Sunday, June 01, 2014
IEA's shadow MPC votes 5-4 for quarter-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its email poll closing Wednesday 28th May, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended by five votes to four that Bank Rate should be raised ¼% on June 5th, including four votes for a rise of ½%.

For those members advocating a rise, the return of strong economic growth implied that the need for emergency levels of low rates had passed, that there was the danger that sustaining such low rates would eventually drive a rapid expansion in credit (though it was acknowledged that credit is not in boom yet), and that the period of extremely low rates had distorted the supply-side of the economy in ways that have damaged productivity and might limit the ability of supply to respond quickly to the recovery in demand.

For several of them, interest rate normalisation is being, as one put it, “neglectfully delayed”. Conversely, the idea that credit pressures or rapid house price rises should be contained by regulation was seen as wrong. Prices and interest rates, not regulation, should discipline demand and risk-taking in a market economy.

Those advocating holding rates noted that monetary growth is modest; credit is stagnant or even contracting; inflationary pressures are low, and the sectoral picture for real economy growth is patchy and insecure. In their view there was no urgency to raise rates but there would be risk – the risk of derailing the recovery just as it began.

Votes

Comment by Philip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate by ½% and hold QE
Bias: Increase Bank Rate; QE to depend on behaviour of broad money

The 2% target for Consumer Price Index inflation is symmetrical. Therefore, we should not be worried about inflation dipping below it: it is important not to treat the target as a floor. As the economy returns to normal in terms of business investment, confidence and so on, we can expect the level of interest rates necessary to keep a given monetary stance to normalise (i.e. move towards 5%). Given the leverage of many households, there are significant dangers in leaving interest rates at too low a level and then having to raise interest rates quickly. There are also huge dangers from the central bank implying that interest rates might well be left very low for a prolonged period and then having to raise them. Influencing expectations in that way may well induce borrowing in ways that are not sustainable in the long term and then, when interest rates are raised, the damage will be that much greater.

I would therefore raise interest rates slowly starting now, with an increase of ½% in the first place. Regarding Quantitative Easing (QE), the decision with regard to QE should be driven by what is happening to the quantity of broad money. The stock of M4ex should correspondingly be monitored on a month-by-month basis. However, the existing stock of QE should be kept where it is for the moment. My bias would be to raise interest rates further in due course, although I have no quantitative bias with regard to QE, only a conditional one.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate and pause QE
Bias: To tighten

The British economy continues to do reasonably well, with strong employment growth that is partly due to significant immigration of working-age people finding work. The international background has proved more difficult than was the consensus expectation at the start of 2014, although the US economy is growing well and should have a good second half. The Eurozone is still struggling, with several economies subject to deflation. Weak commodity prices and a supermarket price war signal further beneath-target UK consumer inflation in the rest of 2014.

Some commentators and even the Governor of the Bank of England, Mark Carney, have expressed concern that the very low of interest rates may stimulate an unsustainable credit boom. However, official data show that nothing of the sort is actually happening. In the year to January 2014 M4ex lending (i.e. bank and building society lending to the UK private sector, excluding that to intermediate “other financial corporations”) rose by a negligible 0.2%. In the six months to March the stock of such lending fell, although only very slightly, with the annualised rate of decline being 0.8%. The numbers are surprising and difficult to square with, for example, the relative buoyancy of the London housing market. (It is possible that UK assets are being purchased from money balances held in foreign banking systems, where credit growth is stronger. The aborted Pfizer take-over of AstraZeneca is an illustration of the possibilities. Other smaller cross-border corporate deals, with an element of bank finance, are proceeding.)

The stagnation of bank credit might have been expected to be accompanied by similar stagnation of the quantity of money. The data show that in the year to January M4ex was up by 3.1%. In association with practically zero short-term interest rates, this very low rate of money growth was consistent with healthy asset price gains, robust balance sheets, decent demand growth and rising employment in 2013. However, to talk of a general boom would be premature and misguided.

Indeed, the three-month annualised rate of change of M4ex in March was 2.9% after a fall in M4ex in March itself. This was not too bad compared with 3% - 4% numbers for much of late 2013 and 5% - 6% numbers in the opening months of 2013. All the same, with money growth apparently decelerating, the case for an early increase in base rates is less than clear-cut. On the other hand, the seeming strength of the real economy argues against a resumption of “quantitative easing” operations. The implied verdict is “steady as she goes”.

The British banking system – like the banking systems of other countries – is still restraining balance-sheet expansion, in order to come closer to the Basel III capital requirements.

However, it must be said that – if bank credit to the private sector were now to start growing at a moderate pace (say, 3%-a-year annualized and certainly 5%-a-year annualised) in association with similar or perhaps somewhat faster growth of broad money – the case for a small rise in interest rates would be persuasive.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: Neutral

The recovery of the British economy has been broadening over recent quarters, but the sustainability of the recovery is not yet certain. Improvement in some areas continues to be offset by weakness in others, and for this reason any precipitate action to raise interest rates or tighten monetary conditions now – which inevitably would affect all sectors – would likely cause a significant setback.

In 2013 real GDP growth finally started to return to more normal rates of growth, averaging 0.7% increases each quarter (or 2.7% annualised) with roughly equal growth of personal consumption (0.55% or 2.2% annualised) and real exports (0.59% or 2.3% annualised), but much stronger growth of fixed capital investment (2.11% or 8.7% annualised). The GDP figures for 2014 Q1 (0.81%) showed a similar pattern for the domestic demand components (consumption 0.77% and investment 2.75%), but exports (-1.02%) weakened, probably reflecting continued slow growth in Europe and the strength of sterling over the past year. However, while the overall GDP figures were encouraging, the detailed picture in different sectors casts doubt on whether the economy has reached self-sustaining momentum. Key areas of weakness include employment, wages, the housing market outside London and the south-east, and credit growth.

The labour market has improved notably in quantitative terms, but there is still a long way to go before the normal quality of employment is restored. For example, employment as defined in the Labour Force Survey continues to rise, reaching 30.4 million in February, 2.9% above its pre-crisis peak in April 2008, and workforce jobs growth has expanded to 32.7 million, 1.7% ahead of its pre-crisis peak in 2008 Q2. The problem here is that although the employment rates (employment as a fraction of the working age population) have recovered almost to their pre-crisis level of 73%, many of these jobs are part-time jobs, and surveys consistently show that those with jobs would like to work longer hours, or have full-time jobs. At the same time unemployment has dropped from a peak of 8.6% in October 2011 to 6.8% in February, but youth unemployment among those aged 18-24, although down from its peak of 20% in November 2011, is still at 16.9%.

Similarly, and for broadly the same reasons, wage growth has been disappointing, persistently declining in real terms since June 2008, a period of almost six years. Only recently has there been an indication of a possible return to real increases in average weekly earnings, but it has not yet materialised. For example, in the period December to February average weekly earnings (including bonuses) increased 1.7% over the preceding year while the CPI averaged 1.9% over those same months – implying negative real earnings growth. In March average weekly earnings slipped to 1.5%, but the CPI increased to 1.6% – implying negative real earnings growth again. Fortunately, the sluggishness of real earnings has been counterbalanced by increases in the total number of jobs, helping to boost overall spending power in the economy, but several quarters of real earnings growth should be permitted before the authorities contemplate rate hikes.

In the housing market only London and the south-east have seen strong house price rises since the start of 2012, with prices up 24% in London and 10% in the south-east since December 2011 (according to the ONS indices). In Scotland, Wales, the south-west, north-east and west-midlands house prices (based on the same ONS mix-adjusted series) are broadly unchanged compared with their levels in mid-2008 or mid-2010. As the governor of the Bank of England recently suggested, there are essentially two housing markets in the UK: London and its immediate surroundings, and the rest of the UK. The London market is driven by global factors – the health of the global financial sector, the search for safe havens and safe property rights, as well as domestic financial forces such as low interest rates. House prices in the rest of the country are driven by the same domestic factors – incomes, interest rates, the availability of credit etc. – but the global or foreign element is far less significant. But low interest rates without a credit boom do not signal a bubble.

Finally, credit growth remains extremely weak, if not declining – despite the two government credit promotion schemes (“Funding for Lending” and “Help to Buy”). The new gross loans to the housing market have been recovering modestly and, according to the Bank of England’s latest data, were running at £17.1 billion per month in the three months January-March. This compares with an average of just over £30 billion per month in the first half of 2007, the pre-crisis peak of mortgage lending. In other words, the current monthly rate of lending is only slightly more than half the peak rate. Furthermore, the increase in gross loans for new mortgages is more than offset by declines in credit elsewhere – either repayments of outstanding mortgages, or reductions in lending to the non-financial corporate sector, or especially to the financial sector. Over the past year total M4 lending has declined by 4.6%. Again, to emphasise the scale of this problem, whereas gross new mortgage loans increased by £51 billion in the first three months of 2014, M4 lending declined by £47 billion.

In this environment the Bank should hold rates stable at 0.5%, and be prepared to undertake additional asset purchases if monetary growth or bank credit plunge again. Bank Rate should not be increased while money and credit growth are so anaemic. 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
(Legatum Institute)
Vote: Hold
Bias: Neutral

As spring turns to summer the economy is warming up, but like the weather, not as much as we would like. One of the key variables suggesting a pick-up in GDP growth over the 2014-15 period was the acceleration in M4ex money supply at the end of 2012 and into 2013. However, the momentum in M4ex has weakened over recent months, recording growth within the 3.5 to 4% band, when it had looked as if it might edge up towards the base of the Bank of England’s 6-9% target range. So there is more money available for spending, but not a lot more.

The relationship between nominal GDP growth and M4ex is far from simple, but stronger nominal GDP growth would require an increase in monetary velocity. So what might trigger an increase in velocity? Certainly consumer and business confidence has picked up and there is room for further reduction in the savings ratio – possibly helped by house price effects on consumer confidence. Of course any price effect on confidence could just be picking up the impact of improved real earnings on both confidence and house prices. Either way there is scope here for faster velocity.

With inflationary pressures weak there seems little need to tighten policy in 2014, even with an output gap which is probably now quite small. But this doesn’t mean there is no concern for inflation. Supply-side rigidities mean that the underlying potential growth rate of the UK economy is probably just under 2% and so a small output gap could be exhausted by the end of this year. The conundrum for next year is whether or not a moderate uptick in the UK will be matched by a slide towards deflation on the continent? If parts of the Eurozone slide into deflation, with an associated risk of a resumption in the euro crisis, UK monetary policy won’t begin to be normalised until 2016 at the earliest.

Comment by Andrew Lilico
(Europe Economics, IEA)
Vote: Raise Bank Rate by ½%
Bias: To raise further; QE neutral

The signs of boom are all around us, except in the lending data. Four-quarter GDP growth is above 3%. Retail sales grew 6.9% in the year to April — the fastest such growth since the heady days of 2004. Consumer confidence is at its highest level since records began in 1998. Yet the preferred measure of aggregate lending (the M4Lx series) is contracting, down 0.4% in the four quarters to March 2014 — and other measures of lending such as that excluding securitisations are contracting at an accelerating pace, down 4.3% in the year to March 2014 from just 0.3% contraction as recently as November 2013.

Broad money (M4ex) growth is a little healthier, at 3.7% in the twelve months to March 2014, but still probably lower than policymakers might like. Inflation is below target, and the overall picture still recommends highly accommodative policy.

The question, though, is what “accommodative” means in the current UK macroeconomic context. Does it any longer mean “the absolute maximum stimulus that can be provided through interest rates”? I say no. I want a highly supportive, extremely loose monetary policy. But I do not see (and have not seen for the past two years) what case there could be for believing us still to be in an emergency when the maximum possible accommodation was required. Obviously, those setting policy have not agreed with me.

But I am now at a loss to know what would persuade them to seek to normalise rates. Must we actually wait until inflation starts to race ahead of target, even though we know that rate rises may only start to have a material impact months after they occur? Must we wait to raise rates even though rates will not become tight (i.e. will not dampen down upon growth or inflation, as opposed to stimulating them further) until they exceed at least 3% and possibly 5%, meaning waiting until inflation actually begins means that gradual rate rises would imply a large inflation overshoot and probably the need to induce a recession to get inflation down?

The irony is that I actually do not object to the strategy of waiting too late to raise and letting inflation go too high. Merely, I would prefer to wait at around 1.75% interest rates, rather than 0.5%. The sooner we can escape the clutches of the strange phobia of shifting from 0.5%, the better.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%
Bias: To raise further in small steps; QE neutral

The economy is showing the signs of recovery that has excited everyone into believing that the long recession is over and the time for a rise in interest rates is drawing near. Clearly, it is better to have some growth than no growth but this recovery is not like others. This growth has occurred without any improvement in productivity which remains flat. The recent growth in GDP has been matched by an almost equivalent growth in employment. The recent retail sales figures underline the consumption led growth that is driving the pick-up. Nothing wrong with that, as household spending has nearly always led the recovery but unlike other recoveries growth is not matched by productivity improvements.

The upshot of this is that the recovery is fragile and has no supply-side response. The long period of low interest rates has inhibited the market from re-allocating resources from the low productive sectors surviving on cheap credit to the high productive sectors that need the investment funds to expand capacity. The correction to the current misallocation of savings resources will take time for capacity to build up and the supply-side to respond and keeping interest rates at its current level does not help.

However, there are other, more short term reasons for raising interest rates. If the Bank believes that a house price bubble is in the making, using quantitative rules to control mortgage lending (like the Corset of a bygone period) is less efficient than simply raising the price of credit. At the current very low interest rate, except for QE monetary policy has lost all traction, so in the case of another euro flare up there is no place for interest rates to go removing the psychological effect of a sharp cut in rates. Investment spending is unlikely to be influenced by small upward adjustments in rates and it is clear that sterling has already discounted a rate rise. There is nothing left but for policy to follow through.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½% and gradually claw back QE
Bias: To raise further

The housing market is now recovering strongly; at the same time the economy is also moving into relatively strong growth close to the 3% per annum mark. It is the relaxation of credit conditions brought about by Funding for Lending and Help to Buy that have pushed up the housing market; previously it was frozen by the blocking of the credit channel. It is now a key part of the general UK recovery and coalition politicians will interfere with it at their peril.

Already cries are being heard from various quarters that there is an uncontrollable ‘house price boom’. This is far from the case when one considers how far the market has fallen. It is more a correction than a boom. According to the Cardiff models it should reach ‘trend’ by the end of 2016. Even London is only just back to where it was before the crisis - the trend for London is above the national one of around 3% per annum. Much of the comment on housing is subject to ‘money illusion’ - that is, people do not correct for the general rise in consumer prices in evaluating the housing market. Once this correction is made, national prices are still well below their previous peaks, between 20 and 40% below depending on the region.

The Bank of England is speaking about housing ‘overheating’ with a forked tongue. On the one hand, there is the Monetary Policy Committee (MPC) with Governor Carney leading it in arguing for continuing monetary ease; this dovish attitude sits uneasily with the strong growth we are seeing in both the economy and housing. On the other hand, the prudential regulators are flexing their muscles suggesting they will intervene with special measures on such things as mortgage affordability, via ‘caps’ of one sort or another. The latter will cause market distortions and ultimately be evaded by the usual market processes. It would be far better to tackle monetary overheating directly by tightening monetary conditions towards normality: they are just abnormally loose at present, given the signs that the excessively draconian bank regulation is being sidestepped increasingly by the government’s special measures and the growing internet lending presence.

How vulnerable is the recovery? Until recently export and investment have been weak; the first related to the Eurozone’s continued weakness, the second reflecting uncertainty about recovery. Both may now be giving way to better things: the Eurozone is at last pulling off the bottom. Business surveys suggest that firms are feeling the need to invest as the recovery proceeds. In short the recovery looks sustainable. Furthermore, with an election looming the coalition is going to take no risks with any dampening down of the housing market.

In particular, real house prices (i.e. after inflation) nationally will recover from their below-trend position gradually over the next few years; I do not foresee a massive boom in prices but rather a steady but unexciting recovery. Much the same is true of UK regions generally - the main exceptions are the London, Northern Irish and Scottish markets which are affected by strong particular factors - London by the strong expansion of City business services, Northern Ireland by the well-known issues there, and Scotland by the unsettling bid for independence.

My judgement on monetary policy remains that it is too loose given the resumption of fairly strong growth, including the housing recovery. My suggestion would be for interest rates on government short term debt, i.e. Bank Rate, to go up by 0.5% initially and then in small steps; and for QE to remain on hold for now and thereafter be gradually clawed back. Intervention in the mortgage market should be avoided.

Comment by Peter Warburton
(Economic Perspectives)
Vote: Raise Bank Rate by ½%
Bias: To raise Bank Rate in stages to 2%

The May MPC minutes contained further proof that the modus operandi of the Bank is now “unconstrained discretion”. Having abandoned any semblance of a Taylor rule reaction function and broadened the reference framework for “forward guidance”, the Bank is flying blind with neither broad monetary discipline nor inflationary anchor. The appreciation of Sterling continues to act as a considerable restraint on the forces of domestic private sector inflation, but this factor cannot be regarded as permanent. The size of the current account deficit, over 5% of nominal GDP in the second half of 2013, is approaching that of public sector net borrowing (6.6% of GDP), earning the UK the “twin deficit” epithet. For the time being, the kindness of strangers allows us to exchange newly-minted sterling fixed interest securities for our external payments deficit.

“Key considerations facing the Committee over the next year or so were the margin of slack and pace at which it was eroded, and the effects of the components of that slack on inflation. The central view of most Committee members was that the margin of spare capacity remained in the region of 1% - 1% of GDP, although it had probably narrowed a little since February.” The characterisation of the policy judgement in these terms is reminiscent of the worst days of fine tuning from the 1960s and 1970s. I maintain that “slack” is so riddled with measurement error that it cannot serve a practical policy purpose.

Notwithstanding the sluggish pace of most credit and monetary aggregates, there is no doubt that there has been a nominal acceleration of the economy. Nominal GDP growth was 4.4% in the year to Q1 and 5.8% annualised over the past 6 months. The UK authorities have wakened the sleeping credit dragon from its slumbers and are basking in the warm glow of its breath. The inflationary side effects of this experiment will not be far behind. What passes for patience on the part of the MPC is a neglect of duty.

The cost of unsettling inflation expectations will be felt very quickly in the Sterling fixed interest market and the absorption of the UK still-massive debt issuance programme may soon become problematic. The weakening of the overseas bid for gilts could readily bring Sterling down from its high perch and the UK’s benign inflation dynamics would be turned upside down.

In my view, the MPC is dangerously distracted by the concepts of domestic slack and spare capacity and should have been raising Bank Rate a year ago. Throwing sand in the wheels of the UK mortgage market (the MMR) or deploying macro-prudential tools allows the Bank to insist that it is reacting to the improving market conditions, but there is no defence against the charge that interest rate normalisation has been neglectfully delayed. An immediate increase in Bank Rate of 0.5% is appropriate, with a bias towards further increases.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking, University of Derby)
Vote: Hold; no change in QE
Bias: Neutral

At first blush, the second estimate of Q1 GDP appears to have been broadly as expected. Both the quarterly and annual rates of growth were left unchanged at 0.8% and 3.1%, respectively – the strongest annual rate since Q4 2007. But looking below the surface, the expenditure breakdown is at best mixed. The improvement was driven yet again by consumer spending (0.8%). And while business investment posted another welcome improvement (+2.7% q/q), the recovery was marred by a fall in exports (-1.0%) and, more importantly, a sharp rise in inventories.

Inventories rose by £2.8bn last quarter, compared with £1.9bn in Q4. Taken in isolation, the rise contributed 0.2% points to the rise in GDP growth in Q1. Sharp rises in inventories in the National Accounts are often initially due to the so-called alignment adjustment, which is the balancing item used to reconcile estimates of output GDP with expenditure GDP. Typically, these get reallocated over time to some other component of expenditure and the inventories data are revised lower. Notably, however, the alignment adjustment was negative in Q1 to the tune of almost £700mn. In other words, the actual rise in reported stocks in Q1 was around £3.5bn, following a similar outturn in Q4. Viewed this way, the magnitude of the rise in inventories is somewhat concerning. It may be that the rise in stocks is a justified response to the anticipated pick-up in demand over coming quarters. At the very least, however, it raises the possibility that output growth may not have to be quite as strong over the coming months to meet the rise in demand.

Another slightly troubling feature of the release is the drop-back in imports and exports, both of which fell by around 1% q/q. The fall in imports looks odd given the strength of domestic expenditure (especially stocks) in Q1. The weakness in exports is perhaps easier to explain given the weakness of the exchange rate; the challenges still facing our key export markets in Europe, and the surprisingly sharp rise in Q4. Still, the difficult external environment is unlikely to dissipate anytime soon. As we have argued for some time, the prospect of a marked improvement in net external trade looks limited – leaving the onus for demand, and by implication GDP, growth on consumer and business spending.

Notwithstanding these reservations, it is difficult to be too negative about an economy that posted its fourth consecutive quarter of above trend growth in Q1. While the composition of expenditure highlights some of the changes still faced, GDP growth in Q2 is unlikely to be materially weaker.

Public finance data also raised some question marks about the health of the economy. Despite the strong rise in GDP over the past year, the key underlying measure of the budget deficit rose by £11.5bn, £2bn higher that it was in April 2013. The ONS attribute the deterioration to a drop in tax receipts and deterioration in the financial position of local authorities. If sustained, the inability of the UK’s fiscal finances to respond to a cyclical improvement in the economy would only add to the suspicion that a large proportion of the deterioration is structural and could require even greater fiscal austerity.

What does this mean for policy? That depends on the inflation outlook. CPI inflation posted a stronger than expected outturn in April, rising to 1.8% from 1.6%. Downward contributions from food, drink & tobacco and hotels & restaurants prices were more than offset by upward contributions from transportation (airfares +17.9% m/m), with clothing and footwear prices (+1.0% m/m) also firmer than expected. These largely reflect the late timing of Easter this year compared to last. To the extent that prices have been boosted temporarily by the late Easter, the impact should reverse next month.

More generally, the underlying inflation backdrop remains subdued. The lagged impact of sterling’s strength and the softening in global commodity prices is still feeding through - as evidenced by a further fall in producer input prices in April. In the twelve months to April, producer input prices declined by 5.5%. As energy price base effects start to wane, headline CPI inflation is expected to drop back again, towards 1.4%, over the summer. However, this will mark the nadir. The downward impetus to import prices should start to slow as the lagged impact of sterling’s strength steadily fades. At the same time, ongoing economic recovery is likely to lead to a gradual decline in the degree of economic slack. For now, we believe there is enough spare capacity for companies to respond to increases in demand without putting up prices. Meanwhile, money supply growth slipped further in March. The M4ex three month annualised rate eased to 2.9%. This means that the average for Q1 was just 2.7%, from 4.5% in Q4, 3.5% in Q3, 3.7% in Q2 and 4.4% in Q1 2013. In month on month terms, the rate fell 2.3% and the 12 month rate was minus 0.3%. No wonder there is little inflation risk. That all means, for now, that my vote is to leave rates on hold and keep QE at £375bn.

Policy response

1. On a vote of five to four, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in June. The other four members wished to hold.

2. There was only modest disagreement amongst the rate hikers as to the precise extent to which rates should rise. Four voted for an immediate rise of ½% but one member wanted a more modest rate rise of ¼%.

3. All those who voted to raise rates expressed a bias to raise rates further. One of those who voted to hold rates had a bias to increase rates in the near future.

Date of next poll
Sunday July 6th 2014