At its meeting of Tuesday 15th July, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended that Bank Rate should be raised on Thursday 7th August, including five votes for a rise of ½%.
Those urging a rate increase took the view that with GDP growing strongly, then even though inflation is low and monetary growth weak, the case for emergency interest rates has lapsed and there should be some normalisation.
They viewed with scepticism the idea that rate rises would seriously derail the recovery, with some members doubting whether initial rate rises would be reflected in rises in the structure of market rate to any significant degree. One member (switching from a hold to a raise vote) noted the growth in aggregate lending in the second quarter of 2014 took it to a five year high.
Those urging rates remain unchanged felt there was no urgency about raising rates and if inflationary pressures or credit or asset price bubbles do in due course emerge, there would be time and scope to raise rates in response. They were sceptical about the view that keeping rates near zero for an extended period is intrinsically damaging to growth or financial stability. Their view was that rates will rise eventually, but there is no reason to raise them yet.
Minutes of the meeting of 15th July 2014
Attendance: Roger Bootle, Anthony J Evans, John Greenwood, Andrew Lilico (Chairman), Vandana Patel (Economic Perspectives observer), David B Smith, Peter Warburton, Trevor Williams.
Apologies: Philip Booth (IEA Observer), Tim Congdon, Jamie Dannhauser, Graeme Leach, Kent Matthews (Secretary), Patrick Minford, David H Smith (Sunday Times observer), Akos Valentinyi, Mike Wickens.
As a result of refurbishments to the IEA the meeting was held at the offices of Europe Economics. The Chairman and host Andrew Lilico opened proceedings by putting forward two issues to discuss. The first was a proposal by Philip Booth to make more explicit comments regarding the activities of the Financial Policy Committee (FPC). Andrew Lilico offered some considerations. He argued that the SMPC is focused on monetary policy, and that some members may feel the remit of the FPC is outside of their expertise.
He also suggested that whilst attempting to broaden the focus of the SMPC is understandable (especially given the lengthy period in which the MPC have maintained the policy stance), this could be the wrong time to change the emphasis given that rate rises are on the horizon. David B Smith added that many SMPC members already factor FPC considerations into their decision, for example in terms of how regulatory issues feed into monetary aggregates. He pointed out that several SMPC members have highlighted problems relating to regulations, albeit in terms of their implications for money and credit. There was general agreement amongst the members present that the SMPC isn’t confined to the brief of the MPC, and it is legitimate to discuss regulatory matters provided it is pertinent to monetary policy. Trevor Williams offered his agreement, saying that the role of the SMPC is to consider all channels, and that this incorporates issues that the FPC would discuss. He said that there doesn’t need to be a specific attention to the FPC and that the SMPC is based on monetary policy for a reason.
Andrew Lilico summarised the conversation by saying that the SMPC should neither be deterred from nor seduced into discussing the FPC. Anthony J Evans asked for clarification as to whether the intention was to generate more media attention and Andrew Lilico replied to say that there was a belief that some issues could be more formally put with explicit reference to the FPC, and that it would be a way of extending the discussions. David B Smith pointed out that the FPC has a different schedule from the MPC and that would impact the SMPC’s ability to make timely comments. Roger Bootle emphasised that there is a necessity to discuss the impact of FPC opinions on SMPC decisions, and Andrew Lilico suggested that one way forward would be to encourage the person compiling the monetary situation to incorporate explicit reference to the FPC in their presentation.
The second issue that Andrew Lilico raised was a proposal by Jamie Dannhauser to incorporate a more detailed comment about the preferred path of interest rates. Currently when members submit a vote they express a bias. However now that forward guidance has been adopted it might help clarify the position of each member if they add detail to that bias, and suggest a projection of interest rates – for example where they would like interest rates to be in one years time. Anthony J Evans expressed a concern that one of the criticisms of forward guidance is that it generates an illusion of certainty, and that it might be confused as an attempted forecast. Andrew Lilico agreed that the projection should be kept as an “ought”, and added that this would be useful for when interest rates do start to rise, and debate turns to at what rate they will be expected to return to. David B Smith commented, saying that an element of this idea is already in operation, as members are free to offer as detailed a discussion of their bias as they wish. He also expressed concerns about formatting issues, but Andrew Lilico believed that it would be feasible to represent each members view in terms of (i) a vote; (ii) a bias; (iii) an opinion about where interest rates should be in 1 years time.
There was a general support amongst the members present for the idea, with the caveat that members would not be obliged to provide a judgment (in the same way that they are not currently obliged to express a bias). A decision was made to canvass opinion from members not present. Following these two operational discussions, Andrew Lilico asked Trevor Williams to commence his presentation.
Trevor Williams distributed a comprehensive presentation and provided commentary. He began by offering an overview of what he considered to be some key themes. He said that there was a genuine recovery under way driven by high asset prices and a somewhat surprising reduction in volatility. He also drew attention to a slowdown in China, concerns about Q1 GDP growth in the US, and subdued earnings growth. He said that near zero interest rates and central bank liquidity were contributing to high risk appetites and questioned whether bubble activity was taking place. He pointed to OECD and IMF estimates of remaining output gaps.
He then turned to the monetary backdrop and pointed out that the growth rate of M2 (year to year) is now negative in the UK. Roger Bootle asked for clarification on the composition of M2 and Trevor Williams confirmed that it contains time deposits but unlike M3 it does not contain CDs and large wholesale deposits. He then pointed out that M2 was growing in the US and Japan (but that velocity was falling in Japan and there were concerns over bank lending). He revealed that M2 is growing at 2% in the Eurozone but that this is driven by monetary growth in Germany. France is almost 0% and Spain is negative. Indeed the M2 growth rates for Portugal, Italy and Greece are also negative. Trevor Williams summarised this information by saying they demonstrate worrying trends and imply doubt about the strength of the recovery.
With regard to the BRICs, M2 growth is solid, although in Russia it has been more volatile and decelerated recently. Trevor Williams pointed to the fact that Russia is highly dependent on a flow of funds and that makes it susceptible to capital flight. Andrew Lilico questioned whether M2 is the appropriate measure given that real GDP is growing in the UK at 3% despite low M2 growth. Trevor Williams replied that this could also be used to express concerns about the sustainability of such a growth rate.
In addition to looking at growth rates of monetary aggregates, Trevor Williams argued that stocks can be useful since they are less prone to showing temporary trends. He showed that the M3 stock in the UK was stagnant since late 2009, and Roger Bootle intervened to query whether this also suggested that M3 is flawed. Andrew Lilico added that real GDP has had a rocky journey since 2009 and M3 fails to reveal anything. Trevor Williams replied to say that there may be long and variable lags, and that it implies that real GDP isn’t on a consistent recovery path. Andrew Lilico raised the possibility that as of 2009 there was lots of money in the economy, and therefore since then it has not been necessary for money growth to precede growth in the real economy.
Trevor Williams then showed that by contrast the stock of M2 had been rising at a sustained rate, whereas Euro M2 was essentially flat. Peter Warburton added that different measures of the money supply have very different growth rates, and velocity figures can differ substantially. Trevor Williams expressed concerns that Portugal, Greece and Spain were showing limited ability to increase bank lending and that growth performance is lowest were lending is low. He acknowledged that there are regulatory factors at play as well.
Trevor Williams then drew attention to debt levels, explaining how UK household debt had fallen but was now starting to pick up again, and that there’s been little improvement in the fiscal deficit. Andrew Lilico recalled research that he’d conducted in 2009 on optimal levels of household indebtedness and questioned whether the existing deleveraging might be considered sufficient. He also asked Trevor Williams if he could explain why UK growth was strong in 2013 despite a contraction in bank lending, and Trevor Williams suggested higher confidence and greater product market flexibility relative to European countries with similar levels of lending. Peter Warburton added that corporate bond issuances have been stronger in Italy than elsewhere, and David B Smith queried the country-by-country breakdown of the Eurozone money supply given that in a currency union money is supposed to be perfectly substitutable. Trevor Williams responded by saying that there is part of the money supply that doesn’t flow across borders.
Next, Trevor Williams turned to growth and inflation. He said that there are concerns about the sustainability of the UK growth rate, although a recovery is clearly taking place, and that core inflation is well contained. Roger Bootle challenged whether inflation was as contained as many forecasters has predicted, pointing out that today’s figures showed a large jump to 1.9%. Trevor Williams presented data showing that US corporate profits were at their highest levels since the 1950s, and that labour market recovery is being driven by the private sector. He concluded that only the US and Germany could be said to be at “escape velocity”, which he defined as returning to pre-crisis GDP.
When challenged by Andrew Lilico to explain why that is a good measure, he pointed out that it’s not worse than any other. In terms of nominal incomes pay is still lower than in 2009, and in per capita terms it’s the same as 2005. Trevor Williams suggested that Eurozone growth may be slowing slightly, and starting to peter out. He asked where future growth is likely to come from, pointing to possible traction in GFCF, and claimed that the exchange rate wasn’t overvalued (but perhaps needed to be weaker). He also suggested that Japan may be about to provide an answer to the question of whether debt matters, given the present experiment taking place. He referred to a fiscal and monetary arrow, but only a structural “dart”. John Greenwood added his expertise on Japan pointing out that recent inflation has been driven by a 3 percentage point rise in consumption tax and a devaluation of the Yen. Peter Warburton added that recent CPI growth is likely to fall back somewhat, but services CPI is strong.
In terms of financial trends Trevor Williams explained that volatility had collapsed, markets seem to have bought Mario Draghi’s promise to do “whatever it takes”, with the probability of a Greek exit falling from 100% in 2012 to 0% now. Almost all asset classes showed positive returns in 2014, and whilst interest rates have risen in some emerging markets Trevor Williams claimed that this was a prudent response to booming credit.
The final section of his presentation looked at UK trends. CBI, BCC and PMI measures all suggest that the UK recovery has a solid base and consumption has been buoyed by rising house prices. Trevor Williams asked whether there was evidence of the supply side gaining traction and pointed to a 10% rise in business investment in the first quarter of 2014, but reaffirmed that inflationary pressures were low when looking at pay data. There was a discussion about pay measures and Andrew Lilico pointed out that figures for average weekly earnings would be released the day following the meeting. The final charts showed that inflation expectations are well-anchored and that even though unemployment has fallen it is still significantly above where it was in 2008.
Andrew Lilico thanked Trevor Williams for his presentation, and opened up the floor for discussion. Peter Warburton began by making some points that he felt underlined the debate. He said that the sustainable growth rate is conditional on existing supply side decisions, and that inflation risk in the system should be judged against the sustainable growth rate. He expressed concerns that the current growth of the UK economy might be significantly higher than the sustainable rate (perhaps twice as high) and that this recovery bears an inflation risk. He added that it is only if you think you can claw back the cumulative output loss since 2008 that you can be complacent about inflation. Monetary policy actions should be judged against the achievable, non-inflationary growth rate. He expressed severe concern about the fact that the government’s budget projections are based on an assumption of rapid growth.
When queried by Andrew Lilico, he said that he would deem a 2.5% growth rate with interest rates at 1% as being preferable to a 3% growth rate with interest rates at 0.5%. He said that consumer confidence surveys show that respondents believe that life is normalising and growth is back, but that this isn’t soundly based. Ultimately he believes that policy makers have an obligation to help frame and calibrate reasonable expectations. He expressed concern for households that are assuming debt that they may find hard to finance in future.
Roger Bootle said that he was concerned about the impact of any interest rate rises on sterling and suggested that there would be valuable things to learn prior to rates going up. Andrew Lilico countered this view by saying that there were also risks associated with waiting too long. Indeed if policymakers are behind the curve and forced into sharp rises this could be catastrophic. He suggested an asymmetry on the part of those who consider the economy to be highly fragile and unable to cope with moderate rate rises, but less concerned about the risks of acting too late. David B Smith alluded to the 1970s view that monetary policy was either “too little too late” or “too much too late”. Roger Bootle said that unlike the 1970s the biggest danger now – especially in the Eurozone – is deflation. Andrew Lilico questioned whether inflation may be the bigger danger, presenting an idea that in 2008 there was lots of money in the system, but for various reasons (regulatory constrains chief among them) it didn’t show up as inflation. But with QE on top of this perhaps there is a similarity to the 1970s. He also utilised BIS discussions about the possibility of high inflation or high deflation, and Roger Bootle characterised this as an each way bet. Anthony J Evans said that in a regime of emergency monetary policy it isn’t ludicrous to believe that the central bank can increase risk such that there’s higher probability of bad events in both directions.
John Greenwood then reminded the group that there is some context that needs to be considered. He used the example of Sweden, who raised rates too early, and then had to backtrack. He believes that there is plenty of time to judge the situation, and that several years of wage growth would be required prior to raising rates. There is not sufficient evidence that credit can be created without emergency stimulus and therefore the recovery is not truly self-sustaining.
Andrew Lilico drew upon further BIS commentary, saying that over the medium term most economists would agree that growth is higher if interest rates are above zero. He pointed out the danger that if policymakers do not even try to get back to a rate that is consistent with a maximum medium term growth rate, you could get locked into low growth. Roger Bootle expressed sympathy with aspects of the BIS view, but pointed out that ultimately it comes down to the relative strength of different factors. He repeated previous requests to be shown where the evidence is for the types of Ponzi scheme that critics of low interest rates fear. David B Smith suggested the public finances of every major government, on the grounds that they weren’t sustainable. Roger Bootle replied to say that if the implication is that there needs to be simultaneous monetary and fiscal tightening there would be a real catastrophe. Andrew Lilico defended the BIS view by saying that low interest rates prevent low value projects from being liquidated and therefore capital is inefficiently allocated. He suggested that 5 years is a very long time to consider retaining supposedly “emergency” monetary policy, but Trevor Williams responded by saying there was a clear and present danger from raising rates now.
Peter Warburton then switched attention to the US, saying that he felt the drive for lower unemployment and focus on labour market slack is a monochrome style of policy. He pointed to numerous sectors already showing high wage inflation, and diminished policy sensitivity to inflation. He wondered what the inflationary condition the world economy would be when it enters a new cycle of defaults.
Comment by Roger Bootle
Vote: Hold Bank Rate
Bias: To raise Bank Rate
1 Year View: ½%
Roger Bootle said that he was intrigued by supply side intuitions about the sustainable growth rate. He said that if there was a massive negative shock to potential growth this should show up in the labour market, but the resilience of the employment figures are impressive and bode well. He continued to say that we was concerned about the housing market, and the balance of payments – especially given the depressed demand from Europe. He said that he anticipated significant forthcoming shocks to sterling, and for inflation to remain low (possibly hitting 1%). He said that it was too early to raise rates but his bias is to raise interest rates “later”.
Comment by Anthony J. Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ½%
Bias: To raise Bank Rate further
1 Year View: 1%-2%
Anthony J. Evans said that recently there has been a window of opportunity to begin nornalising interest rates and advantage should be taken of this. He agreed that M2 and M3 demonstrate concerns about monetary growth but pointed to M4x which is reasonably strong and Divisia measures which are above 10%. He said that provided the money supply isn’t contracting, that growth prospects are strong, and that inflation is not falling below target, there is scope for rate rises. He agreed that there was some uncertainty about the impact of raising rates now, but this would constitute a necessary policy experiment. He said that he is becoming less concerned about house price inflation having spoken to estate agents recently who seem to think buyers are starting to factor interest rate rises into their mortgage decisions, and that the summer period will see slightly less activity. He believes that there is not an overly convincing case to raise rates, but similarly there is not an overly convincing case for them to be at 0.5%. Therefore he thinks it appropriate to move them back towards normal levels.
Comment by John Greenwood
(Invesco Asset Management)
Bias: No bias
1 Year View: No view
John Greenwood believes that the economy can afford to wait until the threat of inflation is more tangible. He suggested that is it misleading to treat the present situation as being similar to 2004-2008. Although house prices and asset prices were rising rapidly then it was a result of rapid credit growth, and alarmists were correct to be worried. However now it is a consequence of low interest rates, which have in fact harmed the credit creation process. The US only started to see an increase in lending in March 2011, and it only started to pick up properly in January 2014. Repo financing and issues of commercial paper are completely dormant relative to 2004-2008, suggesting that we are not experiencing a similar bubble. He didn’t believe that there is a real danger in keeping rates where they are, and expects growth to fall. A period of wage increases would be desirable, and there is little chance of inflation exceeding the 1% band around the target.
Comment by Andrew Lilico
Vote: Raise Bank Rate by ½%
Bias: To raise Bank Rate further
1 Year View: 1¾%
Andrew Lilico said that we should be seeking opportunities to normalise whenever possible and that 3% growth is a good opportunity. He believes that the burden of proof shouldn’t be on those advocating a rate rise but on those who advocate keeping interest rates so far from the natural rate.
Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ¼%
Bias: To raise by ¼% increments over the next few months
1 Year View: 1%-2% and then carry on until 2½%-3½%
David B Smith said that it was noteworthy that UK growth had outperformed OECD growth recently and that the Beacon model forecast this to continue (with 2.2% growth in the OECD compared to 2.8% in the UK). He was not concerned about inflation expecting it to be 1.1% in the final quarter of this year and 2.4% the following year. He expressed a large concern about the next stage in the move to the European System of National Accounts (i.e. ESA 2010). He noted that there would be substantial changes to the value figures – with money GDP being revised up by 3.6% - as well as to the volume data, which will move on to a 2011 chained basis. He also added that since there will be a gap in the expenditure estimates until the new 2011 measure is introduced on 30th September there will be a period of several months in which occur right when the Bank of England is expected to start raising interest rates).
David B Smith said that people have overeacted to the random volatility in recent CPI data, and that while house price inflation was rapid and accelerating, PPI was low and he expected growth to decline in the second half of this year. He also drew attention to real interest rates and argued that there has been a tightening as a result of lower rates of UK inflation relative to other trading partners. He also pointed to impending political uncertainties such as the Scotland independence vote, the General Election, and a potential European referendum. He is concerned by the slow rate of M4x but believes normalisation of interest rates is appropriate.
Comment by Peter Warburton
Vote: Raise Bank Rate by ½%
Bias: To raise Bank Rate further
1 Year View: 1½%-2%
Peter Warburton said that interest rates should have been increased a year ago and that a taboo has formed around changes to Bank Rate. He expressed doubts that any change in Bank Rate would be fully reflected in the structure of market interest rates. It is probable that additional spending by savers will compensate for a loss of discretionary spending by those whose debt obligations rise. He also made the point that rate rises would only make sense in an international context, and therefore his vote is based on an expectation that other countries will do likewise. He added that lots of debt-related vulnerabilities remained but these would not have a material effect on economic growth until Bank Rate reached around 2%.
Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Bias: No view
1 Year View: No view
Trevor Williams said that growth has traction but is not yet inflationary and there is a real danger of slipping backwards. He believes that rates should only rise when there is positive traction on wage inflation (in terms of real earnings). He believes that when interest rates do go up they may peak at 2%-3%.
Votes in absentia
The following two votes were provided in absentia by members unable to attend the physical meeting.
Comment by Tim Congdon
(International Monetary Research)
Vote: Raise Bank Rate by ½% and hold QE
Bias: Increase Bank Rate further, perhaps to 2% by the end of the year
1 Year View: No view
For some quarters UK ‘real side’ indicators have been positive, even strong, while the banking system has continued to struggle and money growth has been weak. But in the last few months bank credit to the private sector has started to expand again, causing money growth to run at a 4% - 5% annualised rate. (In the year to June M4x increased by 3.9%; in the three months to June it increased at an annualised rate of 4.6%. In the year to June bank lending outside the intermediate other financial corporations (M4Lx) was up by 1.1%, but all of this occurred in the three months to June. In the three months to June the annualised growth rate of M4Lx was 4.6%.)
It is possible that the rise in bank credit in the last few months – which seems to be a clear break from the preceding five years – is only a blip. However, a more plausible view is that, with interest rates at only a little above zero, stronger growth of bank credit – and hence a reasonable rate of money growth without the prop of QE – is the new trend. The data need to be watched, but I expect that further base rate rises will be prudent in the rest of 2014, reaching perhaps 2% by the end of the year.
Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½% and gradually claw back QE
Bias: To raise further
1 Year View: No view
The relaxation of credit conditions brought about by Funding for Lending and Help to Buy, reversing previous regulatory policy decisions that had frozen the credit channel, remain a key part of the general UK recovery. But talk of a “house price boom” is over-done. It is still more a correction than a boom. The attempts by regulators to reign in the housing market with special measures on such things as mortgage affordability, via ‘caps’ of one sort or another, are both unnecessary in themselves and focus upon the wrong tools. It would be far better to tackle monetary overheating directly by tightening monetary conditions towards normality.
The recovery looks sustainable. Monetary policy is too loose given the UK’s fairly strong growth, including the housing recovery. Rates should be raised and QE clawed back.
1. On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in August. The other three members wished to hold.
2. Of those favouring a rise, five voted for an immediate rise of ½% but one member wanted a lesser 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 meeting
Tuesday 14 October 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). 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). 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.