At its meeting of Tuesday 14th October, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended that Bank Rate should be raised by ¼% on Thursday 6th November.
Those urging a rate increase took the view that there was still a window of opportunity to raise rates, despite low inflation and the risk of a new Eurozone crisis. With GDP still growing rapidly and unemployment low, and with emerging evidence that salaries for those in work having been outstripping inflation for some time, the economy should be sufficiently robust for some modest normalisation in rates. Some felt that the risk of a downturn at or around the medium-term horizon strengthened the case for a rise now, as it would be a serious policy error to go into a new downturn with rates still effectively zero.
Those urging rates remained unchanged felt there was no inflationary imperative to raise rates and hence no reason not to explore to what extent there is still significant potential for output to expand significantly to replace growth lost during the recession. “Later” and “wait and see” remain the key mantras for this group.
---- Minutes of the meeting of 14th October 2014 ----
Attendance: Roger Bootle, Jamie Dannhauser, Anthony J Evans, John Greenwood, Andrew Lilico (Chairman), Kent Matthews (Secretary), David B Smith, Peter Warburton, Trevor Williams.
Apologies: Tim Congdon, Patrick Minford, Akos Valentinyi.
The Chairman requested that committee members be timely in their submissions as frequently he has found that by the Friday of the week before production he has not got the commitment for a full set of votes. He would like to complete commitment before the Friday of the week before submissions and votes be submitted by the Monday of the week of production.
Andrew Lilico asked Anthony J Evans to commence his presentation.
---- Monetary situation -----
Anthony J Evans distributed a paper of charts and tables to the committee on the ‘Monetary Situation’ for reference. Beginning with domestic money and financial markets Anthony J Evans said that domestic monetary trends had shown no major changes over the 24 months to September. But narrow measures such as private non-financial divisia, MA (Currency and Demand deposits) and household divisia all showed robust growth. It was commented that traditionally narrow money growth is a good coincident indicator of nominal GDP growth. On the currency markets major currencies are back at pre-crisis levels with a tendency for a weakening euro and strengthening US dollar. Sterling continues to strengthen from mid-2013. Production and manufacturing is recovering but still unlike services, is well below pre-crisis levels. Gilt yields continue to slide since the summer but standard variable rates have hardened. The stock market has fallen sharply in recent weeks but remains at similar levels to spring 2007.
Turning to output and the labour market, employment data show a continued improvement in the year and unemployment continues to fall reaching 6.2% in May-July. Pay growth remains moderate at 0.7% but this figure has been affected by changes in the composition of the labour force that has had temporary effects. Average earnings growth could show a rise in the near future.
Large revisions to the National Accounts show a smaller peak to trough drop in 2008/9 which has been revised down from 7.2% to 6.0%. The level of GDP in 2012 is now estimated to be 6.2% higher largely due to the reclassification of R&D from intermediate production and the inclusion of the sex and drug industries. All sectors have shown steady growth driven by services. Domestic demand growth is driven by investment rather than consumption. Business investment is 10% up on the year but consensus forecasts are for a slowing down in 2015 as also indicated by the composite leading indicators. Weakness in the Eurozone economy and the strengthening of sterling has taken its toll on exports. However, in terms of the fundamentals nominal GDP growth has returned to normal – a 4% annualised growth from 1997 shows actual nominal GDP is approximately at this level in the most recent quarter.
Turning to costs and prices, the data shows that CPI inflation is muted and declining on the back of falling oil and input prices. Factory gate prices are falling and surveys suggest that inflation expectations are well anchored. While still high, house price inflation may have peaked with smaller annual increases in September than in August. However, nominal house prices have only just reached the 2007 peak, and real house prices are well below it.
On the international front, the latest forecasts by the IMF anticipate a global recovery in 2015 after an expected slowing in 2014. The IMF’s advocacy of infrastructure spending to boost capacity reveals one of two interpretations. One view is that depressed aggregate demand has created a reduction in potential GDP. Another view is that realising that a lot of pre-2008 growth was due to over-capacity followed by a series of negative supply shocks, means that the world economy faces a supply-side problem. USA and UK output growth is above 2011 levels and leading the pack in terms of growth performance. However, threats to the global recovery come from another Eurozone flare up, a slowing Chinese economy, geo-political tensions in the middle-East and Ukraine, stock market volatility and Ebola outbreak.
The ECB has provided national governments a breathing space to resolve its respective fiscal problems but significant supply-side problems remains. A failure to properly deploy a European QE has meant an undershoot of the inflation target due to monetary timidity. In the far-East, China is tightening credit growth and is set to undershoot its implicit monetary target, based on a long-term growth rate of 10%, inflation of 4% and velocity of -2%. A slowing down in China will be transmitted to the world through a slowing in trade, commodity prices and financial flows. In addition political tensions from the Hong Kong protests add to the air of overall uncertainty.
In conclusion Anthony J Evans said that monetary policy was very loose and even after a rise in the base rate monetary policy will remain loose. Strong domestic demand conditions provide a window of opportunity for the process of normalisation and rates should rise by 0.5bp.
Andrew Lilico thanked Anthony J Evans and opened the meeting out to general discussion. There followed a short discussion of where the view that increased potential output growth would lead to a widening output gap came from. Trevor Williams said that the idea was being pushed by Larry Summers and the IMF. Peter Warburton said that the IMF assume that multipliers of 2.5 for advanced economies and at the zero lower bound the multiplier is even higher has been extended to developing economies. The predictions for the world economy are based on models of advanced economies.
Kent Matthews said that the presumption of tightening in China is based on the assumption of a 10% underlying growth rate. He said that even official Chinese sources do not expect anything like this. Trevor Williams said that a recent meeting with Chinese officials they said that growth rates of less than 7% is likely, given over investment in cities’s infrastructure over the last few years John Greenwood said that he also felt that underlying Chinese growth was considerably less than 10%. He contended out that Anthony Evans’ -2% estimate of velocity was incorrect; he calculated that China’s M2 velocity had declined at an average annual rate of 3.5% p.a. since 1996. Roger Bootle asked about the influence of a slowing China on the rest of the world through the effect on commodity prices, particularly oil. John Greenwood said that oil is less important to China than people think. Most of its energy needs are met by coke and coal, and these prices had declined steeply.
Andrew Lilico observed that Anthony J Evans had not discussed the risk of a rise in UK rates having a feedback effect into the Eurozone and tipping it into recession and crisis. Anthony J Evans said that since this represents an uncertainty it should not be used to paralyse policy. He said that he favoured a policy action followed by a wait and see period. He said that UK domestic demand is strong and that the Bank cannot wait for the Eurozone to correct itself otherwise it could wait forever. The window of opportunity is provided by the nominal GDP growth of 4%.
John Greenwood said that the ECB expectation that growth will recover next year and inflation would rise displayed a misunderstanding of the business cycle. Inflation normally slows in the first two years of recovery and Eurozone M3 growth had averaged only 1.2% p.a. since 2010, pointing to deflation (which he had forecast from two years ago) in 2015. He said that major divergences in global bond yields are very infrequent but clearly something is happening now with German 10-year bond yields, which could fall below JGB yields in 2015. Andrew Lilico said that three Eurozone factors provide the backdrop for the policy setting in the UK; first the reassertion of sovereign bond problems; second the effect on UK exports to the EU, and third QE in the Eurozone.
Peter Warburton said that central banks are positioning themselves to be more powerful and interventionist. Trevor Williams said that the ECB had set out its stall for a return to its 2012 position regarding balance liabilities and so needs to use asset backed securities as part of its armoury. Jamie Dannhauser questioned the effectiveness of ostensibly degrading the ECB balance sheet. David B Smith said that Germany has been providing the ECB credibility by underwriting unusual debt instruments.
Roger Bootle said that the Eurozone crisis is returning because of its ‘inherent contradictions’. The ECB is being taken to the European Court of Justice and may not be able to engage in policy as the Court could tie it up in the immediate future. While the French would want a relaxed monetary policy it is not likely that Germany would agree. David B Smith said that there is an established link between UK growth and world growth through net trade which constrains the UK economy.
Comment by Roger Bootle
Vote: Hold Bank Rate
Bias: To hold
1 Year View: ½%
Roger Bootle said that the growth rate of the economy has indeed been impressive. He said that in certain ranges of the economy expansion leads to lower unit costs and lower inflation because of increasing returns to scale. He expects quite a strong period of growth with low inflation. However, the looming election and the inevitable fiscal tightening that will follow make him cautious on interest rates. The impending cataclysm in the Eurozone will stay the hand of the MPC. There is an argument for interest rates to rise, but not now. He said that basically, we don’t know what is going on and therefore attention should be paid to current price and wage inflation. Similarly, the monetary aggregates are also distorted. He voted to hold interest rates with a bias to hold.
Comment by Jamie Dannhauser
Vote: Hold Bank Rate
Bias: No change
1 Year View: Bank Rate at 0.75%; No asset sales
Jamie Danhauser said that a couple of months ago he would have expected by now to be in favour of an interest rate hike. Recent events have pushed back the likely date of a rate hike. Although the private sector is growing strongly (with major revisions to the data having changed the picture even further), the global backdrop is far less not encouraging than it was a few months back. Eurozone weakness is not a surprise; persistently sluggish growth in emerging markets is, however. While the US economy is still growing robustly, downside risks to global growth are becoming more material. Domestically, there is uncertainty about the amount of slack in the UK economy; but the marked downward trend in domestically-generated it is clear that inflation is trending downwardsover the last year should give greater confidence that past judgements about considerable slack were reasonable. One can add to this the downward lurch in commodity prices in recent months. and it is not just the effect of commodity prices. With fewer fears that the supply side is not as weak as it might have been, the potential weakness of previously thought but is connected to world growth which itself is looking weak. He said that he wouldcalls for rather adopt a ‘wait and see’ policy. If the world economy comes out of this soft patch unscathed and the US expansion remains solid, there will be a case to begin the process of gradual rate hikes.
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 said that he had made his position clear in the presentation. He said that relatively strong domestic demand provides the window of opportunity to begin the process of normalisation and that the Bank should act now when growth has returned to normal rather than wait for it to rise sharply.
Comment by John Greenwood
(Invesco Asset Management)
Bias: No bias
1 Year View: No view
John said that he was in agreement with Jamie that GDP growth was surprisingly strong. Mainly this has come about through an increased number of jobs but at low pay levels. So there remains a question about the quality -- and hence productivity -- of the increased UK employment. The recovery is therefore fragile and remains vulnerable. Strong growth in broad money would be helpful given the ending of QE. There has been some reduction in the savings rate even after the redefinition of savings in the national accounts. Despite the clear strengths he said that he was not in favour of raising rates as a weakening of the economy could occur (as it had in Sweden). Inflation will be below 1.5% and the Governor may have to write a letter. Broad money and credit growth does not indicate runaway demand. Nominal spending is unlikely to change much in the short term and the economy may weaken. Moreover, Draghi’s policies will fail to boost the Eurozone economy. He voted to hold rates with no bias.
Comment by Andrew Lilico
Vote: Raise Bank Rate by ¼%
Bias: To raise Bank Rate further
1 Year View: 1¾%
Andrew Lilico said that after a long period of voting for a ½% he had to change his vote. He said that it was a mistake not to have raised the base rate in the past, but that since he opposed looking through short-term spikes he could not ignore inflation approaching 1% now. He voted to raise rates by 25bp in stages towards and eventual pause at just under 2%.
Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%
Bias: to raise in stages. QE to be used only in the event of euro crisis
Kent Matthews said that he was impressed by Anthony J Evans’ analysis that the conditions appear right for a base rate raise but that his arguments are more microeconomic than macroeconomic. In many ways the situation is reminiscent of the old debate of Liquidity Preference versus the Loanable Funds theory. He asked how long interest rates can be depressed before the allocative inefficiencies of financial repression begin to override macroeconomic considerations. His view which he has repeated at previous meetings was that low rates were subsidising the wrong type of enterprise while badly needed bank credit was not flowing to the right enterprises. Recent research suggests that small firms are using trade credit as a substitute for bank credit in the absence of bank financing, increasing the fragility of the economy. Real interest rates have to return to being positive so that the economy can rebalance and that credit markets be allowed function efficiently. Not since the 1930s has bank rate been constantly at a low rate and negative real interest rates for this length of time are unprecedented.
It seems inconceivable that investment decisions made for a medium term horizon would be affected by a 25bp rise and investment decisions that are conditional on interest rates remaining at these low levels should not be made at all. While there are negative macroeconomic pressures a rise in base rates will create on the exchange rate and potentially on domestic demand, the microeconomic gains have to weigh against the macroeconomic losses, which is why base rate should be raised cautiously and in small steps. The inevitable return of the euro crisis will require a tractable monetary response in the form an interest cut and additional QE. If interest rates are not at a position to be cut the Bank will regret not having raised rates earlier.
Comment by David B Smith
(Beacon Economic Forecasting)
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 he was still trying to digest the Office of National Statistics (ONS) figures released on 30th September. There had been huge changes to the scale and composition of the ONS GDP figures, which had substantially invalidated previous views about the UK economy. ( Editorial Note: A detailed analysis of The UK National Accounts After the 30th September Data Avalanche is available on request from email@example.com.) The changes to the ONS data were so substantial that scientific model-based prediction had become almost impossible at present. As a result, he admitted that he had almost no feel for what was really going on. However, the UK could not escape its historically close links with the wider world economy. Many of the adverse issues in the Eurozone stemmmed from the inability of Germany to enforce sufficient fiscal discipline on the rest of the euro economy. The UK inflation rate was currently being dominated by transitory effects. In the short-term, the much reduced prices of oil and non-oil commodity prices would drive prices lower but this would become part of the base for the annual inflation calculation in a year’s time. In the medium term, domestic inflation was connected to global inflation via changes in the external value of sterling. With global inflation low and sterling reasonably strong, he was not too concerned about any upside risks to inflation over the next year or two. He commented that the tax and price index (TPI), which was relevant to the alleged cost-of-living crisis, had risen by 1.8% in the year to September. In these circumstances, he felt that a moderate ¼% rise in Bank Rate was appropriate for November, with further upwards adjustments being gradually phased in in subsequent months.
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 the actual MPC was stuck in a rut on monetary policy and they were mistaken if they thought that the Financial Policy Committee can do soft tightening in its place. The evidence from Israel is that the economy reacts to interest rate rises. Raising the base rate is the correct decision. A downturn is coming in two years’ time and to go into it at rock bottom interest rates is highly regrettable. Given the recent appreciation of sterling, he said that inflation is surprisingly high. We are running out of time to raise Bank Rate. The Bank has created a mentality that even a small rise in the rate is destabilising. He said that rates should rise in stages to a target of 1.5% over the next year.
Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Bias: No view
1 Year View: No view
Trevor Williams said that growth performance has been good but industrial production is still 5% below its pre-crisis level. Similarly construction is 13% below its pre-crisis peak. The strongest sector performance has come from services, and, even with the new data, this broad pattern is unchanged. We should not be surprised if the recovery now slows further because the UK is an economy that is open to global shocks like Europe, and productivity growth is still too slow. The fall in global inflation is saying something about the disinflationary forces at large, and the weakness of growth impulses. Domestically, there is no wage inflation to speak off and real wage growth is negative. The supply of labour is expanding and profit share in GDP is increasing. Annual consumer price inflation will likely slow even further, to below 1% by the end of the year. We have talked about the slowdown in China but not about the same phenomena in Russia (recession), Brazil (recession) and India where there is growing evidence of the need for substantial structural change and surety it will be delivered despite an electoral majority that makes it doable. In the event of a global down turn, there is indeed little monetary policy could do to help but tightening now will heighten the risk of a more severe downturn.
1. On a vote of five to four, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in August. The other four members wished to hold.
2. Of those favouring a rise, three voted for an immediate rise of ¼% but two members wanted a greater rise of ½%.
3. All those who voted to raise rates expressed a bias to raise rates further.
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.