Sunday, March 01, 2015
IEA's shadow MPC votes 6-3 to keep rates on hold
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

The Shadow MPC has voted to keep rates on hold, entrenching its reversal,
at the last meeting, of its long-standing call for rate rises.

Those favouring a hold included members arguing that there is no inflationary
pressure and/or that the recovery is not sufficiently rapid that the economy
needs or could tolerate rate rises. Others contended that with inflation so
far below target, with the notional inflation target (misguidedly) expressed
as it is, rate rises could not be considered compatible with that target. One
member urged, vigorously, that there should be a band of short-term
discretion set around the inflation target that constrains how far it is permitted
to deviate from target in the short-term, set at a level that the Chancellor
wants met and is prepared to enforce.

Those advocating raising rates have 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. Low monetary growth has
been the result of excessively strict prudential and liquidity regulations
imposed upon banks. Monetary policy-makers should not collaborate in
such financial repression.

Votes

Vote in by Roger Bootle
(Capital Economics)
Vote: Hold base rate. Hold QE.
Bias: Neutral

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: Raise once inflation returns to the 1%-3% range

Continuing low rates of inflation make interest rate decisions in an inflation targeting regime difficult. On the surface, there should be a clamour for
expansionary monetary policy. In the year to January 2015 the CPI grew by
just 0.3%, which was even lower than for December 2014. Policy makers
must attempt to disentangle whether this is a supply side or demand side
phenomenon. If they get it wrong, the results would be catastrophic. However
it seems highly likely that this is driven by a falling oil price, which presents
good news for consumers since it constitutes a positive supply shock.
Policymakers are therefore wise to “see through” this (assumed) temporary
reduction in the rate of inflation.

The problem is that the balance of risks is probably in the other direction.
Nominal GDP growth figures suggest that aggregate demand is in line with,
if not exceeding, the capacity of the UK economy. It will be interesting to see
how falling oil prices affect the GDP deflator but we will have to be patient.
An advantage of inflation targets is that CPI data is issued monthly and so
oil shocks can be quick to show up. But it will be important to ensure that the
GDP deflator is not dragging down nominal income.

Narrow measures of the money supply have been in decline over the last few
months but this slide seemed to subside by the end of 2014. In December
2014 the growth rate of broad money (M4ex) jumped back up to 4.2% (from
2.9% in November 2014), which was the highest rate since February 2014.
The deflation demonstrated by M3 has fallen (from -2.3% in November 2014
to -1.3% in December). And Divisia measures remain strong.

With an inflation target of 2% it is hard to justify a rate rise with inflation of 0.3%. Aggregate demand growth may be exceeding capacity growth. Monetary growth may be picking up slightly. It is hard to know what policymakers should do right now. With such a dramatic fall in inflation a close eye should be focused on inflation expectations, but there is no sign that these are falling dramatically. The second release of the national accounts, due at the end of February, will help tell us more. And early March will see the publication of the Bank of England/NOP Inflation Attitudes Survey. For now, the sensible option seems to be to wait and see.

When inflation returns to normal this could present another opportunity to
normalise interest rates but the timing could be difficult. Thus far policymakers
appear to want to wait until the evidence that the economy is recovering is
irrefutable. This risks leaving things too late. If inflation rises at a quicker
than expected pace whatever credibility that the Bank of England have for
delivering 2.0% inflation will be in tatters. After so long of seeing “through”
inflation targets, perhaps we can start to see beyond them.

Vote by John Greenwood
(Invesco)
Vote: Hold base rate. Hold QE.
Bias: Neutral

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

With inflation so far below target and no clear guidance from the inflation
targeting regime that a departure of more than 1% is permitted, rate rises
now cannot be considered compatible with the notion that the inflation
target constrains policy-making (as it should do). This is just as wrong and
dangerous now as it was in 2011 when inflation was permitted to go far
above target but without any change to the target or guidance regarding
how far above target was or was not permitted by the regime.

An inflation target is not simply a vague long-term aspiration or a forecast
by the central bank. It is (when well-constructed) a regime of constrained
discretion. It should consist of a point target, to which policy must attempt
to drive inflation over the policy impact horizon (some two to three years)
plus a range of discretion within which inflation is permitted to deviate from
the medium-target in the short-term. That range of discretion should be
an inflation band — something like +/-1% or +/-3% or whatever range of
discretion the goal-setter (in the UK, the Chancellor of the Exchequer)
wants to grant the monetary policy-setter.

This was precisely the form of inflation target the UK had from the
introduction of inflation targeting in 1992 until the band of discretion was
breached and then, as a consequence, abandoned (rather than enforced or
changed) in 2007. It is absolutely remarkable that, when inflation targeting
using the combination of point estimate and band of discretion, had worked
so well from 1992 to 2007, that it was so casually and pointlessly tossed
aside — merely to avoid the political embarrassment of admitting that the
target had been breached.

When the inflation target was systematically and significantly breached in
2008 and then again in 2011, without any attempt to change or enforce
it, there seems to have been great confusion regarding some of us that
complained that credibility had been lost. For me, at least, the point in
2008 and 2011 was not, in the first instance, that the Bank of England
should be attempting to keep inflation to 2%. I urged on both occasions
that since it was clear to everyone that it was undesirable to keep inflation
below 3% in 2008 or 2011, the inflation target should be changed — either
by raising it or by increasing the band of short-term discretion. The process
of setting a target one does not want to meet seems to me to be literally
a basis of ridicule. There seems to be some paranoia about changing the
inflation target. Why that is, I am unclear. The inflation target was changed
in 1997 and again in 2003 without that destroying the credibility of the
regime. Why should it have been so bad to set a different target in 2008 or
2011 or 2015? No-one, as far as I am aware, believes that inflation should
be being kept to between 1% and 3% or exactly at 2% in the early part of
this year. So why have a rule that says that is what should happen?

Obviously, the consequence of setting such a “rule” that one never tries to
meet is that that ceases to be how to the “rule” is understood. We now see
that there is no constraint whatever upon the extent to which inflation is
permitted to deviate from target in the short term. Inflation of 0.3% is not a
breach of the target. Inflation of -0.3% would not be a breach. Presumably
inflation of -1.3% would not be a breach. Does anyone know what would
constitute a breach? Minus 5%? Minus 20%? Nothing tell us. If nothing
counts as missing the target, then the target does not constrain policy and
ceases to be any kind of rule at all. It is nothing more than a vague longterm
aspiration or a forecast. I repeat: an inflation target is supposed to be
more than that and when we deployed inflation targeting in its true form it
worked very well.

UK monetary policy-making is now far out at sea with no compass to guide
it. This is not a failing of the Bank of England as such. It is a failing of the
Chancellor. He should set a medium-term target he wants monetary policy
to meet — a target for inflation or for monetary growth or for the price level
or for nominal GDP. He should grant the monetary policy-setters a shortterm
range of discretion, allowing them to deviate from the target for a
period to take account of macroeconomic conditions. The target and the
range should be ones he actually wants them to stick to and he should enforce the target. Something should count as missing; if there is a miss
he should begin by expressing disapprobation regarding the miss and
demand remedial action; and then if the miss persists someone should
get fired. He should be willing to change the target if his view as to what
is best changes, especially if the target itself is for some annual variable
(e.g. annual inflation) as opposed to something longer-term (e.g. the longterm
average inflation rate). I find the lack of concern about this issue very
disturbing. We are back to the sort of anchorless discretion regime that
was tried in the 1970s. That did not end well. I submit that there may be a
lesson there.

Vote and Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold bank rate
Bias: To raise QE if the Eurozone crisis returns.

While low inflation is here to stay for the immediate future, with interest rates
already effectively zero they cannot usefully be cut if the Eurozone crisis flares
up again. In the event of a euro crisis we should instead be prepared to man
the liquidity pumps with additional QE.

Vote and Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate; ½%;
Bias: To raise and QE to be reversed.

We are faced with a conundrum. The economy is recovering strongly,
employment is growing strongly too and unemployment plunging, almost
reaching the ‘full employment’ rate (of around 5%, I would estimate, against
an actual of 5.8%). There are now also signs that wages are rising faster, and
with inflation temporarily low, probably substantially faster than prices. And
yet the two ‘hawks’ on the Bank’s MPC have withdrawn to the dovish end of
the spectrum and the MPC is unanimous once more in not raising rates, while
leaving on hold Quantitative Easing (the purchases by the Bank of UK
government bonds, which now stand at £375 billion, about a third of the total
government debt outstanding).

It seems that the joker in the pack is inflation which is temporarily low — the
latest figure, for the January 2015 CPI, is 0.3%. This is fuelling fears of
‘deflation’ which has become a fear word, on the grounds that deflation in the
1930s created rising real debt and held back the recovery, according to some
accounts. Yet this threat is to be honest quite empty; the situation is not at all
like that of the 1930s.

Another element causing the unwillingness to tighten is the still slow growth
of money and credit. Indeed the banking system is still under huge pressure
from regulators, and still trying to shrink its balance sheet, it would seem.
I would argue that there are great dangers to leaving money so loose in these
circumstances, especially with an election looming the results of which are
quite unpredictable and a public deficit still at 5% of GDP. Furthermore the
current inflation figures are dominated by the collapse in oil and other material
prices — a one-off phenomenon. Money and credit growth is reflecting the
excesses of past-crash bank regulation; this in turn is leading to explosive
growth in the new ‘shadow banking’ of peer-to-peer lending. Even though
statistics on this are patchy, its rapid growth is undeniable. Without moving
too sharply, the backdrop indicates a need to move monetary policy towards
normality.

However, one also needs to probe why we have reached this state where
monetary policy is endlessly easy while the supply of credit and money has
been so restrained. Of course the answer lies in the great reaction of regulative
enthusiasm to the banking crisis. The irony of all this is that the crisis itself
was caused by central bank failure to coordinate the supply of liquidity to the
international banking system. It is true that we had a strong credit boom in
the run up to the crisis, itself also permitted by excessively easy monetary
policy. Yet a credit boom should not lead to a banking crisis. So we are
constantly led back to the villains of the piece: the central banks themselves.
First, a failure of excessive monetary ease; followed by a failure to ensure
the liquidity of the world banking system. The political classes closed ranks
around the central banks whom they effectively directed in their tasks; then
they turned on the world’s commercial banks, alleging that all was due to their
cupidity and stupidity in taking outsize risks. It is true that some banks made
bad decisions- certainly so in the light of later events. When things go wrong
in the world economy, it is often the case that decisions made by individual
actors turn out poorly. Like ants rolled over by a large tractor, they lie there,
squashed and victims of tragic error. But could they have foreseen the tractor
would suddenly roll down the road?

At any rate, we now have the regulative reaction to these events; and as many
of us warned they have worsened the state of the economy. We in Cardiff
Business School have argued in recent work that they will not stop another
crisis because crises stem from large-scale world shocks (usually to commodity
prices) and the best hope of controlling crises is through active monetary
policy, both in boom and slump. In the UK and the US there has been some
attempt to dilute the new regulative excess. Here there have been the Funding
for Lending Schemes (that subsidised lending to banks that expanded their
balance sheets) and the Help to Buy scheme (that subsidised first-time home
owner mortgages). In the US the regional banks have been less intruded
upon than the big money-centre banks; and competition and new lending has
come from them. In the eurozone unfortunately the banks have been quite
unable to recover from a series of hammer blows: first the collapse of the economy, then the impulse from the ECB for them to buy southern countries’
government debt to help resolve the run on euro debt, and finally the ECB’s
misguided vilifying of their balance sheet weakness (much of which resulted
from this very impulse). So eurozone credit and money show no signs of life.
It is against this background that monetary ease has become totally entrenched.
Yet the irony is that the situation is caused directly by government regulative
action. The logical way forward would be to dismantle this excess regulation
and to move monetary policy back to normal. Instead we have a moribund
banking system, increasingly being replaced by a new banking order via the
internet- but like all such ‘shadow’ systems we cannot discover exactly how
fast it is developing. Monetary policy is desperately trying to stimulate bank
activity, but instead is feeding a whole substitute financial system. The outcome
of this process is highly unpredictable.

Accordingly, once again I urge that monetary policy move back towards
normality, with a small initial rise in interest rates and a bias to continue raising
in small steps. Similarly I would like to see the QE stimulus gradually withdrawn,
say in monthly steps of £25 billion for the first year.

Vote 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.

Vote and Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold base rate. Hold QE.
Bias: Neutral

Nothing has changed in the big picture my view. Low inflation will persist for
some while. Low wage inflation will persist as well, despite the Bank of
England’s expectation of an acceleration as price inflation picks up. In my
view, pay rises offered by employers will slow along with inflation. The supply
of workers, from higher participation rates and net migration, still outweighs
demand. Europe remains in the doldrums, albeit temporarily boosted by lower
oil prices. Low and negative short term rates in Europe and elsewhere, and
well below long run average long term rates, are sending worrying signals
about long term trends in advanced economies. Divergence from US policy
change later in the year poses a big financial market risk. Reliance on domestic
demand in the UK poses a risk for the trade and current account deficit, at a
time when productivity is poor. This is not a time to be changing the policy
stance, especially with so many global risks.

Policy response

1. On a vote of six to three the committee agreed to hold Bank Rate.
Three members voted for rise.
2. All three rate risers expressed a bias to raise rates further.
3. There was a mixed recommendation regarding QE. Some members
recommended that QE be reversed. Others recommended that no further
QE be deployed but the mix might change. Others said that QE should
be held in reserve if the euro crisis worsens.

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.