Saturday, October 05, 2013
Shadow MPC votes 5-4 to hold rates despite stronger growth
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, finalised on 1st October, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be left unchanged on Thursday10th October. Among the dissidents, two members wanted an increase of ¼%, while two advocated a rise of ½%.

There was considerable agreement on the shadow committee that the UK economic recovery had gathered momentum in the second quarter and that the evidence from business surveys suggested that growth might have accelerated in the third quarter, for which there is almost no official data at present.

There were two main reasons why a majority of the SMPC did not want to raise Bank Rate; even if some ‘holders’ believed that a rise might be appropriate in a quarter or two’s time. One reason for holding rates was that there was still significant excess capacity available and that inflation would stay subdued until this was used up.

A second reason was concern that the economy had not achieved ‘escape velocity’ and could slow early next year, either for domestic reasons or because of adverse shocks emanating from overseas. These included the fear that the recent Eurozone crisis was dormant – but not dead – and worries over the potential adverse consequences of the fiscal standoff in the US. In contrast, the more hawkish SMPC members thought that the most common error was to underestimate the pace of the upswing at this stage in the business cycle and that recovery was likely to be maintained, unless there was another adverse shock to the money and credit creation process caused by further misguided regulatory attacks on the banking system.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Hold Bank Rate for next three months and use rate setting and QE to achieve growth in broad money of 3% to 5%.

The UK economy is recovering and now achieving above-trend growth. Survey evidence is clear-cut, with the monthly survey carried out by the Confederation of British Industry (CBI) – which is mostly of manufacturing – showing the highest balance of companies expecting to raise output since the mid-1990s. Past experience is that above-trend growth can be maintained for several quarters without provoking more inflation, as long as the revival is taking place from a depressed condition in which the level of output started well beneath trend. In fact, the September 2013 CBI balance on price-raising intentions was very low.

Money growth is satisfactory, but not particularly high. M4ex (i.e., broad money excluding balances held by intermediate ‘other financial corporations’ or quasi-banks) was 4.5% higher in July 2013 than a year earlier, but the annualized growth rate in the three months to July was only 3.3%. Reasonably strong growth rates of demand can be reconciled with these rates of money growth, which are modest by long-run standards, largely because interest rates are more or less at zero, and people and companies are finding ways of economizing on their holdings of unattractive non-interest-bearing money. In other words, the desired ratio of money to expenditure may be falling. The argument for ending Quantitative Easing (QE), which has not been in effect since the July meeting of the Monetary Policy Committee (MPC) anyway, and/or raising interest rates has more cogency than at any time in the last five years. However, analysis of data from the Bank of England shows that over the last year money growth would have been negligible in the absence of QE.

Despite the impetus that is supposed to have been given to extra bank credit by the Funding for Lending (FLS) and ‘Help to Buy’ schemes, banks are still not expanding their risk assets (i.e., their portfolios of loans to the private sector, and securities issued by companies and financial institutions) at anywhere near the rates that were normal before the onset of the Global Financial Crisis (GFC) in 2007. According to the Bank of England’s latest Money and Credit press release, “M4Lx excluding intermediate OFCs – i.e., lending by genuine banks to genuine non-banks – increased by £4.6bn in July, compared to the average monthly decrease of £0.9bn over the previous six months”. The three-month annualised and twelve-month growth rates were 0.3% and minus 0.5% respectively. So the July number was much stronger than that in other recent months, but it was far from spectacular. Before the GFC, the UK’s banks often expanded their loan assets by £15bn or £20bn a month! It cannot be overlooked that banks are still being forced to adjust to extra regulatory burdens, including the requirement that they keep their overall leverage ratio at a fairly high figure regardless of the quality of their assets.

Most of UK banks’ strategy re-appraisal from the regulatory upheavals of 2008 and 2009 now seems to be complete. With base rates only a little above zero and the pound still far below its international value before mid-2008, the UK economy is at last making a decent recovery. However, the money creation due to QE was stopped in July. With QE no longer boosting the quantity of money, a few months of extra data are needed before analysts can be confident that the UK banking system is once more in an expansionary mode. It may be that Britain’s banks can readily boost their risk assets while complying with all the new rules and regulations. Perhaps, but one has to be sceptical. The immediate inflation prospect is fine. It remains too early to advocate an increase in base rates. Nevertheless, the situation might be quite different six months from now if the banking system really is on the verge of – or already in the throes of – rapid credit expansion. (I doubt that this is likely, but have an open mind and let us watch the data.)

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Over the last month, more evidence has emerged of a strong bounce in UK output. Complete National Accounts data for the second quarter confirm that real GDP expanded by 0.7%, with growth led by housing investment and exports. First-quarter growth was revised up by 0.1 percentage points (from 0.3% to 0.4%). Market sector output, which removes the output of government and charities, the imputed rent of owner-occupiers etc. from real GDP, grew even more swiftly. Indeed, this was also true of the first quarter, when market output expanded by 0.6%.

Measurement of financial sector activity remains extremely tricky, with Office for National Statistics (ONS) data at times diverging wildly from survey-based indicators. It makes sense therefore to track non-financial market sector output as well. While this does not affect the interpretation of the first quarter data, it suggests an ever more rapid upswing in activity in the second quarter, when annualised growth in the non-financial market sector output was 5½%.

The latest GDP figures are not however uniformly positive. Revisions to the expenditure breakdown were slightly negative on balance, revealing stronger support from inventory accumulation and government spending, and on-going weakness in business investment. The continuing sluggishness of nominal spending also remains a worry. Annualised growth in private-sector home demand was less than 4% over the first half of this year, with overall Nominal GDP (NGDP) growth even weaker. Solid output growth in the first half of this year largely reflected very subdued economy-wide inflation as measured by the GDP deflator.

The weight of survey evidence supports the official ONS output data for the second quarter. Indeed, several different business surveys point to even faster growth in the current quarter. If historical relationships continue to hold, (annualised) market sector output growth in 2013 Q3 could be in excess of 5%. The latest composite Purchasing Managers Index (PMI) climbed to a sixteen-year high. The same is true of the most recent European Commission economic sentiment index as well.

There are also encouraging signs of rapidly improving risk appetite amongst Britain’s largest companies. Deloitte’s third quarter survey of UK Chief Financial Officers (CFO’s) highlighted a substantial pick-up in expected capital spending and credit demand over next twelve months. For the first time in six years, a net balance of responding CFOs saw the current environment as a good time to take on additional balance sheet risk.

The apparent revival of ‘animal spirits’ is especially welcome. Elevated uncertainty has been a major hindrance to capital spending for some while. If sustained, upside growth risks – e.g., from business capital expenditure and house-building – could materialise. Given this, and the strength of near-term growth momentum, there is no longer a need to maintain a bias towards additional monetary ease.

However, the case for a withdrawal of monetary stimulus is weak. Monetary indicators do not suggest a rapid pick-up in demand growth. While bank lending to the private sector is now growing, the more relevant indicator – broad money – is at best consistent with NGDP slightly below its long-run average. Real output may now be growing strongly, but the level of activity remains hugely depressed. The economy is operating with considerable slack, especially within the labour market, and as a result can sustain a prolonged period of robust growth. While the financial crisis has undoubtedly done permanent damage to the sustainable level of UK output, there are good reasons to believe that supply capacity will be endogenous to the pace of demand growth in the years ahead to some degree. Some of the apparent supply-side weakness that has emerged since 2007 should be reversed in a robust recovery.

Ultra-easy monetary policy is still needed in the UK. Indeed, with the Eurozone crisis far from over (witness the on-going Italian political farce, the rise of far-right parties in Austria, Holland and Greece, the bribery scandal engulfing the Spanish prime minister’s party etc.) it seems complacent to downplay external risks to the UK recovery. Domestic conditions are much improved over the last six months, but ‘escape velocity’ has not been reached.

Comment by Anthony J Evans
(ESCP Europe)
Vote: Raise Bank Rate by ½%.
Bias: Further rises in Bank Rate.

Generally speaking, the growth figures are healthy. Real GDP rose by 0.7% between the first and second quarters, and the September release of the national accounts revised up the growth between 2012 Q4 and 2013 Q1 from 0.3% to 0.4%. The growth rate for NGDP in the second quarter of 2013 was 3.5%, which is the first time it has been above 3% since 2011. Although this is below the pre-crisis trend, it is still a reasonable rate. Within these figures, there are some concerns about business investment. The growth rate of private investment (i.e., business investment plus private sector dwellings) has fallen steadily through 2011 and 2012, and is now virtually zero. A large increase in general government investment should not be treated as a sustainable solution.

In recent months, I have voted for rate rises on the grounds that moderate growth is sufficient evidence that the economy is recovering, and there appears no reason to change that now. External factors – such as the Eurozone crises or the regime uncertainty driven by the US fiscal cliff – remain muted. Broad money continues to grow above 4% on an annualised basis and the monetary stance can be considered to be accommodating. It could be argued that, had the Bank of England utilised an effective exit strategy, and began the process of interest rate normalisation in an anticipated way, there would be less fear about the impact of rate rises now. However, every month that passes prevents expectations from adjusting. It would be imperative that rate rises are accompanied by effective communication, and forward guidance is intended to do the exact opposite. Consequently the Bank of England has painted itself into a corner – they are staking their reputation on a commitment to a policy that is becoming increasingly ill-suited to the state of the economy. It would shatter confidence for the Bank to reverse course and raise rates whilst inflation and unemployment are at their current levels. However, this opens up the prospect of a battle of wills with financial markets driven by stubbornness. These are all examples of regime uncertainty that has been introduced by forward guidance.

In addition, there is an emerging concern that the UK housing market is demonstrating the same sort of exuberance that led us into the 2008 crisis, and the Bank of England’s assurances that they are able to spot, and prick, asset bubbles lacks credibility. One of the lessons from the previous boom is that they can occur under a stable consumer price level; therefore a slight fall in the rate of increase in the Consumer Price Index (CPI) figures should not be interpreted as evidence against a bubble. Furthermore, whilst shortfalls in aggregate demand are undoubtedly a key reason for the present state of the economy, this does not mean that aggregate demand is still too low. On the contrary, output figures, unemployment figures, and price figures all suggest the problems lie elsewhere.

Ed Miliband’s recent conference speech has raised the prospect of a return to 1970s style socialism. However, existing policies are causing immense damage to both the short run and long term growth rate already. The various ad hoc policies intended to improve lending to SMEs, and assist first time buyers, involve government interference in the allocation of capital. We should not be surprised that this leads to negative unintended consequences. One of the major downsides of existing QE is the public finance implications of the authorities becoming such a large buyer of government debt. But any rebalancing towards non-gilt assets would reduce further the neutrality of the central bank, and cement its role as a market participant, rather than as a market regulator.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate at ½%; maintain asset purchases at £375bn.
Bias: Use Bank Rate changes and QE to keep annualised M4ex growth at 4% to 6%.

After an increase of 0.7% quarter-on-quarter in real GDP in the second quarter, the UK economy showed numerous further signs of improvement in the July-September quarter across several sectors. This upswing in momentum can be expected to continue through the year end, though not at the same rate. Nevertheless, despite the recent upturn, the level of activity still languishes below its pre-crisis peaks, so the recovery is still in its very early stages.
The official index of manufacturing production increased by 2.0% (month-on-month) in June and 0.2% in July. Similarly the more important index of services (which accounts for close to 80% of the early, value-added GDP estimates) increased by 0.7% in May and 0.6% in June. Survey data such as the PMI’s have increased even more sharply. The manufacturing PMI increased strongly to 57.2% in August, its highest level for two years, and marking six successive months of increase. The service sector PMI has been above 50 since January, increasing moderately to April and then soaring to reach 60.2% in July and 60.5% in August.

Employment has continued to rise steadily reaching 29.836 million in June on the official definition and 32.486 million on the basis of total jobs (which includes those doing more than one part-time job), an increase in both cases of over one million since the employment trough in 2010. In addition the housing market has notably strengthened during recent months both in terms of production, prices and the availability of finance. House-building starts increased to 29,510 in the second quarter, about 65% of the pre-crisis level, while the number of new mortgages on dwellings has increased to 61,000 in June, again still only about half the pre-crisis level. Meanwhile, average national house prices increased by 3% to 6% over the preceding year in August, although prices in London and the south-east are up by as much as 8% over the same period.

For some analysts, the precise source of this recent upturn is somewhat of a puzzle. Some may claim that the Bank of England’s new ‘forward guidance’ together with the two government schemes to support bank lending – the FLS – and the initial phase of Chancellor George Osborne’s ‘Help to Buy’ scheme – have contributed to the upturn in performance. However, overall bank lending is still declining while the shift in the Bank’s policy is far too recent to have contributed. In fact, Governor Carney announced the new forward guidance strategy only in August. Under the new guidance, the Bank will not consider any rate increases until after Labour Force Survey (LFS) unemployment has declined to 7% – subject to three conditions: that inflation and inflation expectations were within suitable bounds, and that financial stability was not threatened. With unemployment at 7.7% in June, the Bank of England has forecast that its 7% unemployment goal would not be reached until 2016.

Realistically, there are three possible sources for the recent economic upturn: first the upturn in the Eurozone; second an easing of fiscal restraints; and third the delayed results of earlier monetary relaxation. The upturn in the Eurozone is not likely to have had much influence. While it is true that UK exports did increase by 3.6% quarter-on-quarter in 2013 Q2, it is domestic demand that has been strengthening more consistently, and since June sterling has been appreciating. Consequently, if exports were a source of renewed growth, this stimulus would be fading in the second half of the year. Second, fiscal easing is a more plausible contender because fiscal spending can have a rapid impact on domestic demand. Since February, government cash outlays have increased steeply, mainly due to higher spending on current goods and services plus transfers, though not on investment. But again, this appears more like a statistical fluke because the government has not changed course – at least officially – and the Coalition will be keen to show that it can maintain budgetary discipline and still generate a recovery.

The third possibility – earlier monetary relaxation – is a much more plausible explanation. Since August 2012, M4ex – i.e., the money supply held by households and mostly non-financial companies – has been growing at a fairly steady 4% to 5% per annum, which is ahead of the rate of inflation, and therefore steadily building up purchasing power in the hands of the private sector. The growth of the broader M4, which includes the money balances of financial institutions and bank-like intermediaries, has also recently turned positive on a year-on-year basis. The upturn in both series is, in turn, attributable to earlier QE or asset purchase operations by the Bank. Although wages and salaries have been falling in real terms, the rise in employment will have gone a long way to compensate for the weakness in incomes.

It therefore appears as though the seeds of a sustainable recovery have been laid thanks primarily to monetary policy. Given the high margin of unused capacity in both labour and capital markets, I would expect the recovery to be a sustained one, accompanied by low inflation for at least the next three years, possibly even longer. In this environment, the Bank should hold rates stable at ½%, but be prepared to undertake additional asset purchases if monetary growth plunges once more, or the Eurozone crisis flares up again. Rate increases at this stage would damage the prospects for economic recovery, and should be delayed until the recovery is substantially more secure.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral but use QE to keep growth in M4ex broad money at 4% to 6%.

Received wisdom tells us that the UK economic recovery is ‘in the bag’. Well, yes and no. The pick-up in broad money supply growth, as measured by M4ex, over 2012-13 is certainly being manifest in real economy and survey measures over recent months. Furthermore, there seems little doubt that the UK outlook is better than at any stage since the onset of the financial crisis. So yes, the outlook looks better, but no, there is little room for complacency. While the UK economy is likely to perform well over the next six to nine months, that does not mean it has attained ‘escape velocity’. Any acceleration in growth is unlikely to exceed potential output growth, which is probably around 2% at most.

Consequently, this recovery continues to be characterized by weakness on both the demand and supply side of the economy. In addition, the UK banking system is unlikely to deliver ‘escape velocity’ when regulatory constraints and balance sheet reduction suggest that the broad money supply will not expand sufficiently to maintain trend GDP growth, without active QE by the Bank of England.

On the supply side, the negative impact of the extent and range of the state on the incentive to work, save and invest means that potential output growth is weak. Faced with the choice between radical supply side reforms and politically expedient demand side reforms, the Government has chosen the latter.

On the demand side, the Government continues to pursue statist solutions to state created problems, with ‘Help to Buy’ the latest example. Given the steepness of the housing market supply curve, active measures to stimulate demand are more likely to be manifest in higher prices than increased output. More people may be able to get on the housing ladder, but they will pay more for the privilege as well. Government intervention on the demand side of the housing market will only push up prices. Government intervention on the supply side of the housing market, with genuine planning liberalization, would drive down house prices. Of course, the cynic might say that with less than two years to the next General Election, all that matters to the Government is the vote buying wealth effects on consumption which might ensue from an upwards spike in house prices.

House price growth may well create a limited ‘feel good’ factor and generate positive wealth effects on consumption, but significant constraints remain. Inflation continues to run ahead of earnings growth and the savings ratio rose in 2013 Q2. Rewind to the economic recoveries in the 1980s and 1990s and real income growth was much stronger, as was the potential stimulus to consumption from a rundown in the savings ratio. This is not to argue against a consumer stimulus, merely to argue that it will be more muted than in previous economic recoveries.

Thus far, all the analysis has focused on the economic outlook from a ‘Made in Britain’ perspective. Obviously the global dimension is critical also. The UK recovery could run out of steam in late 2014 of its own accord. Throw in a potential resurrection in the Euro crisis, a hard landing in China and jitters in the US bond market and the coming years appear as uncertain as the recent past.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE by £25bn per month.

A fault line is opening up between Conservative politicians keen not to bring the economy to another grinding halt and the ‘Taliban tendency’ among the regulatory establishment, to use Vince Cable’s delightful and, for once, quite accurate phrase. In particular, it had begun to dawn on the Conservatives and maybe also the Lib Dems, around a year and a half ago, that the economy’s previously glacial recovery had something to do with the lack of credit for small businesses and first-time home buyers. This in turn could be traced to the new regulatory rules, especially the burdensome capital-raising requirements. These requirements, when combined with general post-crisis nervousness, were causing the banks to shrink their balance sheets and particularly the ‘risky’ parts that carried the biggest capital-raising penalty. Longer term, these requirements raise the cost of making loans; short term they stopped them altogether. So the Coalition government came up with two ways of undoing the regulations by the back door: the FLS and ‘Help to Buy’, both in effect subsidising loans, respectively to business and first-time house buyers.
Lending to small businesses has not yet started to recover. However, and mercifully for the Coalition, lending to house buyers has done so with a vengeance and the house market is now starting to recover quite reasonably. London has been strong throughout and must be kept out of this picture – as it is a special market, dominated by an on-going influx of foreign buyers.

However, the rest of the country is now improving markedly, albeit from a low base because real house prices are still well below the pre-crisis peaks. This is true of the national average including London; and strikingly more so for the regions outside London. Our forecasts show that even the whole country average does not get back to the pre-crisis level until after 2016. It is true the housing market is now turning and it could of course move faster. However, it has a long way to go before it reaches what the usual suspects are calling ‘bubble’ levels. Indeed, all it is doing is remedying extremely depressed conditions as credit once again begins to flow.

While Mark Carney’s forward guidance is not in our view of much significance, it is good news that he and the Bank are treating these ‘bubble’ remarks with scepticism. The moral that should be drawn from these events is not that renewed credit is a bad thing but rather that the regulatory framework should be adjusted to allow it to get back to its old vigour. At this point, these various special schemes should be withdrawn. In practice, what seems most likely is that the schemes will be left in place and some lip service paid to the need to monitor developments down the road. What we can say is that the economy is at last recovering as credit starts recovering, at least in parts. A housing recovery is a particularly strong driver of the business cycle. Already construction is growing strongly again, led by housing. We can also expect consumer durable spending to pick up with new house construction. Meanwhile, real living standards are levelling off after a long decline; this is the result of steadier raw material prices, improving employment and rising tax thresholds.

Investment is picking up also, with large companies sensing that the economy’s corner has been turned and new improved capacity will be needed. While export markets in the emerging countries have cooled a bit, those in the Eurozone are at last levelling off after their long decline and in some cases improving.

The decision by the US Federal Reserve to keep monetary conditions continuously loose can be added to all these positives. The Fed warned recently that it would ‘taper off’ its programme of buying assets in the market with printed money. However this led to a big sell-off in bond and equity markets all over the world, which took the Fed aback. In the past few days, Bernanke has announced that the taper is temporarily off the table; and markets have instantly bounced back somewhat. As in the UK, the Fed’s current programme of asset-buying (the so-called QE3) is really an antidote to the new regulatory mania sweeping Washington as it has London. As this episode of ‘taper and then not to taper’ shows, it is going to be hard to withdraw this stimulant. For now, it is needed to keep some sort of credit growth going in the US, thus offsetting the headwinds from regulation. The Fed, unlike the Bank, buys assets across a wide range of classes and so to some extent competes directly with bank lending by lending directly on mortgages and corporate bonds. The Bank has found that its QE buying of UK government bonds only has had precious little, if any, effect on credit conditions; hence the need for those special schemes.

At some point in the future, the banks will be back in the full flow of business; no doubt they will eventually lobby regulators to ease back and as the economy improves their share prices will rise allowing them to acquire new capital more cheaply. Once this has happened, QE will need to be reversed rapidly to avoid excess credit and money expansion. However, the recent episode highlights the risk that this will not happen quickly enough, given the pressures withdrawal creates. For now, inflation remains muted while growth is picking up. Nobody in the Coalition is going to want to stop that combination. Meanwhile, markets are calm about longer-run inflation, somehow trusting that policy will reverse when needed. While I am not so calm, that is also my basic view.

My view remains that we now need bank regulation to be cut back; a short term agenda that moves in the same direction and seems to be having an effect is to keep the FLS and ‘Help to Buy’ on the boil, in spite of all the protests. Meanwhile, monetary policy needs to be tightened towards normality with a rise in Bank Rate of ¼%, and a bias to continue raising it; QE needs to be unwound gradually, withdrawn by £25bn a quarter; longer term I would like to see QE/the monetary base related to the growth in M4ex (versus some target growth).


Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up state-dependent banking groups before privatisation; raise Bank Rate to 2½%, and maintain QE on standby.

Last month’s SMPC contribution of necessity devoted so much space to the theoretical and conceptual issues arising from the Bank of England’s 7th August Monetary Policy Trade-offs and Forward Guidance paper that it was decided not to proceed to the next logical stage and ask what difference state contingent forward guidance made to UK economic prospects in the short and medium term. There are two ways of regarding forward guidance. One is as communications device pure and simple, which does not alter the likely course of interest rates but simply reduces the uncertainty facing private sector economic agents. The other, which the Bank has rather backed away from since August, is that it represents a commitment to hold Bank Rate lower for longer than would otherwise have been the case. The first possibility requires an ability to look inside people’s heads which is really the preserve of the psychologist or opinion pollster rather than the economist. However, the second possibility gives rise to the sort of bread-and-butter simulation on a macroeconomic forecasting model that econometricians have been carrying out for several decades. No such study has appeared since the announcement of forward guidance to the author’s knowledge. The purpose of this month’s SMPC contribution is to describe the results of such a simulation on the author’s Beacon Economic Forecasting (BEF) macroeconomic model of the international and domestic economies, which has existed in one shape or another since the early-1980s.

The BEF model differs from current official UK models because it treats the UK as a small open and trade-dependent economy with the UK sector of the model being substantially driven off a model of the international economy. In addition, more weight is given to supply-side effects and the behaviour of the broad money stock than is conventional practice nowadays. For the current exercise, three scenarios were run: 1) a base run in which the model equation for the UK short-term rate of interest was allowed to run freely from now to 2024; 2) a frozen Bank Rate run in which the three month domestic money market rate was set at 0.6% and Bank Rate itself (which has a lesser role in the model) at 0.5%, and 3) a long-run ‘neutral’ Bank Rate run in which the three month interest rate was set at 5.1% and Bank Rate at 5% throughout. Clearly, there is no limit to the number of plausible counter-factual model simulations that could be run, and it is not claimed that any of the three scenarios are realistic. Rather the intention is to get some rough and ready feel for the effect of different Bank Rate policies in a model where most of the key economic magnitudes, including the public sector accounts, the exchange rate, the broad and narrow money supplies and bond yields are all determined endogenously. This contrasts with current official UK models where many of the key variables are set by assumption, including in some cases potential output and inflation. Such ‘open systems’ can give rise to misleading policy recommendations because they do not properly allow for the second round and subsequent effects of policy changes.

In the BEF model, the key UK three-month interest rate is predicted using a statistical Error Correction Model with the long run properties that the UK interest rate equals the real ‘world’ interest rate plus the UK inflation rate. This is what one would expect in a small open economy, such as Britain possesses; one reason being that an excessive divergence of the real domestic rate of interest from the international norm is likely to generate undesirable volatility in the exchange rate and inflation. In practice, the large margin of spare capacity in the international economy means that the real world short rate is expected to only slowly adjust from the minus 1%, or so, observed in recent quarters to a smidgen over zero in the out years of the forecast. With UK inflation expected to ease over the next year to eighteen months – in part, because of the stronger external value of sterling, whose disinflationary power is probably widely underestimated – before picking up again in late 2014, the base run only includes a relatively modest upturn in Bank Rate to 1¼% late next year, just over 2% in late 2015, and some 2½% or so from 2017 onwards. This means that the difference between the base run and the frozen Bank Rate run is almost exactly 2 percentage points throughout most of the ten year simulation horizon.

Because the base run has Bank Rate sticking at ½% until the spring of next year, there is almost no discernible difference between the two simulations before the close of 2014. Even subsequently, the effects are small to start with because of the lags involved before the economy responds to higher interest rates. Thus, by the end of 2014, CPI inflation is only 0.1 percentage points higher with a frozen Bank Rate, with the same being true of real GDP. By the final quarter of 2016, the level of the CPI is 0.6 percentage points higher and the level of real GDP is raised by 0.5%. However, by the end of the simulation, in 2024, real GDP is 1.2% higher with the frozen Bank Rate but the CPI is almost 8% higher, corresponding to an increase in CPI inflation of 0.8% per annum. The balance of payments deficit is also worsened by some £24.3bn (0.3% of GDP) in the frozen rate scenario, although the PSNB is improved by some 1.3% of GDP by 2024 – the PSNB is in surplus on both runs under the base run assumption of a government current spending volume freeze – and the LFS unemployment measure is some 355,000 people lower. Gilt yields are also reduced with the frozen interest rate but the effect is more marked at the short end, as one might expect, with five year yields 0.9 percentage points lower and twenty year gilt yields down 0.6 percentage points. Finally, the M4ex broad money stock is 7.3% higher in 2024 with the ½% Bank Rate, which is not dissimilar to the extra rise in the CPI, while the ONS house-price measure ends up 19.6% up.

There is no need to consider the 5% Bank Rate scenario in the same detail, since this is a less likely outcome, at least until after the 2015 general election. The main cost of such hawkishness would be to lose 1.8% of GDP in 2024, compared with the base run, while the CPI would end up 13% lower and the balance of payments deficit would be reduced by some 0.3% of GDP. However, these gains would have to be counterbalanced against a worsened fiscal position and an extra 471,000 LFS unemployed. Overall, it is hard to avoid the conclusions that: 1) the short term effects of holding Bank Rate at ½%, say, up to the date of the 2015 general election would not be particularly significant, and 2) whether the longer term consequences are considered desirable or not depends on one’s trade-off between output and inflation. However, the fact that it takes an extra 6.7 percentage points on the price level to buy an extra 1 percentage point of GDP, suggests that the trade-off is not a particularly favourable one and that other measures – such as supply friendly tax reforms and less onerous financial regulation by the bureaucratic Taliban – would, almost certainly, deliver better output results at noticeably less cost. Also, the distributional effects of hyper cheap money polices enrich property speculators but bear down particularly hard on private sector savers who lose both an interest return and suffer exacerbated real capital losses as a result. It is also pretty galling for private savers that the central bank officials responsible for these consequences are just about the last people left in the UK to enjoy the luxury of RPI-linked pensions.

Since the wider economic background has been well covered by the other contributors to this report, there is little reason to go into the details here. The analysis above suggests that changes in Bank Rate within the relatively narrow range considered here are unlikely to have a major impact either way. It is not difficult to simulate, say, a 10% adverse regulatory shock to broad money in the BEF model and this would seem to have a more powerful effect than relatively modest changes to Bank Rate. In essence, there are three main reasons for wanting a Bank Rate increase of ½% in October, accompanied by no further increase in QE. First, British interest rates will have to be normalised at some point and it is less disruptive to start the process early, and in small steps, rather than leave it too late and then have to slam on the brakes, perhaps after a 2015 general election. Second, the evidence suggests that the recovery is gathering momentum. The normal policy error at this stage of the cycle is to underestimate the power of the upswing; one reason being that the initial ONS estimates seem to understate cyclical swings because of the way they are compiled. Third, the continued large deficit on the current account balance of payments is a prime face indicator that domestic demand is running ahead of aggregate supply, at least in a relative sense compared to our main trading partners. Finally, anyone interested in the wider monetary debate might like to know that the Fall 2013 Cato Journal (Vol. 33, no. 3) is devoted to monetary policy and includes papers by many distinguished monetary economists and former central bankers, including John B Taylor, Allan H Meltzer and Jurgen Stark (www.cato.org/cato-journal/fall-2013). Professor Taylor’s explanation of why the US Federal Reserve is misapplying his famous rule and exacerbating monetary instability is relevant to other central banks, not just the US Fed.

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

Various MPC members have delivered speeches in support of the new decision-making framework now that the dust has settled on the 7th August statement. Paul Tucker sums it up as follows: “the MPC’s forward guidance provides an articulated framework for a probing approach to policy, without a change in our preferences on inflation.” There are several points to be noted. First, the stance of policy is unaltered by the introduction of the new framework: it has neither a tightening nor an easing bias as a result of the change. Second, the previous dissension within the MPC over the desirability of making further asset purchases is hidden by the broad-based improvement in economic activity. This is not the same as saying it has disappeared.

Third, the August statement should be read as an articulation of existing policy preferences rather than a brand new policy. It is far from clear whether Mark Carney’s influence has moved the UK any further along the forward guidance spectrum. Presuming that each member of the MPC will have a say on each of the ‘knockout’ clauses, the governor’s opinion will be unlikely to hold sway.

Fourth, if the previous statements are accurate, then the MPC is in danger of substituting influence over interest rate expectations for influence over inflation expectations. If it is the agreed policy of the MPC to steer expectations for the first Bank Rate rise into 2016 and to present a united front on forward guidance (such that QE squabbles are left at the door), then it is unclear what purpose is served by holding monthly votes – for the MPC, the Shadow MPC or anyone else. The notion of selecting policy settings which are appropriate to achieve an inflation objective, or a path for inflation over a two-year horizon, seems obsolete.

The most significant event for British monetary policy in the past month was the decision by the US Federal Reserve not to commence tapering of its large scale asset purchases. Gilt yields at ten years have pulled back from 3% to around 2.7% since this announcement. Nevertheless, the Sterling curve is higher than it was on 7th August and Sterling itself has appreciated modestly. The MPC’s dilemma remains. Does it scream at financial markets that their interest rate forecasts are all wrong and hope to change the outcome? Or does it follow up the statement on forward guidance with an asset purchase programme designed to prise apart the short end of the UK and US curves? I am hard pressed to define the distinctive character of UK monetary policy.

In passing, it is worth noting that the UK balance of payments was in current account deficit of 4.3% of GDP in the first half of the year, up from 3.8% in 2012. While this deterioration has been driven by a loss of net income on investments, rather than an adverse movement in the visible trade balance, it is nonetheless deeply concerning that a barely recovering economy should have a sizeable external deficit.

Against a background of sluggish potential GDP growth and stagnant productivity, even a modest improvement in the growth outlook must be regarded as an invitation to begin the painful task of normalizing the short-term interest rate. The era of ½% Bank Rate should have ended in 2010; instead it lingers on. The first steps towards rate normalization – which might only be as far as 2% – should not be delayed. My vote is to raise Bank Rate by ¼% and to keep going.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking and University of Derby)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

Recent data show that the UK economy continues to recover. According to the latest Lloyds Bank business confidence Barometer, economic prospects rose to an all-time high in September, with more than two-thirds of companies indicating greater optimism than three months ago. Firms’ own trading prospects fell marginally, but the quarterly average is at the strongest level since late 2007, prior to the height of the global financial crisis. The robust levels of economic and trading prospects point to the potential for economic growth to remain strong and even accelerate in the second half of the year. Indeed, based on our survey growth could be ¾% in the third quarter and possibly the same in the fourth, giving annual average growth of 1½% this year.

Further, more than two-fifths of companies plan to increase staff levels in the coming year. The industrial sector (manufacturing and construction) and the south of the UK have the strongest economic prospects in the latest quarter, though all sectors and regions have seen prospects improve since the start of the year. Do I believe that the recovery can be sustained at this pace, no? But it does not look like it will slow appreciably until well into 2013 Q4 and that will not show up in quarterly data until the first quarter of next year, if the survey data are to be believed.

In short, this backdrop does not mean that recovery is so assured that official rates should now be increased. Unemployment is still at 7.7%; real pay is still falling by a little over 2% a year and investment spending is still declining. Recovery is based on renewed borrowing by households, which seems unsustainable at the current rate for long enough to as yet make recovery assured.

The revised and more detailed ONS national accounts for the second quarter published on 26th September included details of the household sector accounts. The good news is that the household saving ratio rose to 5.9% in 2013 Q2, from 4.4% in the first quarter (revised from 4.2%). In part, this reflected the modestly softer growth in household spending in April-June. However, the swing in the saving ratio primarily reflected a large increase in compensation of employees in 2013 Q2 after the unusual dip in the first quarter, likely reflecting a shift in the timing of payments after the reduction in some personal tax rates in the new tax year. Household sector accounts are likely to be a key measure for activity looking ahead. Future growth in household spending will be more dependent on real income growth and is thus likely to be more restrained.

Another downside risk came from the details of the current account data. It was not so much the second-quarter deficit, which came in at £13.0bn, but the upward revision to 2013 Q1 to a gap of £21.8bn (5.5% of GDP), from £14.2bn deficit (3.6% of GDP) in the previous release. This was almost completely driven by a £7bn adverse revision to the estimate of investment income to minus £9.2bn. This is by far and away the biggest shortfall in investment income on record. The ONS ascribed the scale of this revision in part to a change in the survey format in the first quarter, which contributed to a relatively low initial response. Nevertheless, the scale of the first-quarter income investment deficit now recorded is daunting (albeit it narrowed in 2013 Q2) and this asks significant questions of the UK’s ability to fund the external deficit over the coming years, if it is not further revised in subsequent quarters.

True, the third release of second-quarter GDP saw no change to the estimate of quarterly growth and did not reflect these risks. Growth was unrevised at 0.7% as expected. Within this there were modest changes to estimates of output in particular sectors, with industrial and construction output revised higher to increases of 0.8% and 1.9% respectively (from 0.6% and 1.4%). However, with estimates of service sector output left unchanged at 0.6%, this did not result in a change in the total estimate of output.

More significant, were the revisions made to the initial estimates of the expenditure components. Contributions from net trade and business investment changes were scaled back markedly, once again dashing hopes of more balanced expansion. Business investment is now estimated to have fallen by 2.7% (from a previously estimated 0.9% rise); net trade contributed nothing to GDP in 2013 Q2, reflecting adverse changes to both export and import estimates; consumer spending was revised a little lower to 0.3% from 0.4%. On an expenditure basis, GDP only remained at the previously estimated rate because inventories are now seen to have added 0.2% to GDP (initial estimate were for minus 0.2% points) – reducing some of the momentum from that source for the third quarter.

Meanwhile, price inflation is not a serious concern, especially with wage inflation of only 0.6% on an annual basis in the three months to July. CPI inflation inched lower in August to 2.7%, in line with market expectations. Inflation has averaged 2.7% over the past nine months, rarely varying from this rate. RPI inflation, by contrast, accelerated by a little more than the markets had expected, rising to 3.3% in August from 3.1% in July. The difference between RPI and CPI annual rates rose to its highest level since December 2011. This change was chiefly driven by a reduction in the compression caused by ‘weights’, which captures the different data source and population bases in the two indices. August’s producer price indices came in lower than markets expected. Input prices fell on the month. Output prices were softer than markets expected with headline factory gate inflation up 0.1% on the month.There is little here to suggest pipeline CPI inflation pressures. As for monetary growth, M4ex remains consistent with the recovery we are seeing so far but does not suggest it is accelerating. Recovery remains sensitive to unfolding events in the US and Europe, which could create serious issues for the UK in the weeks and months ahead. In this environment, I vote to leave rates on hold and QE at £375bn.

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 and University of Derby). 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.