Sunday, July 06, 2014
IEA's shadow MPC votes 8-1 to hike rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its email poll closing Wednesday 2nd July, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended by eight votes to one that Bank Rate should be raised on July 10th, including five votes for a rise of ½% and three for a rise of ¼%.

Those advocating a rise acknowledged that the economy is not yet over-heating, money growth is low, and inflation overshoots are not an immediate risk. They did not propose raising rates to cool down the economy but, instead, sought to withdraw some of the excess monetary stimulus introduced at the time of the financial crisis so as to allow the price mechanism to allocate loans and capital. The current strategy of keeping interest rates very low whilst using bank regulation to prevent money and credit growth was loudly condemned.

For several of the members the Bank of England has already waited far too long before raising rates, with some criticising its “neglect” whilst others focused upon the confusion created by the signals from forward guidance. The main way to signal should be by changing a price — the interest rate — not by speeches or regulatory changes.

The member that preferred to keep rates on hold noted that not only is inflation low, but pipeline inflationary pressures are also low, as are wage growth, money growth and credit growth. For that member there was simply not enough reason in the data to raise yet.


Comment by Philip Booth
(Institute of Economic Affairs)
Vote: Raise Bank Rate by ½%
Bias: Further rises

The situation has not changed greatly from last month, though inflation has fallen again. However, we should remember that the 2% target for Consumer Price Index (CPI) inflation is symmetrical and we should not be worried about inflation dipping below it. Certainly, the Bank of England was very sanguine when inflation went above target.

It is quite clear that the economy is returning to normal in terms of business investment, confidence and so on. We can therefore expect the level of interest rates necessary to keep a given monetary stance to normalise. It is, though, ridiculous to try to predict, as the Bank of England seems to be trying to, what the appropriate level of interest rates might be in many years time and whether equilibrium interest rates will settle at (for example) 2.5% or 5% over the coming decade. Certainly, the Bank of England has not covered itself in glory when it comes to forecasting and prediction in recent years.

Perhaps the Bank would do well to focus more on the present level of interest rates necessary to hit the inflation target two years out. There are dangers in raising interest rates too quickly. However, given the leverage of many households, there are, perhaps, greater dangers in leaving interest rates at too low a level and then having to raise them 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 be monitored correspondingly 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.
I would like to add that it is a travesty that the Bank of England and the government are simultaneously raising capital requirements for bank mortgage lending, underwriting the risk of mortgage lending using taxpayers' money, keeping monetary policy very loose and talking about restricting private sector bank credit to the mortgage market. The Bank should set monetary policy appropriately and then allow the markets to determine how to allocate credit. Ted Heath and Harold Wilson will be chortling in their graves.

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

CPI growth has slowed to 1.5%, but this is only generating anxiety given the extended period of time in which it has been allowed to go above target. If the inflation rate continues to fall, then this would be a cause for concern, but the Bank of England’s Inflation Attitudes Survey suggests that expected inflation remains above 2%, and therefore there’s scope for this to come down. There are some mixed messages coming out of the monetary aggregates. Eurozone M3 is worryingly low and the UK measure is now contracting slightly. M4ex continues to grow within a band of 3%-5%. This isn’t sufficiently high to fret about credit-induced booms, but it’s also not indicating that monetary policy is too tight. My preferred measure of the money supply – MA – has seen the growth rate fall dramatically since the beginning of the year. It was showing double digit growth in late 2013 but has since fallen to 1.84%. However, this has been driven by a one off adjustment made in January 2014 due to “improvements in reporting at one institution”. This demonstrates a downside of looking at relatively narrow measures (since they are less robust to one off adjustments), but also reminds us that indicators can behave in odd ways and we shouldn’t be over reliant on any single one.

Economic growth continues to be strong. The final estimate of 2014 Q1 puts business investment growing by 10% more than the same time last year, and 5% more than the previous quarter. This rate is unlikely to be sustained but shows signs that the recovery has a foundation. The growth rate of NGDP rose throughout 2013 and continued into 2014, almost hitting 5% in Q1. Although this seems too little too late for those desperate to reach the pre crisis trend path, I believe that horse has bolted. Real GDP growth is higher than it has been for several years, and from where we stand today if anything this might be considered too high.

A fear of rate rises shouldn’t prevent a tentative step into exit strategy being made. There is a real danger that so far forward guidance has been interpreted to mean, “you don’t need to worry about interest rate rises yet”. But this conflicts with the necessity to factor in future interest rate rises to current decisions. Higher debt burdens don’t need to be paid today, but they do need to be planned for. The Governor of the Bank of England has suggested that the new normal may be around 2.5%, whilst the Deputy Governor for Monetary Policy has expressed the view that the long-term rate will still probably be around 5%. Regardless of where one thinks rates will be in the long term (and indeed how long that is), there is a general consensus that moderate rate rises will start happening within the next year or so. My concern is that we shouldn’t wait that long.

Whilst the economy is healthy, it is worth testing the waters to ensure market participants are factoring future rate rises into current decisions. Economic commentators seem to give the impression that any increase in the Bank Rate will automatically feed into all other interest rates. In fact, it’s only people on tracker mortgages that will see an immediate change (and let’s also note that the risk of a rate rise has already been factored into the interest rate they’ve currently been paying). For people on variable rate mortgages it will depend on that particular transmission mechanism, and there are lots of unknowns about the extent to which banks have already begun to factor in rate rises. Having said this, it seems that some lenders are starting to increase their fixed rate mortgage offers. But this also suggests that there may be a free lunch whereby the Bank of England acquires the communication benefits of a rate rise without passing on the costs of higher interest payments.

Either way, there are over 1 million households that have never experienced an interest rate rise. If they’ve been anticipating interest rate rises, then the costs of a moderate rise now will be low. If they haven’t, this would indeed be costly. But it implies an even bigger cost to come when rates approach their normal levels (even if this is just 2.5%). The bigger the shock of an interest rate rise, the more important to confront it early. With inflation subdued and earnings growth only just starting to pick up, there is a danger that if the Bank shocks markets it will threaten the recovery. But for the recovery to be sustainable interest rates need to be at their natural rate. It is notoriously difficult to estimate this, but I believe it is around 1.8%, and therefore monetary policy remains too loose.

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

With strong construction, manufacturing and service sector PMIs continuing in June, sector quarter growth in excess of 0.8% seems assured. Consumer confidence is at a nine-year high. The housing market is racing, with prices in the most recent quarter up 8.7% on a year earlier (on the Halifax index). Unemployment is down to 6.6% and expected to fall further.

The real economy boom is still not feeding through into faster money or credit growth. Broad money (M4ex) grew at just 3.6% in the year to May 2014, down from 4% three months earlier. Aggregate lending (M4Lx) has stopped shrinking (as it was doing earlier this year, contrary to the talk of “debt-fuelled growth”) but still only grew 1.1% in the year to May 2014 (though that was its strongest growth since 2012). CPI inflation was down to 1.5% in May (though that may pick up from around July as international oil price rises feed through).

There is thus certainly no need to raise rates in order to “cool the economy down”. Inflation is low. Money growth is poor. GDP growth of 0.8% is solid but not spectacular and shows no signs of getting out of control yet. There is no overheating, yet or upon the horizon, that would justify anything remotely close to tight monetary policy.

However, the argument for raising rates is not an argument for tight monetary policy. The reason to raise rates is (a) that we no longer require the epic emergency levels of monetary support — with all monetary spigots twisted to maximum — that were the reasons interest rates were cut to near-zero and QE was begun in 2009; (b) that near-zero rates damage growth over the medium term, introducing distortions to economic decision-making, retarding the liquidation of inefficient companies and investment projects and facilitating new mal-investments, and the longer rates are kept too low the worst such distortions become and the greater the pain when rates finally do rise; (c) that rate rises when the economy is doing well could be interpreted as good news and boost short-term growth whereas if policymakers wait until they are forced to raise by bad news (e.g. rising inflation) that will be a bad signal that may damage short-term growth, and (d) raising rates from near-zero gives policymakers scope to cut rates if the economy experiences a negative shock whereas with rates already zero any negative shock cannot be offset by rate cuts.

The steer the Bank of England governor has been offering is that, even when interest rates rise, they will not return only to 2% to 3% at peak, rather than the 5% or more that was normal pre-crisis. Since the equilibrium rate of interest is (as a first iteration estimate) approximately given by the sum of the medium-term growth rate and the inflation target, at a 2% inflation target a 2% to 3% equilibrium interest rate would imply the Bank believes the UK’s medium-term sustainable growth rate is only 0% to 1%. That is much too pessimistic.
Recovery may be choppy and we may well see another recession later in the 2010s, but with public spending coming down and the debt imbalances of the 2000s being worked off, the sustainable growth rate should return to 2% to 2.5% by the latter 2010s, implying an equilibrium interest rate of above 4.5% not 2%. If inflation gets going a little, in an otherwise healthy economy the interest rate peak could be above the equilibrium rate. We should not swing from the excessive optimism of the 2000s to permanent pessimism now.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise rates by ¼%; no further QE but can be held in reserve for the next euro crisis
Bias: To raise

There has been little that has changed in the economy in the space of a month, except for the mixed messages coming out of the Bank of England. At first, there was a recognition that interest rates may rise sooner rather than later. More recently, there has been a backtracking with the message that the appreciation in Sterling had to be moderated. The markets have already factored a rise in rates and Sterling has appreciated by around 10%. The rise is inevitable; the uncertainty is about the timing.

The longer the Bank delays the stronger the probability that the rise in rates would be larger. The argument for raising rates is a supply-side one and is therefore not dictated by short term objectives. The efficient intertemporal allocation of resources requires that real rates of interest have to be positive. Investment needs to be diverted from low productive to high productive sectors and the market for savings has to provide a positive real yield.

These are of course medium term to long term considerations and it can be argued that a rise in interest rates will hinder the nascent recovery. Certainly, there will be pain for those who indebted themselves on the basis that mortgage rates will remain low for several more years or to those firms that exist on cheap bank credit. But there is also evidence of a short term nature that points to a developing recovery which gives added impetus to the more medium term arguments for raising rates. The pain can be mitigated by raising rates in small stages to wean those enterprises out of their dependency on low rates, but the longer the delay the greater the likelihood that the inevitable raise in rates will be higher.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate 0.25% and start to reduce the stock of QE gilts
Bias: Further rate rises and more run-down of QE

We have a largely new Monetary Policy Committee and it seems to be learning on the job, side by side with a brand new Financial Policy Committee (FPC), endowed with ‘macro-prudential controls’. The Bank of England is the location of both these Committees, a logical development brought about by the crisis. Before the ill-fated ‘Tripartite’ set-up created by Gordon Brown in 1997 which split powers over monetary, financial and regulative policy between the Bank, the FSA, and the Treasury, all these powers had been wielded by the Bank in consultation with the Treasury. Hence, what has been done now by George Osborne in the wake of the crisis is to return all these powers back to where they once were. The only difference is that their exercise has become more formalised and ‘transparent’; also the regulations that are now being implemented are recent and complex.

Currently, the conventional view is that developments in the housing market (e.g. prices and mortgage lending) was not controlled adequately by monetary policy in the run-up to the 2008 financial crisis and so instead need to be controlled by additional direct intervention (e.g. regulatory measures enacted via the FPC). Yet there are two key objections to this view that both seem to me to be strong. First, monetary policy could have been conducted in the past so that the credit and housing boom would have been moderated, had policymakers chosen to do so at the time. And second, direct intervention may create its own costs in the distortion of market behaviour.

Turning to the present situation I welcome the decision by the FPC to go softly on intervention in the mortgage market. Their remarks effectively amount to no more than what the mortgage providers themselves and the markets would be doing anyway - namely keeping an eye on the high loan/house-value borrowers. Having said this, these borrowers are in most cases fairly low risk as they have a lifetime of earnings ahead, i.e. high ‘human capital’. Intervening against them would be to handicap some of the more dynamic agents in the economy.

At the same time, can one discern in the confusion created by the Governor’s many conflicting comments on future monetary policy that there is a hardening of the MPC’s approach to interest rates and QE? I hope so and for long have been arguing that it is high time to ‘normalise’ monetary policy. The economy is picking up rapidly at a time when the best estimate of spare capacity is quite low; the labour market is buoyant and not far from the 5% unemployment rate at which, roughly, full employment prevails. It seems rather clear that the economy is no longer in the intensive care that justifies emergency low rates and a massive overhang of official liquidity.

It is usual in these situations, when memories of the recession are still fresh, for many people to argue against ‘premature tightening’. However, this is also a dangerous time to listen to such arguments. The strongest point in their favour is the slow growth of the money supply and the glacial growth of credit that is associated with this slow growth. The problem is to interpret these developments. There has been a wave of new regulation which has impacted massively on bank behaviour, forcing banks to shrink their balance sheets aggressively. Now we seem to be entering a phase when firms are finding ways of substituting away from bank credit; the surge in the mortgage market is the only vibrant part of the credit scene, and ironically in view of all the concern being expressed about housing is also low risk-weighted in bank regulation.

While still slow, broad money growth (on the favoured M4ex definition) has picked up in the past year to a pace comparable with that of nominal GDP. So if it is also distorted downwards by substitution due to the new regulatory environment, then its message reinforces the case for monetary normalisation.
To conclude, I am in favour of moving towards a cautious normalisation of monetary conditions, with an immediate rise in interest rates of 0.25% and a move to reducing the Bank’s portfolio of gilts. In future months this process should continue.

Comment by David B. Smith
(Beacon Economic Forecasting, University of Derby)
Vote: Raise Bank Rate by ¼%; hold QE
Bias: Avoid negative regulatory shocks to the financial sector; gradually raise
Bank Rate up to 2% to 2½%, and quietly run off QE as stocks mature

There was a time when central bankers were considered stern and unbending gentlemen who uttered few words in public and only carefully chosen ones at that. Nowadays, with their speeches, podcasts and press conferences, some central bank representatives appear in danger of becoming a part of ‘celeb’ culture. Clearly, openness and transparency are good things. Furthermore, central bankers are now generating the massive income transfers within their societies – e.g., from savers to borrowers – that were considered traditionally to be the role of re-distributive fiscal policies; policies that were themselves highly politically controversial. This means that central bankers have to explain themselves to the people who have suffered collaterally from their policies, in order to maintain social acceptance for measures taken in what is perceived to be the wider public good.

However, there are also risks in a high media profile designed to service the 24-hour news media. One risk is that the central bank discredits itself if it seems to be flip-flopping from one stance to another. Policies such as forward guidance rest on the implicit assumption that central banks can know more about the future than private agents – in other words, that “the gentleman in Whitehall really does know best”, to quote a later 1940s Labour minister. Unfortunately, there is little evidence in terms of its forecasting record that the Bank of England can look further ahead than other people, despite the massive resources, including some two hundred economists, it devotes to the endeavour. This is probably because accurate economic forecasting on a sustained basis is philosophically impossible in the first place.

The other risk associated with placing constant new utterances in the public domain is that it adds to the uncertainty facing economic agents in the private sector. Economic decisions to invest in productive activities, such as capital formation, education and training, not only reflect current economic circumstances, and/or the most-likely central scenario, but also the risks attached to the outlook. Governments that run large budget deficits and show no stomach for cutting back on public spending are effectively telling private agents that their tax burden will go up in future but not how, where or when, for example. Similarly, politicians who engage in anti-business rhetoric, or propose arbitrary price controls, are adding to the uncertainties of doing business and leading to sub-optimal levels of capital formation in the sectors concerned.
Likewise, the Bank of England appears to have entered the zone where its numerous comments are adding to the uncertainties about future interest rates. Such statement-induced uncertainty discourages productive investment by the private sector and thereby reduces future aggregate supply. The supply-side damage caused by an overly discretionary monetary policy explains why people sometimes prefer heavily-constrained ‘rules-based’ policy making. One example is that some US commentators are now claiming that the old ‘gold standard’ would have provided a better monetary anchor than the machinations of the US Federal Reserve since the early1970s. Another is the long-term stability orientated approach implemented by the Bundesbank between the 1970s and European Monetary Union, which would be the author’s preference.
The revised first quarter national accounts data, released on 27th June, added more detail, and some significant revisions, to the statistics from 2013 Q1 onwards but did not massively change the underlying picture. In the light of the new figures, the UK is expected to grow by 2.8% this year, 2.2% next year and 1.9% in 2015, before settling at around 1.8% to 1.9% in subsequent years according to the latest runs of the Beacon Economic Forecasting (BEF) model. One unusual feature of the BEF projection for 2014 is that the British growth rate exceeds the 2.2% projected for the Organisation of Economic Co-Operation and Development (OECD) area as a whole. This is historically unusual but it also happened in 2013, when the UK grew by 1.8% and the OECD by 1.3%. However, OECD growth is expected to overtake Britain’s next year, when an OECD growth rate of 2.8% is expected, and also in 2016 when OECD growth is predicted to be 2.1%. In the longer term, OECD growth is expected to run consistently some ¼% to ½% higher than Britain’s. Nevertheless, Mr Osborne will be able to go into the May 2015 election campaign with the claim that he is presiding over a better than average performance where developed-country growth is concerned.

However, a major fly in the ointment is the continuing size of Britain’s twin deficits on the balance of payments and the government’s fiscal accounts, where recent figures have been disappointing. This gives rise to concerns about the sustainability of the recovery beyond the May 2015 election. Thus, the balance of payments data, released alongside the GDP figures on 27th June, revised up the 2013 current account deficit by £1.7bn to £72.8bn and announced a deficit of £18.5bn for the first quarter of this year, while Public Sector Net Borrowing, defined to exclude the temporary effects of financial innovation, was £20.1bn in the first two months of the current financial year (i.e., April and May 2014) compared with £14.5bn in the first two months of fiscal 2013-14.

One detail from the latest national accounts is that the volume of general government capital formation is running well below the figures projected by the Office for Budget Responsibility (OBR) in the March Budget documents. Thus, real government investment is reported as £7.1bn in 2014 Q1 measured in ‘chained’ 2010 prices compared with an OBR forecast of £8.5bn, representing a shortfall of 16½% (however, these are very erratic figures). This investment shortfall suggests that, not only are the public accounts only coming right at a glacial pace, but that the positive growth-enhancing parts of public spending have been crowded out. One dreads to think what would happen to the public finances, and financial-market confidence in the management of the UK economy, if a putative Labour government tried to increase public spending after the May 2015 election, starting from such an unsustainable base.

The May inflation data showed the annual rise in the CPI easing from 1.8% in April to 1.5% in May. However, it is likely that the extent of the deceleration was exaggerated by the timing of Easter and other special factors. Also, the most recent hike in the price of oil will probably not appear in the official figures until the July CPI is compiled, or possibly later. However, it is also likely that inflation has turned out lower than expected because the importance of Sterling as an influence on the domestic prices is badly underestimated in ‘output gap’ models of the inflationary process, such as those preferred by the Bank of England. The latest BEF projections show annual CPI inflation easing to 1% in the final quarter of this year but rising to 2.1% in late 2015 and 2.5% in the final quarter of 2016, before broadly sticking around this rate for several years thereafter. Other indicators of current UK inflationary pressures, including average earnings and producer prices also remain at or below 1% and there is little justification in the current data for wanting to raise Bank Rate.

However, monetary policy is meant to be both forward looking and take account of the balance of risks on all possible scenarios. There is also the issue that the extreme medical intervention that may be appropriate immediately after, say, a cardiac arrest will itself prove fatal to the patient if persisted with for too long. The 9.9% annual rise in the Office for National Statistics measure of UK house prices in the year to April; the strength apparent in the price of some other financial markets, and the evidence of suppressed inflation in the balance of payments figures, suggest that it is now time for a less extreme treatment regime. The annual increase in the M4ex broad money definition admittedly has slowed from the recent peak of 5.2% recorded in May 2013 to 3.8% in both March and April 2014. This is hardly a ‘Boom, Boom Britain’ headline rate of increase. However, it seems enough to sustain the recovery, particularly given the very unattractive returns from holding money on deposit, which have probably reduced the demand to hold money.

The conclusion is that Bank Rate should be raised by ¼% in July and then increased cautiously in a pre-announced fashion, by ¼% every second month or so, until it reaches 2% to 2½%. Likewise, QE should be allowed to unwind gradually as stocks mature, through a process of partial re-placement. A final comment is that there is almost no justification for attempting to offset the financial consequences of an unduly low Bank Rate by imposing direct controls on the lending and borrowing decisions of financial institutions and adult citizens. Such policies represent a classic example of ‘the gentleman in Whitehall knows best’ syndrome; were tested to destruction in the 1960s and 1970s, and totally failed then. One reason is that the politicians and HM Treasury officials – who then largely set rates – found it more politically convenient to slap on additional controls than to raise Bank Rate. At a time when inflationary expectations were rising anyway because of oil price shocks and other factors, this policy preference was a major contributor to inflation getting out of control in the mid 1970s.

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

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. Yet it would be a travesty to consider this mild uptick in household credit growth as posing any kind of systemic threat.

The new recommendations of the FPC appear quite innocuous, confirming that it is not the Bank’s intention to hit the economic recovery on the nose. The limit of 15% for the proportion of high (more than 4.5 times) loan to income multiples is far from a binding constraint. The stipulation that new mortgages should be stress-tested for a 3 percentage point rise in Bank Rate is reasonable enough, considering that it does not lay down what assumptions should be made for the spread between Standard Variable Rate mortgages and Bank Rate. A narrowing spread as interest rates normalise would be a reasonable assertion. Also, lenders are free to assume faster growth of borrowers’ incomes to help them through the stress test.

The inflationary side effects of this experiment in delayed interest rate reaction 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 has been 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 (via the Mortgage Market Review) or deploying macro-prudential tools allow the Bank to insist 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 Mike Wickens
(University of York, Cardiff Business School)
Vote: Raise Bank Rate by ½% and decrease QE to £250bn
Bias: Start to unwind QE and slowly raise interest rates as the economy grows

Despite inflation being below the 2% target, nearly all of the signals are that the economy is recovering rapidly. Although goods prices have not reflected this yet, house and asset prices, which are forward-looking, have. This has caused the Bank for International Settlements to warn of “euphoric” financial markets. It says that they are detached from reality, but it is more likely that excessive liquidity and growing confidence in the future has caused a huge portfolio switch from bonds and idle reserves to equity.

This has caused some confusion in the MPC. Having announced that interest rates would remain unchanged in the immediate future, Governor Mark Carney warned that interest rates were likely to rise before long which caused a strong increase in the value of Sterling. To general confusion the Governor then reverted to his previous stance of no immediate change. At the same time Financial Policy Committee announced that macro-prudential concerns about rising house prices required constraining the availability of loans through limiting mortgage leverage ratios. In other words, even though it agrees that that there is a problem, the Bank continues to prefer quantitative non-price to its price instrument, the interest rate.

Further insight into the thinking of the MPC was revealed by departing Deputy Governor Charlie Bean, who indicated that even when interest rates are raised it would take several years before they were restored to hitherto normal levels such as 5%.

My own view is that, in order to minimise market distortions such as the current surge in asset prices, interest rates should reflect market forces and policy should rely as little as possible on non-price constraints. As interest rates take time to affect the real economy and sharp increases in interest rates tend to increase market distortions through inertia and falsifying expectations, the long hike in interest rates envisaged by Charlie Bean should start now and non-price QE should be reduced now.

Under Mark Carney monetary policy has become quite confusing and has lost its clarity. First there have been the opaque overrides, then the unemployment threshold debacle and now the gyrations on interest rate expectations. All of these may be interpreted as the use of non-price monetary instruments. The sooner monetary policy returns to normal the better.

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

The UK economy continues to recover at a solid pace. Recent data suggest that Q2 growth will be close to 0.8% expansion recorded in Q1. It could be even slightly faster than that, depending on how much net trade detracts from growth in the quarter. What does this mean for monetary policy? That should also depend on the inflation outlook, and the risks to growth. CPI inflation posted a weaker than expected outturn in May, falling to a 1.5% annual rate from 1.8% April. This is well below the Bank of England’s 2% target - the sixth consecutive month this has occurred and the slowest rise since October. Retail Price Index inflation also declined, from 2.5% to 2.4%, its lowest rate since December 2009. Service sector inflation fell to just 2.2% - the slowest annual pace since the official harmonised series began in January 1997. The fall in service sector inflation was due principally to weaker transport prices. Goods price inflation held at 0.9% - the lowest since October 2009. Notably, pipeline price pressures were also subdued. Annual producer input prices contracted by 5.0%, while output price inflation slowed to just 0.5%. Although the price inflation rate may remain little changed over the near term, Sterling’s strength and subdued pipeline price pressures are expected to keep downward pressure on it over the coming quarters.

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 May. At the same time, however, ongoing economic recovery is likely to lead to a gradual decline in the degree of economic slack. That said, wage inflation remains very weak, rising just 0.7% in April. It should not be forgoetten that the long term unemployment rate remains relatively high, posing a downward pressure on wages that some seem to ignore. For now, we believe there is enough spare capacity for companies to respond to increases in demand without putting up prices. Meanwhile, headline money supply growth was -0.6% year on year in March, with a decline month on month of 0.2%. No wonder there is little inflation risk.

There are also risks to growth, although they are mainly from overseas. This includes slow growth in Europe, Ukraine, the Middle East, Asia and the financial risks from overpriced financial markets suddenly tumbling to earth as the US Fed moves to a less loose stance.

After intense speculation following the Governor’s Mansion House speech in June, the MPC voted unanimously to keep policy unchanged at the June meeting – an outcome that surprised some following the Governor’s more hawkish Mansion House speech. The tone of the minutes was a little more hawkish than at the last meeting, with the MPC expressing “surprise” at the low probability attached by the market to a rate rise this year. The MPC reiterated that the timing of the first rate rise would depend on inflation developments, which in turn, would depend on the MPC’s view on the absorption of spare capacity. Although the prevailing weakness of inflation and wage growth set a fairly high bar, the MPC noted that the surprise strength of the labour market and economy posed a clear upside risk. There appears to have been particular relief in financial markets that the decision to leave policy unchanged was unanimous at the June meeting. I also happen to believe that there are first mover risks (just look at how the pound has risen), and the risk of tighening too soon, as Japan did a decade ago. That said, I vote to leave rates at 0.5% but acknowledge that the monthly data are becoming increasingly important to focus on with regard to the timing of when Bank rate rises.

Policy response

1. On a vote of eight to one, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in July. The other member wished to hold.
2. There was disagreement amongst the rate hikers as to the precise extent to which rates should rise. Five voted for an immediate rise of ½% but three members wanted a more modest rate rise of ¼%. On standard Monetary Policy Committee voting rules, that would imply a rise of ½% would be carried.
3. All those who voted to raise rates expressed a bias to raise rates further.

Date of next poll
Sunday August 3rd 2014

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 Andrew Lilico (Europe Economics, IEA). 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), Patrick Minford (Cardiff Business School, Cardiff University), David B Smith (Beacon Economic Forecasting and University of Derby), 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.