Sunday, February 01, 2015
IEA's shadow MPC votes to hold rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In a significant reversal of its longstanding recommendation to raise rates,
the Shadow MPC has voted to keep rates on hold. It should be emphasized
that the driver of this shift was not a change in the personnel voting.
Instead, three members that had, at previous physical meetings, supported
raising rates changed their votes to support a hold.

Those favouring a hold included members that have been long-standing
opponents of raising rates, arguing that there is no inflationary pressure
and that the recovery is not sufficiently secure that the economy could
tolerate rate rises.

To this group were added three new votes for a hold.
Two of these argued that raising rates at a time when inflation is far below
target was incompatible with the inflation targeting regime. A third felt that
political and geopolitical uncertainties are sufficiently high to warrant a
temporary delay in rate rises.

Those advocating raising rates emphasized that the strategy of maintaining
near-zero rates has been damaging to real economic growth, to productivity
growth, to the pressure to achieve a sustainable fiscal position and to
longer-term financial stability. There was an excuse for setting rates near
zero in 2008/09, but subsequently they have been kept at that level for far
too long, the taboo of rate rises should be broken and normalisation is
long overdue.

Minutes of the meeting of 13 January 2015

Attendance: Philip Booth, Anthony J Evans, Andrew Lilico (Chairman),
Kent Matthews (Secretary), Patrick Minford, David B Smith,
Peter Warburton, Trevor Williams.
Apologies: None received

Chairman’s comments

The Chairman requested that the committee discuss the frequency of future
e-poll recommendations in the light of the announced change in the actual
MPC frequency of meeting in 2016. The meeting agreed to continue with the
monthly poll and review the e-poll frequency at the October 2015 physical
meeting. The committee also agreed that future physical meetings will devote
some time to issues of common interest other than the setting of Bank Rate.
Furthermore, there is to be a change in the required format of voting whereby
a comment is not always required. (That approach is adopted from these
minutes on.)

He then invited David B Smith to present his analysis of the global and
domestic trends.

International Background

David B Smith distributed his briefing paper (this is available from and commented that one running theme of
his presentation was the continual changes to, and occasional disappearance
of, previously well-established domestic, international and financial-market
data. The general picture for the global economy was one of disappointing
GDP growth but with some mature economies doing well. Global industrial
production fared a little better but was slowing in the Eurozone area. Inflation
in the OECD was also slowing. Official figures for broad money in the OECD
area are no longer published but unofficial figures were consistent with stable
low inflation and trend growth.

On the currency and commodity markets, the Yen had depreciated by 7.6%
and the dollar appreciated by 8.1% since the last meeting of the SMPC. The
Euro had weakened by 1.5% and sterling stabilised on the trade weighted
basis. Oil prices had fallen by more than 40% to $50 a barrel (it was mentioned
that oil had fallen to $47 that morning) and non-oil commodity prices had
fallen 2.8% since October.

There had been a worrying deceleration in broad money M4ex in recent
months, possibly portending a slowdown in the economy. Headline M4 lending
had contracted signalling the effects of regulatory overkill on the growth of
bank assets. However, the divisia monetary aggregates indicated a more
buoyant outlook for the household sector and non-financial corporations.

The revisions to the UK statistics announced on 23rd December had invalidated
significant parts of the Autumn Statement and were inconsistent with the
Office for Budget Responsibility (OBR) projections. The constant adjustments
to the data had also made the job of forecasting hugely difficult. Components
of domestic demand showed a mixed picture of modest and robust growth.
Household consumption was up 2.4% yearly in the third quarter, while gross
domestic fixed capital formation was up 6.4% in the same period. Services
recorded strong growth as did manufacturing in November. The main worry
was the current account deficit which on revised figures was £3.19 billion
higher than earlier figures. Both the size and deteriorating trend were cause
for concern.

Employment statistics suggested that the labour market was tightening.
However, average earnings (excluding bonuses) rose only 1.8% in the year
to October with the private sector recording a rise of 2.3% and the public
sector only 0.5%. Productivity growth measured by output per hour remained
flat in the third quarter with only a 0.3% rise year-on-year. Unit labour costs
had flattened in the first three quarters of the year representing good news
for those who believe that inflation is principally determined by earnings growth.

November producer input prices continued to show the sharp decline of recent
month contributing to the modest fall in producer output prices. CPI inflation
eased to an annual rate of 0.5% in December and headline RPI inflation fell
from 2.0% to 1.6% in December. The old RPIX measure also showed a slight
fall to 1.2% on the year in December. House prices were indicating a modest
slowing but with strong regional differences. Global and domestic uncertainties
along with the numerous data changes domestically and internationally make
forecasting particularly hazardous in this environment. Conditions could
become very different after the May election for the MPC and any decision
they make now will have an impact only after the election. The forecast is
for a long period of low inflation with growth converging to a trend rate of
1¾% a year. The slow reduction in the fiscal deficit coupled with the deteriorating
outlook for the current account raises questions about how the UK is to meet
its twin deficits.


Andrew Lilico thanked David B Smith and since Patrick Minford had to leave
early he asked him for his comments before opening up the meeting to a
general discussion.

Patrick Minford said that he believed one should not exaggerate the
significance of difficulties with recent GDP and other real economy data
since they have long been known to be flawed. Andrew Lilico said that this
is all the more reason why more attention should be paid to the monetary
aggregates. David B Smith said that the ONS was more concerned with
satisfying the requirements of Eurostat than producing statistics of relevance
to UK users. Trevor Williams said that the statistics are important because
of the way they are interpreted for business confidence.

Patrick Minford said that the Bank continues with an unsustainable monetary
policy. The existing monetary aggregates provide poor signals. Firms were
substituting for alternative means of credit ranging from crowd funding to
trade credit. The current policy of the Bank of accumulating the debt of the
government was highly risky and that debt could turn out to be worth a lot
less if a Labour government is elected. He said that monetary policy needs
to be normalised. Fiscal policy is the key to inflation through its effect on
expectations and the exchange rate. The rate of interest needs to get back
to a norm of around 2-3% and the Bank needs to reverse QE and start the
process of removing the mountain of government debt on its balance sheet.

Andrew Lilico said that the meeting should address three issues.
• Europe, political risk and the implications for financial risk.
• Deflation in the eurozone.
• UK money supply

He asked David B Smith to comment on the implications of political risk in
Europe in his forecast. David B Smith said Greece will probably exit the
Eurozone but its relatively small size meant that this development was digestible
and need not threaten the long-term survival of the rest of the monetary union.
Andrew Lilico asked if deflation will be driven by oil prices alone. David B
Smith said that deflation can have a positive a ‘Pigou effect’ – i.e., it raised
the real purchasing power represented by the existing stock of money – but
there is a negative effect from the rise in the real interest rate. The net effect
was correspondingly uncertain. He said that regarding Europe, Germany has
been asked to shoulder an unreasonable burden. Germany faces acute
demographic problems which will make it difficult for it to continue with its
current burden in Europe. Trevor Williams said that falling yields are usually
interpreted as stimulatory so why is a steady-state of 1¾% justified? David
B Smith said that his model allows for a Ricardian Equivalence effect. Firms
are holding fire on investment decisions. He added that much of the policy
discussion in the past had been rendered irrelevant by revisions to the data.

Andrew Lilico said that lack of monetary growth, despite the stronger growth
in the real economy, is a mystery. Trevor Williams said that it was the nature
of the recovery. The corporate sector is repaying debt and households are
not borrowing. Productivity is stagnant, so GDP growth is being generated
by employment growth.

Andrew Lilico also noted earlier remarks about tightening in the labour
market and asked what the evidence for such a tightening labour market is.
Peter Warburton said that unskilled workers have seen major reductions in
real wages but wage inflation is on the way back in pockets of the labour
market. Trevor Williams said that because of low productivity growth, the
growth in GDP is unsustainable.

Peter Warburton said that national statistics has revealed the interesting
pattern that up to 2007 Net National Product (NNP) had been growing faster
than GDP. Since 2009, this has been reversed. The economy is sufficiently
flexible for low-cost businesses to be set up by foreigners and to remit the
earnings stream abroad. A higher proportion of domestic assets are now
held by foreigners. Policymakers should not focus solely upon GDP but
should also take account of such portfolio effects — which were not favouring
UK citizens as much, at present, as in the recent past.
Andrew Lilico called the meeting to order and asked for votes to be cast.

Vote by Philip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate ½%. No further QE.
Bias: To raise, and as broad money rises to withdraw QE.

Vote and Comment by Anthony J Evans
(ESCP Europe)
Vote: HOLD
Bias: To hold QE

Anthony J Evans said that the window of opportunity to raise rates has passed.
Growth is not taking-off as money supply data is weak. Therefore there is no
overwhelming reason to tighten. Inflation is below the target but the effect of
a positive global productivity shock cannot be celebrated because of the
inflation target. The inflation target of 2% creates a communication issue for
policy. Ideally the target should not be inflation but having committed to it, the
Bank has no choice but to communicate policy through it.

Vote and Comment by Andrew Lilico
(Europe Economics and IEA)
Vote: HOLD
Bias: To wait to raise rates until inflation rises.

Andrew Lilico said that after a long period of voting for a rise in rates by ½%
he had altered his position to a rise of ¼% at the last physical meeting and
in the January e-poll he voted to HOLD. He said that it would be a mistake to
use the below target outcome to ‘see through’ the inflation figures. He was in
favour of building credibility based on rule-following behaviour. Rates should
have been raised in the past according to the rule. It is not appropriate to ignore
the rule when inflation is below target. If a eurozone crisis re-emerges,
then the Bank can revisit QE. Rates should rise only when inflation picks up.

Vote and Comment by Kent Matthews
(Cardiff Business School, Cardiff University)

Vote: HOLD Bank Rate.
Bias: To rise in stages and QE to be used in the event of euro crisis.

Kent Matthews said that his decision to be a modest Hawk at past meetings
of the SMPC was based on balancing microeconomic arguments against
macroeconomic ones. He said that the economy has reached the point
where the stopped clock of holding rates is giving the right time. The
microeconomic arguments pointed to a rise in the base rate while the
macroeconomic arguments pointed to a hold. The misallocation of loanable
funds and the ensuing financial repression caused by low interest rates
remains a strong argument for a rate rise. However, the prospect of a Grexit
and another euro crisis has added to the macroeconomic factors, swinging
the balance against raising rates at the moment. The world will know what
the prospects for a euro flare-up is very soon and there would be no purpose
in raising the base rate only to lower it again in a few months. He voted to
HOLD base rate but with a bias to rise as soon as the markets are less
turbulent and to have QE in reserve to deploy if the euro crisis creates too
much mayhem in financial markets.

Vote by Patrick Minford
(Cardiff Business School, Cardiff University)

Vote: Raise Bank Rate; ½%;
Bias: To raise and QE to be reversed.

Vote and Comment by David B Smith
(Beacon Economic Forecasting)
Vote: Raise Bank Rate ¼%. No QE.
Bias: To raise Bank Rate.

David B Smith said that he wanted to make three points. First, the election
creates considerable uncertainty. Whatever the outcome of the election,
interest rates will probably have to rise. This was because there would probably
be a relief rebound in private investment and recruitment if the Conservatives
won, while a Labour victory could induce a potentially highly inflationary drop
in the pound. Such a development could lead to major tensions between a
government pledged to more fiscal spending and the inflation mandate of the
Bank of England. Second, the national accounts data is so poor that a forward looking
interest rate policy is nearly impossible. Third, some economists now
believed that the policy regime can be more robust under rules – including
rigid rules such as the old gold standard - rather than the current discretionary
approach. Fundamentally the economy could not escape the need for further
fiscal retrenchment in the long term, Unfortunately, QE had created moral
hazard for the government because it had removed the pressure to cut the
budget deficit.. David B Smith said that at previous meetings and e-polls of
the SMPC he had voted for a moderate ¼% rise. He felt that there had been
no purpose in being too aggressive as he was mindful of the reaction of the
bond and FX markets. Rather than ‘flip flop’, he said that he would stay with
a ¼% rise and hold QE with a bias to further rises.

Comment by Peter Warburton
(Economic Perspectives Ltd)

Vote: Raise Bank Rate ¼%. QE restructure by £50 billion.
Bias: To raise rates to 1½% over 12 months.

Peter Warburton said that he had been a consistent rate rise voter for some
time and that he will continue in this way. The oil cartel is well and truly
broken and will not be easily resurrected. Similarly the oligopoly structure
of the supermarkets has also broken down with the implication for retail
price inflation. Nominal GDP growth in the order of 4-5% justifies normality
for interest rates. He said that it is important to send the message that rates
need to return to 1½-2%. He also said that the Bank should be looking to
sell its holdings of longer dated Gilts and offsetting this with purchases of
infrastructure bonds and securitised loans. He suggested a transaction in
the order of £50 billion. He voted to raise rates by ¼%.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)

Vote: Hold base rate. Hold QE.
Bias: Neutral

Vote in absentia by Roger Bootle
(Capital Economics)

Vote: Hold Bank Rate. Hold QE.
Bias: Neutral

Trevor Williams said that deleveraging in the economy was continuing and
that the growth in broad money supply is not consisted with above trend
growth. Growth in domestic demand is unsustainable because productivity
growth remains flat. External uncertainties such as the slowing down of China
and deflationary forces in Europe suggest that this is not the time to change
monetary policy. He voted to HOLD the base rate with no bias.

Policy response

1. On a vote of five to four the committee agreed to hold Bank Rate. Four
members voted for rise.
2. All four rate risers expressed a bias to raise rates further. One of the rate
holders voted to raise rates when the euro situation is cleared.
3. There was a mixed recommendation regarding QE. Two members
recommended that QE be reversed. Three members recommended that
no further QE be deployed. One member said that QE should be held in
reserve if the euro crisis worsens and another member recommended a
restructuring of QE from Gilts to other types of bonds.
4. The narrow vote to hold rates reverses a long trend of a calling for a
modest rate rise.

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 and
IEA). Other members of the Committee include: Roger Bootle (Deloitte and
Capital Economics Ltd), Tim Congdon (International Monetary Research
Ltd.), Jamie Dannhauser (Ruffer), Anthony J Evans (ESCP Europe), John
Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking
Group), Patrick Minford (Cardiff Business School, Cardiff University), Gordon
Pepper (Cass Business School), David B Smith (Beacon Economic
Forecasting), 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 Corporate
Markets). Philip Booth (Cass Business School and IEA) is technically a nonvoting
IEA observer but is awarded a vote on occasion to ensure that exactly
nine votes are always cast.