

3. In consequence, it was recommended that Bank Rate should be raised by ½%.

4. All six members that voted to raise interest rates indicated a bias to raise rates further.
5. There was unanimous agreement that excessively onerous financial regulation was hindering the efficient working of the banking sector.
Date of next meeting.
Tuesday 15th October 2013.

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 (Beacon Economic Forecasting and University of Derby). 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 Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), 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 Bank Commercial Banking). 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.