In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) again voted unanimously to leave Bank Rate at ½% when the Bank of England’s rate setters meet on 9th July.

The unanimous SMPC vote reflected the belief that there was little case for a rate increase in the near future – even if one or two members were becoming slightly more trigger happy - combined with the view that ½% was close to the effective lower limit where the official interest rate was concerned. There was a widespread feeling among the members of the IEA’s shadow committee that Quantitative Easing (QE) was the only effective monetary policy instrument presently available to the authorities.

Several committee members believed that the present schedule of gilt purchases should be extended. Some members thought that an additional £100bn to £150bn of debt re-purchases was required once the current package had run its course.

The SMPC poll was largely carried out before the UK Office for National Statistics (ONS) announced a substantial downwards revision to its previous estimate of UK GDP in the first quarter of 2009, on Tuesday 30th June. The lower starting base tempered even further the modest hopes engendered by the early signs of ‘green shoots’ appearing in the economy.

One member pointed out that the shortfall of total OECD industrial production below its long-term trend was roughly twice as large in 2009 Q1 as it had been in any previous recession of the past half century. The size of this negative output gap limited international inflation risks in the immediate future.

However, there was some concern that relatively robust monetary growth in the OECD area as a whole posed a longer-term inflation threat. Several SMPC members discussed the difficulties of interpreting the UK broad money data when the figures were so heavily distorted by the deposits of other financial corporations.

Comment by Tim Congdon
(Founder Lombard Street Research)
Vote: Hold
Bias: Neutral but persist with Quantitative Easing to ensure that core M4 growth remains at, or above, 5% at an annual rate

Since the announcement of Quantitative Easing (QE) in early March many indicators of economic activity have improved and there are signs of a return to growth, even if only beneath-trend growth, in the third quarter. As one of the advocates of QE, I ought to be delighted by this turn of events. (I take QE to be the deliberate creation of new bank deposits by state purchases of assets from the non-bank private sector. In this particular case it is of course the central bank, not the government itself, making these purchases and the purchases are of government securities predominantly.)

However, the data are full of puzzles, some of which are disturbing. A major policy change has undoubtedly occurred. In the year to December 2008, net sterling lending (by UK M4 institutions, i.e., banks mostly) to the public sector was minus £13.6bn. By contrast, and in the year to May 2009, such lending was positive at £78.8bn. So whereas the state’s financial transactions actually destroyed money in 2008, in the first five months of 2009 they added over £90bn (or about 5%) to M4 money.

In my Council for the Study of Financial Innovation (CSFI) pamphlet How to Stop the Recession I argued that this creation of money balances by the state would ease balance-sheet strains in the private sector, partly by increasing the money holdings of genuine non-bank financial institutions - which would lead to a rise in asset prices if they kept money/asset ratios constant - and partly by increasing the money holdings of companies as such (which ought to be evident in their ratio of M4 money to their M4 borrowings). If QE were on a big enough scale, the result ought to be an ending of the recession.

In practice, M4 growth has resumed, even if the data are murky because of the role of the shadow banking system (i.e., the SPVs, conduits, etc.). But so far the extra money appears to have stayed in the financial sector, despite a surge of corporate fund raising. However, equity prices have done well since early March, while the commercial property market has begun to recover, so there is no problem there. My disappointment is that company money holdings remain stuck. If the data released on 29th June are to be believed they fell by £7bn in the three months to May and are roughly unchanged from the start of 2009. This is not what I was expecting.

These are still early days, but my initial interpretation is that the monetary situation in early 2009 was every bit as dangerous as the most pessimistic observers thought at the time - I must admit that I was certainly not as pessimistic as I ought to have been. If QE had not been announced, banks would have seen their balance sheets and their M4 bank deposits shrink by about 1% a month, compared with the ½% to 1% or so a month that was being registered in late 2008. A monthly fall of about 1% in money is roughly that recorded in the USA’s Great Depression, when M2 dropped by about 40% between October 1929 and March 1933.

QE has restored money growth at an annualised rate of about 5%, which is very good compared with what might have happened, but is frankly disappointing compared with my hopes in the CSFI pamphlet. Unfortunately, there are two official measures of M4 excluding intermediate OFCs for the time being because there is not enough detail in the monthly statistical forms to reconcile the monthly figures with the quarterly ones (the numbers are available from Martin.Udy@bankofengland.co.uk on request). However, the general message is broadly the same. Money was collapsing in late 2008, but has perked up in 2009.

The economic situation is improving, but remains fragile. I am in favour of keeping Bank Rate at ½% and continuing and probably expanding QE, so that the Bank of England purchases sufficient gilts to ensure that money growth runs at least at a 5% annualised rate. As before, it would be very sensible if the DMO and the Bank worked together, so that the Bank is not buying gilts sold only a few months (or even weeks) earlier by the DMO. The critical objective – while banks are ‘deleveraging’ and private sector financial transactions are destroying bank deposits at a rate of ½% to 1% a month – is that the state creates enough money by its own financial transactions to keep money growth positive. By ‘the state’ I mean the government and the central bank co-operating with each other to produce the best monetary policy for the economy – regardless of institutional reputations, turf wars, etc.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate and maintain current quantitative easing targets
Bias: Prepare to extend quantitative easing beyond £150bn after July

The effects of QE are easy to see on the books of the banks. Reserves of commercial banks at the Bank of England have risen from around £20bn to £30bn before the credit crisis began to £138bn (as of 26th June). In one sense, this is the fuel that will enable banks to lend and invest in securities, when they are ready to do so, and when their customers’ appetite to borrow returns. However, other conditions must also be in place first. In particular, banks must be happy that they are adequately capitalised, and that the risks in new lending or securities purchases are justified.

The effects of QE are less easy to see in terms of their impact on households and non-financial companies. In April, M4 less money balances held by Other Financial Companies (OFCs) slowed to just 1.8% year-on-year. On a three-month annualised basis the rate accelerated to 5.0% from a trough of minus 3.4% in October 2008. Bank of England revisions to the monetary data are on-going, but monthly data that exclude the holdings of ‘Intermediate OFCs’ will only become available later this year. My judgement is that monetary growth - on this redefined basis - needs to be of the order of 6% to 8% p.a. from a long term perspective, although some temporary overshoot could be justified to compensate for the recent undershoot. This 6% to 8% long-term optimum rate contrasts with the excessive growth of bank and financial sector balance sheets in the period January 2004 to August 2007, when banks’ sterling assets grew at 15% p.a., and interbank lending and borrowing grew at 22.7% p.a. A side effect of this permissiveness was excessive growth of M4 in 2005-07.

In my view QE will need to be maintained and expanded in order to ensure the full effects are transmitted to households and businesses across the country. The Bank of England should therefore increase QE beyond the £150bn (or 7.4% of M4) that it is currently authorised to complete, requesting authorisation for a further £150 billion in asset purchases. In the meantime Bank Rate should be held at its current level of ½%.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold
Bias: Neutral

Soon after the last MPC meeting there were two pieces of economic news which seemed to suggest that the ‘green shoots’ of recovery were indeed appearing. The Office for National Statistics (ONS) announced that April’s manufacturing output was up a tad and the National Institute of Economic and Social Research (NIESR) suggested that GDP in April and May might have increased marginally.

The GDP figure for 2009 Q2 could be a pleasant surprise. However, such an outcome should not be seen as so unexpected after the quite unprecedented collapse in stocks in the last quarter of 2008 and the first quarter of 2009, at the height of last autumn’s financial turmoil.

The hundred dollar question is of course whether a genuine, sustainable recovery is in the offing. And this is highly questionable. The consumer sector is still negatively affected by rising unemployment and the need to repair its balance sheet further. Exports will be curtailed by the continuing problems in the US and the Euro-zone – Britain’s main markets. At some point, but sooner one hopes rather than later, government spending will have to be cut. And, as the Governor of the Bank of England has been at pains to point out, bank lending remains weak and threatens to hold back recovery. Economic performance could well disappoint in the second half of the year and a better second-quarter GDP figure could be more of a blip than the harbinger of recovery. Under these circumstances, monetary policy will continue to remain very slack.

Unless the pace of weekly Gilt purchases slows, the £125bn allocated to QE will have been utilised by the end of July. One of the main issues at the next MPC meeting, therefore, is likely to be whether the MPC will vote for the remaining £25bn of QE to be utilised. This £25bn has already widely discounted by the markets. Perhaps of more interest will be any signals that the MPC intends to request an increase in the Asset Purchase Facility from the Chancellor. In the meantime I support the Bank’s policy of keeping interest rates very low and continuing with quantitative easing – including the remaining £25bn.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral

There is much discussion at the moment about whether the economy has turned and, assuming the turn, how soon interest rates might start to rise again. All this discussion appears premature to me. If cutting interest rates by 5¼ percentage points, doubling the narrow money stock, and running a £200bn budget deficit had not resulted in at least a temporary upturn in the real economy, the economics profession would have little left to say. The issue was never whether the economy might experience a quarter or two of reduced decline or even slight growth. The question was whether this was a turning point or a temporary reprieve.

In my view the natural assumption is still that this is a reprieve. House prices still need to fall a further 20% or so, deleveraging by households has barely begun, the banking sector is so vulnerable that it could yet be driven into widespread default by even a moderate further shock, UK government spending is so exorbitant that it will certainly have a major effect upon the sustainable growth rate of the economy if it is not rapidly curtailed, and the UK government deficit is so wild that it must be brought under control rapidly, by tax rises if not spending cuts, if the government is to retain credibility with its creditors. All of this augurs ill for the future growth path of the economy. Even if there is not a further significant downturn (and my expectation is that there will be such), the chances of rapid growth in the recovery phase must be slim to none.

I continue to believe that it is by no means certain that the deflation danger has passed (In particular, I still have grave concerns about wage falls leading to prime creditor defaulting, and I think it remains to be seen whether there might not be a further credit crunch crisis in the late summer and autumn as there was in 2007 and 2008). We should thus maintain our current quantitative easing stance, and be ready to do more if necessary. Likewise, I consider it all but certain that there will be significant inflation on exit - once banks begin lending again the broad money stock is liable to rocket out of control. If inflation on exit is kept to only one year of 10% inflation, I would consider that a success and believe that policy-makers should be clear about their limited ambitions in this regard.

Finally, the inflation target in its current form is clearly now irrelevant and the framework should be replaced quickly. I recommend an average inflation target (a price-level path target) as I have these past ten years. But we do need something - even if only an indication of much more year-to-year flexibility in the annual inflation target - if we are to hope to manage exit from quantitative easing with only moderate volatility.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral on rates but continue with aggressive quantitative easing

Based on the models of the economy that I use, it is about time that we should be seeing the beginnings of recovery across the world economy. This does seem to be happening, though some parts of the world are lagging behind others. Stock markets are reflecting this anticipated improvement in the situation pretty generally, even if they are now reasonably pausing. Risk spreads between official base rates and rates in the market place have come down. Surveys of purchasing managers and consumers have picked up. The improvement has yet to show up in output. However, and in the UK, the NIESR estimates of monthly GDP are flattening out, for example. It looks as if the second quarter of 2009 may show a flattening out in many other countries and in some, like China, faster growth. The reason for this turnaround lies in the rapid response to the world collapse induced by the Lehman bankruptcy in September 2008. That bankruptcy was the result of the US government’s decision not to support Lehman in its efforts to find a buyer (such as Barclays) at the time. Had it realized the effect of this decision, it might well have decided otherwise. Instead it and other governments around the world were forced by the resulting world collapse into massive fiscal/monetary support policies.

I would argue that these policies or ‘packages’ must be seen as essentially credit packages, not a normal fiscal policy ‘stimulus’ (which may well be quite ineffective in normal circumstances according to much evidence). In a credit crisis the only agent able to provide credit unavailable from the banks and the markets is the taxpayer. While central banks provided cash to the markets in exchange for whatever assets the markets could offer (‘quantitative easing’), permitted to do so by the taxpayer who picked up the risk on those assets, governments themselves were providing credit and capital to the banks themselves and more generally to the private sector via its greatly increased deficits. These deficits are credit because they too must be paid off in due course through cuts in spending or rises in taxation. This overall provision of credit by the government, whether through the central banks or directly on its own account, has been vital in staunching the wound to the economy caused by the Lehman-induced credit crunch.

According to the models I have been using the lags in effects from both the credit shock and the response are quite short- between two to three quarters before the peak effect. If we date the shock to the fourth quarter of 2008, the improvement in the second quarter of 2009 fits with this pattern.

However it by no means follows that the recovery from the crisis will be strong and vigorous or ‘V-shaped’. In my view this is most unlikely because of the fundamental reason for the growing problems in 2007 and 2008 that brought the world boom shuddering to a halt and so precipitated the financial conditions that brought Lehman down. This reason was the acute and growing shortage of raw materials in the face of the huge growth in the world economy and especially of China and its satellites. As the world economy recovers this shortage will reappear, indeed that is already visible in rising commodity prices.

Unfortunately this shortage is not quickly or easily remedied. It requires major technological change reducing the use of raw materials per unit of GDP, as occurred after the oil crises of the 1970s and early 1980s. Extra supplies of raw materials may also be brought on stream with some lag but the main need is in curbing demand. This could take a decade to come to fruition. Hence we should expect growth to be held back until this has happened. As occurred in the earlier period capacity that was viable at the old raw material prices will prove uneconomic at the new ones; cars, aeroplanes, factories and so on will need to be replaced with ones that are more resource-efficient. My forecasts therefore look for a resumption of growth but not back to the same path that we were getting used to in the mid-2000s. It seems likely that there has been a permanent loss of capacity and that there will be a slower rate of growth from that lower level.

As for policy, my view is that it should remain stolidly devoted to ensuring recovery for now - fiscal deficits must be tolerated, and quantitative easing continued. ‘Exit strategies’ are implicit in the commitment to inflation targets, which clearly imply that once recovery is not just firmly underway but also inflationary pressures beginning to appear on the horizon, then policy must be tightened; we should remember that the lags are not very long at all. But we are a long way from this situation and we cannot forecast when it will occur; meanwhile premature exit-type moves could badly delay recovery.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Neutral but continue with the current programme of Quantitative Easing

The decision about interest rates is an easy one to make. There is a clear case for holding in July and continuing to hold in future. The more important decision is what to do about quantitative easing (QE). Is it too much, too little or about right? The aim is to stop a monetary contraction caused mainly by the collapse in bank lending. The correct way of judging it is to monitor monetary growth. The trouble is that the published data are heavily distorted. Transactions that are in effect within banking groups, that is, the deposits of what are now called ‘intermediate other financial corporations’ should be excluded. There are two ways of assessing what is happening. The first is to use the quarterly adjusted data now being published by the Bank of England. The second is to monitor the deposits of the private non-financial sectors of the economy (PNFSs). According to the Bank of England, the adjusted series grew by only 4.2% between the first quarters of 2008 and 2009, compared with 18.1% growth in M4. Further, experimental monthly estimates suggest that much the same rate of growth continued during the three months to May. This growth of just over 4% is not too high. If anything it is a little low. The indication is that QE has not been too much.

Turning to the PNFSs, this consists of households and private non-financial corporations (PNFCs). The combined M4 holdings have not grown at all during the last quarter. In particular the M4 holdings of PNFCs have slumped by £7.1bn. The private sector’s holdings of treasury bills, which have much the same liquidity characteristics as the Certificates of Deposit that are included in the definition of broad money, have however risen by £16.8bn. In normal times the changes in such holdings are trivial compared with those in M4 and it is not worth monitoring an aggregate broader than M4 that includes them. This is not the case in the current situation. The broader adjusted aggregate has risen at an annualised rate of about 8% to 9% this year, which does not suggest that QE has been too little. The conclusion is that QE has probably been about right and the programme should continue at the current rate pending further evidence.

Professor Pepper would like to thank Jamie Dannhauser, Senior Economist, Lombard Street Research, for his contribution to the detailed analysis.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Downwards revisions to UK GDP data, released on 30th June, suggest that ‘wait and see’ is least damaging option

Britain has a small, open and trade-dependent economy and overseas developments have a more powerful and rapid impact on domestic economic behaviour than the monetary and fiscal levers controlled by the domestic authorities. The Organisation for Economic Co-operation and Develpment (OECD) have recently re-weighted and re-based their economic indicators for the OECD area. The new data make it possible to perform a health check on the current state of the industrialised economies as a whole. Their long publication delays mean that the OECD’s figures for GDP and its components are less relevant than the more timely monthly indicators, such as consumer prices, the money supply, and industrial production.

The production figures confirm that there has indeed been a catastrophic collapse in OECD industrial activity. In 2009 Q1, OECD industrial output was 16.5% lower than in the first quarter of 2008, which also happened to be the peak of the business cycle. Using the new figures, OECD industrial output appears to have had a trend rate of increase of almost exactly 2¼% since 1974, although it was previously 5¼% from 1962 to 1973. The 16.1% shortfall about this trend observed in 2009 Q1 was the largest negative figure on record. It is also a significant multiple of the previous troughs of minus 8.7% in 1975 Q2, minus 8.3% in 1982 Q4, and minus 5.3% recorded in 1993 Q3. The greatest positive deviation about this fitted trend was the plus 7.2% recorded in 2000 Q3. The OECD industrial-output gap was correspondingly 21¾% in 2009 Q1 if the all time peak is defined as 100%, as seems to be customary in such calculations.

However, while the collapse in OECD industrial activity invites comparison with the Great Depression of the early 1930s there is no sign of a similar monetary implosion. Instead,published OECD broad-money growth has remained remarkably robust since the present crisis commenced. There has only been a modest deceleration in the year on year growth from a peak of 9.1% in 2008 Q1 to 8.3% in the first quarter of this year and 7.4% in April alone, if formerly high inflation countries are excluded. Even the April growth rate is above the rates of increase recorded in 2004, 2005 and 2006 and it is not significantly below the 8.3% average recorded in 2007 and 8.5% in 2008. It can be argued that OECD broad money only avoided an implosion because of the extreme stimulatory measures taken by the leading central banks. However, it is also possible that the negative effects of the credit crunch were amplified by financial-market and media hysteria. This may then have caused the reduced business confidence that brought about the global de-stocking that induced industrial activity to collapse.

Measures such as ‘P-star’, which attempt to correct broad money for the trend increase in productive potential, also suggest that current OECD monetary growth is funding a positive inflation rate of around 4½% to 4¾% in the very long run, rather than the imploding price level feared by some people. This would represent a similar performance to that observed in the second half of the 1980s, before the so-called ‘Great Moderation’. Core OECD inflation was 0.9% in the year to 2009 Q1 and 0.5% in the year to April. However, the monthly figures for individual countries in May, suggest that the rate of price increase may have slackened off, or possibly even turned negative, subsequently.

A more parochial concern is the extent to which British inflation has remained stubbornly higher than that in other leading economies. This suggests that, if inflation picks up modestly overseas, there could be a serious knock-on effect in the UK. Britain’s CPI inflation was 2.2% in the year to May, when the annual rise in RPIX was 1.6% and that in the ‘double–core’ RPI excluding both mortgage interest rates and housing depreciation was an unchanged 2.5%. The equivalent CPI figure for the US in May was minus 1.3%, compared with minus 1.4% in China, minus 1.1% in Japan, minus 1.0% in Switzerland, zero in the Euro-zone, and plus 0.1% in Canada. One reason for Britain’s relatively high inflation rate was presumably the 9½% drop in the external value of sterling in the year to June. In which case, the pound’s almost 10% recovery since its March 2009 low-point – when it was 19% down on the year - must be regarded as a welcome development, even if it removes some of the competitiveness gains from British industry.

The uncertainties about: a) the outlook for global inflation, especially as to whether the negative output gap or rapid money growth eventually emerges as the predominant influence - one suspects that it will be the output gap first and money subsequently; and b) the future course of sterling, will make it very difficult for the MPC to make the right call over the next few months. The quite appalling fiscal background - and the Balkan-brigand style feuding between the regulatory agencies responsible for the health of Britain’s financial system - does not make monetary-policy decisions any easier. One can only recommend that the MPC endeavours to do as little harm as possible, while watching global and domestic developments like a hawk. Bank Rate should be held in the short-term, and the current programme of QE maintained – and, possibly, extended if the core monetary aggregates remain weak.

Before the release of the downwards revised first-quarter UK GDP figures on 30th June, I might have recommended that UK monetary policy should be tightened after the summer recess, starting with a Bank Rate increase before gradually stopping – but not initially reversing – quantitative easing. However, a downwards revision of 0.7 percentage points to the year-on-year growth rate, to minus 4.9%, in 2009 Q1 significantly changes the starting point. ‘Wait and see’ consequently appears to be the least damaging option presently available.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold
Bias: Neutral now but raise in the longer term

There is no immediate pressure on UK inflation, but the long term prospect for inflation in the UK, the US and the Euro-zone is up. As inventory destocking is ending and the housing market is picking up, the UK recession appears to be bottoming out. The Bank is forecasting a fall in the CPI but at present it is still within the permitted range. Whether the Bank’s inflation forecasts are correct depends on future GDP growth which is still highly uncertain and a source of unusual controversy.

In the longer term, it will become necessary to reverse the monetary expansion in all three areas to avoid its inflationary effects. The balance sheets of the three central banks have all grown hugely. In the US and the Euro-zone especially, it is now clear that much of this has been to purchase government debt. In other words, there has been a huge increase in their money supplies to finance government expenditures. As output picks up this will become inflationary. The German government, with its strong aversion to inflation and budget deficits, is now strongly at odds with most other Euro-zone governments who have large government deficits and are using the ECB to fund them via their domestic banks. This creates considerable uncertainty in Euro-zone monetary policy and in EU inflation. A not too dissimilar situation holds in the US. There is therefore considerable uncertainty about the future inflationary environment surrounding the UK. Caution indicates a bias for raising rates before long.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold and spend the full allocation of £150bn in the Asset Purchase Facility
Bias: To cut Bank Rate further if required and request another £100bn for Quantitative Easing

On the surface, the M4 monetary statistics are looking better following the start of QE. After rising by just £4.6bn in March, M4 was up by £4.9bn in May. But the monthly growth rate has been stuck at 0.2%, and the annual rate has declined from 18.1% in March to 16.6% in May. After rising £30.5bn in March, M4 lending fell by £14.6bn in April, recovering to £25.0bn in May. But since these lending figures include the effects of securitisations, they should be excluded to give a better picture of underlying lending flows to UK borrowers. Doing this shows that M4 lending rose by £29.3bn in March, fell by £8.8bn in April but rose by £23.1bn in May, so not a big change to the trend.

We should also exclude the effects of the Other Financial Institutions (OFI) from M4 and M4 lending because they include so much inter-linked activity within the financial sector, including banks. If this is done, then M4 rose by just £0.4bn in May. This is better than the fall of £1.5bn in March but worse than the growth of £0.8bn in April. For May, this means that M4 lending growth (excluding securitisations and OFIs) was zero and just 2% up on the year before. On the lending side, there was a rise of £0.9bn in May after a repayment of £3.0bn of M4 loans in April. These are the sort of figures that justify the MPC decision to embark on QE, because M4 lending would have almost certainly been weaker without QE.

Looking at the details of how the aggregate M4 lending figure decomposes into the household and private sector non-financial corporations (PNFCs) in terms of their bank borrowing positions, shows that commercial companies continued to repay debt in May, but by a smaller £0.3bn in May after £0.9bn in April. The annual growth rate of M4 lending to the corporate sector was just 0.3% in May. Clearly, these figures are not compatible with an increase in private investment in the economy and so do not support any sustained economic recovery in the months ahead. For households, the figures for M4 lending are a bit better, with households borrowing a total of £1.2bn in May, after £1.5bn in April. It is true that banking sector deposits (reserves) with Bank of England have risen since QE, but the fact is that deleveraging by the UK private sector is continuing.

Signs of economic recovery in the real economy (retail sales, manufacturing output) and some rise in business and consumer confidence should not be interpreted as the start of a sustained economic recovery process but rather as a sign that the economic downturn has bottomed out for now. In short, the pace of the economic downturn is lessening but the prospect is for an extended period of weak activity. Hence, the need for the central bank to keep monetary policy loose is as urgent as ever. For these reasons, my vote is to keep Bank rate at ½% and to continue QE. Further funds may be required, and should be sought now, if the current situation persists beyond the summer months, as currently seems likely.

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.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Roger Bootle (Deloitte and Capital Economics Ltd), Tim Congdon (Founder, Lombard Street Research), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Peter Spencer (University of York), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) unanimously voted to leave UK Bank Rate at ½% when the Bank of England’s rate setters meet on 4th June.

The unanimous SMPC vote reflected the belief that there was little case for a rate increase in the near future – despite signs that the lower turning point of the international and domestic business cycles may not be too far off - combined with the view that ½% was close to the effective lower limit where Bank Rate was concerned.

The SMPC had been an early advocate of quantitative easing (QE) and there was a general belief among its members that QE was the ‘least-bad’ option available under current circumstances. Some members of the IEA’s shadow committee thought that the scale of QE would need to be stepped up. Others thought that the current thrust of monetary policy was about right for the time being.

The SMPC also welcomed the Bank of England’s belated publication of a back run of quarterly statistics for ‘core’ M4 broad money, excluding the deposits of other financial corporations, and the Bank’s accompanying announcement that it would resume publication of the table showing the links between public borrowing, funding policy, bank credit and broad money in early June, having previously suspended publication last autumn.

This information was vitally important, given that QE was essentially an attempt to boost ‘core’ M4 using open market operations in the hope that the links between money and activity would then prove tight enough for this to stimulate demand. However, there was concern about the longer-term consequences of present policies. A particular worry was whether it was possible to make a smooth re-entry from QE without provoking either a renewed downturn or losing control of inflation.

Comment by Tim Congdon
(Founder Lombard Street Research)
Vote: Hold
Bias: Neutral

Since the announcement of quantitative easing (QE) in early March, UK business surveys have improved sharply and the stock market has advanced over 30%. The increase in claimant-count unemployment – 136,600 in February – dropped to 57,100 in April. The UK is likely to be the first of the traditional industrial economies out of the current recession. (Chinese growth merely paused in late 2008 and seems again to be running at a rate which in most countries would be regarded as full-scale boom.)

Given the timing, it could be suggested that quantitative easing was the decisive step that checked the recession. However, the attribution of the turn-round solely to quantitative easing is implausible in certain respects. In my February 2009 Council for the Study of Financial Innovation (CSFI) pamphlet, How to Stop the Recession, I argued that – even if an increase in the quantity of money (M4) were initially concentrated in the financial sector – it would quickly move into corporate hands and ease the cash strains in the business sector. The high volume of corporate fund raising in recent weeks may reflect this pattern at work.

Unfortunately (for me), this view is difficult to reconcile with the virtual stagnation of M4 in both March and April. The trouble may be that the M4 numbers have been distorted since at least mid-2007 by deposits held by intermediate OFCs. Until we have the breakdown of the money numbers by sectors (on 2nd June), we cannot be confident what was happening in April, but I suspect that M4 excluding intermediate OFCs rose strongly. A key number to monitor will be M4 held by non-financial corporations (i.e., companies, not financial institutions or households). I will be surprised if this did not rise in April by at least 2% (i.e., at an annualised rate of almost 30%). If companies had three to six months in which their money holdings climbed at an annualised rate of 25% or more, the recession would be over. My guess is that QE is in fact already leading to a dramatic amelioration in company balance sheets of the desired kind, but we will be able to check – properly and with some degree of confidence – only when we have the data in the autumn.

Obviously, I agree with the general thrust of monetary policy at present. So I am in favour of ‘no change’ in either interest rates or the scale of QE. As I show in my PowerPoint presentation (Editorial Note: this can be obtained from timcongdon@btinternet.com) official policy towards banks’ acquisition of claims on the public sector changed dramatically in early 2009. The apparent stagnation of M4 in March and April may be disappointing, but – if the banks had not been acquiring claims on the public sector on such a large scale – the quantity of money would have been falling. QE and/or under-funding was the right course to take.

But a whole mass of issues remain for debate. How are the authorities to be persuaded that their focus on bank lending to the private sector - Bernanke-an “creditism”, as I call it in a forthcoming piece for Standpoint (Editorial Note: this can be obtained from timcongdon@btinternet.com) - is misguided? Are the Bank and the Debt Management Office (DMO) now cooperating in this vital area of public policy or do they continue to operate autonomously? What happens to gilt yields when – as is surely inevitable sooner or later – loan demand revives and the authorities will need to start selling gilts to non-banks again to combat inflation? For the moment, while the recession is still with us, the official programme to raise M4 growth by QE is correct.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: Prepare to extend QE beyond £150bn after July

Despite sharp declines in quarterly real GDP in 2008 Q4 (-1.6%) and 2009 Q1
(-1.9%), there have been a number of bullish signals from the British economy recently. First, the stock market has recovered strongly since the lows of early March, led by banks and other financials, as well as cyclical and commodity-related shares. In the money and capital markets, London Inter-Bank Offered Rates (LIBOR) have eased, and non-financial companies have been able to raise impressive amounts of funds, mainly through corporate bond issues. The ISM measures of manufacturing and non-manufacturing have slowed their rate of decline, and other survey data have been improving. Retail sales volumes, recently revised downwards in recognition of past overestimation by National Statistics, have been reasonably buoyant, rising 2.6% in April from April 2008. In addition, gilt yields have risen.

While signals from the housing sector remain mixed, though preponderantly pointing to continued weakness, and capital expenditure by the business sector has been extremely weak, the rapid deterioration seen in 2008 Q4 and 2009 Q1 appears to have ended. Private sector wages are slowing abruptly, and unemployment seems likely to continue rising, but at a lower rate from here onwards. The economy at last seems to be finding a trough. Can a recovery be predicted? In my view that depends firstly on the monetary measures taken and their consequences for the banking system, and much less on the government’s fiscal spending plans (where the multipliers are small and early positive gains are likely to be undermined by subsequent negative effects). It also depends, secondly, on the health of the balance sheets of the private sector in the economy.

Leaving aside the recapitalisation of the banks, one of the most important developments from a macro-economic standpoint has been the continued growth of bank balance sheets since the collapse of the inter-bank markets in September-October 2007. This is in large part due to central bank lending and purchases of securities, including (since March) QE. Although the Bank switched to a fully activist role only from September 2008, if these measures had not been taken, commercial bank balance sheets would probably still be declining, money growth would be negative, and the economy would still be in a downward spiral.

In terms of the monetary data it is too early to see much improvement yet. Total M4 is heavily distorted on the high side by the deposits of intermediate OFCs (other financial corporations) which undermine M4’s value as a meaningful indicator for the real economy, while adjusted M4 (which excludes intermediate OFC holdings) has slowed from 10% in 2007 to about 3% recently – far too slow. Nevertheless, according to the Bank’s May Inflation Report “four-quarter growth in M4 excluding intermediate OFCs ticked up to 3.9% in Q1, from 3.5% in Q4”. Moreover, one key change on UK banks’ balance sheets between June 2008 and March 2009 has been a sharp increase in sterling investments (including gilts) of £172 billion (+65.6%), more than compensating for the absolute decline in lending to households and non-financial companies of £66 billion (-4.4%). In other words, although bank lending to households and businesses is still falling, bank credit to the non-financial sector as a whole is rising – a necessary precondition for a recovery in adjusted M4 growth and hence a recovery in nominal GDP growth.

Even though QE might seem to be gaining traction, a major problem in ensuring its transmission to a recovery and stable growth of adjusted M4 could occur if the rate of decline in bank lending to the private sector offsets the increase in bank holdings of securities and other investments. This could yet happen if the household and corporate sector balance sheets are so impaired that these two sectors continue to contract their balance sheets, reducing their borrowing (as happened in Japan under QE). Fortunately, this does not seem likely for the non-financial corporate sector - where, as mentioned, corporate bond issuance has already been active - but it is quite possible for the household sector. For this reason it will almost certainly be necessary for the Bank of England to extend QE beyond the £150 billion (or 7.4% of M4) that it is authorised to complete by July.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold
Bias: To hold

The Governor of the Bank of England was quite right to warn that there may be problems with the sustainability of the recovery, when introducing the May Inflation Report recently. Green shoots spotters beware! Such warnings, along with some remarkably benign inflation projections, suggested that the Bank will be running a very loose monetary policy for the foreseeable future. And the minutes of the May MPC meeting indicated that the MPC thought the risk of doing too little to stimulate the economy was greater than the risk of doing too much. There were also indications that the £150bn (£125bn committed so far) quantitative easing sum could be increased “should the economic conditions warrant it.”

At the moment the QE train is happily charging down the track full steam ahead. But it becomes increasingly clear that the unwinding QE could prove very problematic indeed – especially as there will be a glut of gilts to sell in forthcoming years because of the parlous state of the public finances. The Bank’s Deputy Governor Charles Bean’s recent comment that “it is not necessary to unwind the asset purchases before raising Bank Rate” may suggest that the Bank will be sitting on the gilts purchases for a considerable period of time and tighten monetary policy, when deemed appropriate, with higher interest rates rather than selling off the gilts. We shall see. In the meantime I support the Bank’s policy of keeping interest rates very low and continuing with quantitative easing.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral

On the real economy side, the picture of a three- to six-month stimulus-induced temporary reprieve from 2009 Q4 to 2010 Q1 seems ever more likely. Further recession through the latter half of 2010 and into early 2011 seems almost equally assured. House price falls continue unabated. Financial markets have stabilised, but only in the sense of a patient described as ‘critical but stable’. The threat of wage deflation is now acute. Average weekly wages fell an incredible 6% in the year to February, and overall employee compensation fell 1.1% in the first three months of 2009. The nightmare scenario of heavily indebted households facing nominal wage falls now seems upon us. If matters do not turn around on the wages front as a matter of urgency, we could yet see widespread prime defaulting on a scale to dwarf the subprime issue.

Quantitative easing is continuing apace - our last weapon to try to limit nominal wage falls and the defaulting they would herald. The scale is enormous, and must surely result in high inflation down the line. I find it implausible that quantitative easing could be extracted so precisely that deflation can be safely averted without inflation spiking upwards. I would now consider it a success if deflation does not go beyond 5% and if there is only one year of 10% plus inflation on exit. Neither of these is assured. We must also worry about the implications of the policy measures required to get inflation down from 10% - will the economy be ready, by 2012 or 2013, to tolerate the high interest rates that might be required? Can we escape with only a mild tightening-induced recession in 2013?

Public expenditure is totally out of control, and must be brought under control as a matter of extreme urgency. Spending on current levels must have a material impact on the UK's long-term growth rate, and might undermine confidence amongst international lenders in the UK's creditworthiness. Politicians must understand that it is the spending itself, not merely the debt or even the deficit (serious though the deficit is), that is the real issue. This cannot be solved by tax rises or by hopes of future growth. The spending nettle must be seized, and seized urgently.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral

While the press conference by the Bank of England for its May Inflation Report was typically cautious, the Bank is fortunately sticking to the policy of injecting money into the economy on a large scale to maintain the pressure for recovery. All the evidence from episodes like the 1930s Great Depression and Japan’s ‘lost decade’ is that policies to remedy the situation were abandoned too early and caused ‘double dips’. So in this key respect the Bank is doing what it should. Meanwhile, the world economy is looking up decisively.

This is most obvious in the Far East where stock markets are now well up (in China more than 50% up) on the end of 2008, as the evidence has poured in of: firstly, the end of the stock run-off that caused the collapse in world trade and manufacturing at the end of 2008; and, second, of the effectiveness of the huge programmes of support from governments in that region. In the earlier Asian Crisis, these countries found they had insufficient reserves to counteract the pull-out of money from their economies. As a result, they drew the lesson that they should build up huge reserves to counteract these shocks in future. These reserves have used them effectively in this western crisis.

The last six months have seen the most dramatic monetary easing of the post-war period. This has been accompanied by: firstly, direct credit provision by the taxpayer on an unprecedented scale, in the form of support to banks’ balance sheets of various sorts; and, second, the emergence of huge budget deficits triggered by automatic stabilizers plus ‘fiscal packages’ where the stabilizers are small, as in the US. Effectively these deficits are a way the taxpayer provides direct credit to households and firms in the downturn. In the long term, of course, these firms and households still have to pay the same amount to the taxpayer; but they would not be able to raise the finance to keep going without big cuts in their own spending in the downturn. Thus, the availability of this credit from the government is vital - that credit aspect has been the key contribution of fiscal action, not the conventional ‘stimulus’ which may not be much.

So overall we have had a massive creation of money and credit by the taxpayer. This is beginning to have an effect in easing the economic downturn. According to our models, the lag before the full effects of monetary easing kick in is around two to three quarters. That is more or less what we are now observing. Some people argue that it will all be different this time because the balance sheets of key players have been so badly hit. But this argument makes no sense if what motivates people and firms is opportunities and the costs of exploiting them. Clearly soon after the Lehman bankruptcy the costs of credit rose very sharply, with many unable to access it at all. But this has now changed markedly under the impact of the massive easing described above. Rates for most households and firms are well down on September 2008. Thus the average spender can now exploit opportunities at a much lower interest cost. Also as the situation eases risks themselves get lower for such exploitation.

A particular element in the current situation has been the dramatic inventory cutbacks generated by the credit crunch; firms unable to get credit reduced their working capital hugely in the final quarter of 2008. But this is a self-limiting process; at some point inventories cannot be cut further. Also with credit costs falling inventories will be rebuilt. When inventories fall - for example, by one month’s output - that implies that production falls by a third in that quarter (one month’s output cut from the normal three months of output). Something like this seems to have prompted the huge falls in manufacturing output and trade we saw in the fourth quarter of 2008. This is now being reversed, even though its impact is bound to be partially offset by other cuts in spending as the recession bites. Hence the prospects for 2009 are for a steadying of output from the second quarter after sharp falls since the Lehman disaster. There should be a modest revival in demand towards the end of 2009 which should make 2010 a better year.

This means that policy is, at last, proving successful in getting the crisis under control. It is now necessary for the Bank to ‘make sure’ by keeping policy steady in its easy phase, with low interest rates and continued monetary injection (‘quantitative easing’). In my view the lags are short enough for the Bank to be able to extract liquidity from the system rapidly once the situation has firmly stabilized in a moderate recovery pattern. In turn inflation can be headed off quite effectively because the lags from that to inflation are fairly short.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: To expand QE programme further

At its May meeting, the MPC voted unanimously both to keep interest rates at ½% and to increase the QE programme to £125bn, but it recognised the potential need for further stimulus. The MPC mulled over the option of increasing the QE programme to £150bn – the initial upper limit set by the Chancellor – but came to the conclusion that “as the precise amount that would ultimately be required was so uncertain, there was no pressing need for the larger extension at this meeting”. All MPC members agreed that the asset purchase programme should be extended this month rather than next given the view that the economic recovery was likely to be slow and that ultimately more money would be required to bring inflation back to the 2% target over the medium term. However, the Committee acknowledged that a considerable amount of monetary stimulus had already been applied and that “there was a risk that the Committee would not be able to identify early enough when it should be withdrawn”.

This stimulus will seriously complicate policymaking during the recovery phase. On the one hand, a premature reversal could result in a ‘W- shaped’ recovery or even a Japanese-style relapse. Alternatively, if the reversal comes too late, we risk a ‘V-shaped’ recovery in output that mirrors the steep descent, followed by a serious overshoot in inflation. There are clear signs that the financial markets are stabilising and that the economy has passed the inflexion point, at which falls in output and house prices begin to moderate. However, in my view, the risks of not giving the economy sufficient stimulus still outweigh that of giving it too much and I support the MPC’s decision to step up the programme this month. Interest rates should remain on hold until clear evidence of a recovery emerges.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Hold for next few months but prepare to start tightening this autumn

British monetary policy seems to have settled remarkably quickly into the grooves of a ½% Bank Rate and QE. As a result, the main monetary development since last month has been statistical, not a policy initiative. In particular, the Bank of England issued a News Release Recent Developments in Statistics on 25th May that contained two important announcements. The first was that that the Credit Counterparts Table A3.2 - which shows the relationship between the budget deficit, funding policy, bank lending and the expansion in broad money - will be reinstated in the forthcoming 2nd June edition of the Bank’s Monetary and Financial Statistics report. This is a welcome development that SMPC members have requested ever since Table A3.2 was discontinued last autumn. The re-instated figures will make it easier for independent commentators – and, one might suspect, an increasingly nervous International Monetary Fund (IMF) – to monitor the effectiveness of the QE programme and ensure that it does not de-generate into crude inflationary finance.

The second major statistical development was the Bank’s simultaneous publication of an article Measures of M4 and M4 Lending Excluding Intermediate Other Financial Corporations - this now seems to be the main intermediate target of the QE programme - and its release of a back run of quarterly data for the new monetary aggregate back to 1997 Q4. This series can be downloaded from the Bank of England’s data bank using the code RPQB53Q.The new data is seasonally-adjusted but it is calculated as a residual by subtracting ‘Other’ Intermediate OFC (OIOFC) deposits from the established M4 money definition. Unfortunately, this means that the quarterly figures are of lower statistical quality than the more established Bank data series. In addition, monthly statistics will not be available until 1st September 2009, and annual growth rates on a monthly basis not until September 2010.

Nevertheless, the quarterly data was sufficiently adequate to enable some preliminary analysis. The first stage was to compare the year-on-year growth rates of the two series, something that the Bank has been doing in its Inflation Reports. This shows that the annual growth rates in the two series were reasonably close from 1998 to late 2003. However, they then started to diverge in 2004 while the extent of the divergence became increasingly marked from 2007 onwards, producing a classic ‘Jaws’ effect. The annual increase in total M4 was 17.8% in 2009 Q1, compared with the 2.5% reported for M4 excluding OIOFC deposits. The next stage was to calculate the ratio of the new M4 definition to the old one. This showed that in 1997 Q4 the new M4 definition was 98.5% of its forerunner, but that this ratio had fallen to 76.6% by the first quarter of this year. The difference in 1997 Q4 might be because the Bank have subtracted OIOFC deposits from a different M4 measure to the latest break-adjusted figures in their data bank. Alternatively, it could reflect a pre-existing OIOFC distortion. The subsequent divergence between the two M4 series has important implications for anyone attempting to model the behaviour of broad money and its links with the real economy in an Error Correction Framework in which the long-run relationships eventually catch up on trend. The final stage in the preliminary analysis was to splice the new M4 series onto its predecessor before 1997 Q4, deflate the result by the double-core Retail Price Index – i.e. RPI less mortgage rates and house price depreciation – compare it with the annual growth of real GDP and see how the current downturn compared with previous recessions. The result showed strong similarities with the abrupt deceleration in real broad money and the weakness of real GDP observed in the recession of the early 1990s. This is clearly not the case with headline M4, where the annual price-deflated increase was 14.2% in 2009 Q1 compared with minus 0.7% using the new broad money series (Editorial Note: the charts can be obtained on request from xxxbeaconxxx@btinternet.com).

In addition to the graphical evidence, there are a number of statistical tests that can theoretically be applied to see whether OIOFC deposits should be excluded from M4 - either, in total or in part - using demand-for-money equations and other relationships. This subject will be returned to in future. However, a quick and dirty methodology was to replace the old M4 series with the new ex. OIOFC deposits series in the input stream into the Beacon Economic Forecasting (BEF) macroeconomic model. The BEF forecasting model incorporates a wide range of feedbacks from money to the real economy as well as vice versa. The BEF model was last re-estimated in the autumn of 2008 and it has been badly over-forecasting national output in recent quarters. What we did was a highly dubious procedure from the viewpoint of econometric purity. However, given that the data runs used for estimation typically go back to the mid 1960s and the worst distortions are to some extent post the estimation period, it seemed worth a try. The results of this exercise were spectacular with a 1.4 percentage points greater fall in national output being projected for this year, and 1.6 percentage points coming off the growth forecast for 2010.The tracking performance of other areas of the model, including the exchange rate and broad money itself, also seemed to be improved by the substitution of M4 less OIOFC deposits for total M4. This made it possible to run the model with far fewer residual adjustments than previously.

With hindsight, it is clear that our forecasting record has been badly corrupted by our reliance on the Bank of England’s published break-adjusted M4 series in recent years. However, statistical models have to run on data. There is little that one can do if the figures supplied by the UK statistical authorities are not fit for purpose. As the US economist Professor Kenneth Boulding humorously commented forty years ago in the August 1969 National Westminster Bank Review:

‘We must have a good definition of Money’
For if we do not, then what have we got,
But a Quantity Theory of no-one knows what,
And this would be almost too true to be funny’.

Essentially, QE represents an attempt to shore up M4 ex. OIOFC deposits using Open Market Operations, in the hope that the links between broad money and activity are sufficiently tight for this to stimulate real demand. The new M4 definition appears to be superior to its more inclusive predecessor but it has taken far too long for the data to appear in the public domain. Much statistical research will now have to be done in the Bank and elsewhere to test each link in the chain of logic that justifies Britain’s present monetary approach.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: To increase Bank Rate to 2% before the end of the year

The key events of the past month have been the extravagant borrowing projections contained in the UK Budget and the early announcement of an extension to the Bank of England’s Asset Purchase Facility (APF). While some would place the 1.9% reported decline in UK GDP for the first quarter as the most important development, I do not. Appearing only two days after the delivery of the UK Budget, a variety of economic and political commentators rushed to declare that the Budget’s economic projections were instantly outdated. Indeed, the Bank of England, in its May Inflation Report, expects GDP to fall by around 4% this year. There are sound reasons to suppose that the consensus has overreacted to the sharpness of the decline in 2009 Q1. In particular, the contribution of de-stocking was extremely significant in the first quarter as was also the case in the US national accounts. In the past couple of months, there is evidence that the global trade slump is in the process of a spirited recovery, consistent with that of a stabilising trauma patient.

Continuing the theme expressed in previous commentaries, the UK banking system remains a python attempting to digest a pig. The porcine in question is the replacement finance for hundreds of billions of pounds of assets in the Other Financial Corporations sector. Specifically, the mortgage securitisation and other fixed income vehicles that had previously been funded using the international money markets and by the issue of debt securities to foreigners, often in other currencies. The expanded QE programme should permit a gradual relaxation of lending capacity constraints with respect to the real economy sectors (businesses and households) as the rehabilitation of disintermediated financial structures moves towards completion. To reiterate, the banks have been preoccupied with the indigestion in the financial sector for the past twenty-one months. The pressing nature of this problem - maturing finance - has superseded their responsibilities towards the real economy, even the financing of seasonal inventory patterns. This has been a key trigger for the trauma in the goods economy. The worrying decline in lending to PNFCs in recent months is partially mitigated, for large companies, by improving capital market trends. The early expansion in the QE programme, to £125bn, is a positive step and should be followed by a further extension within the next three months.

Striking new evidence has emerged that deflationary pressures are abating rapidly in the UK. Despite the alarming profile of nominal GDP deceleration, a more careful examination of the data allows a different interpretation. First, the detailed analysis of GDP in the first quarter reveals a staggering £6bn of de-stocking, an amount larger than the quarterly decline in GDP. As in other developed countries with large current account deficits, the rate of domestic production plus imports dropped well below the prevailing pace of domestic consumption in 2009 Q1. The uncertainty over the outlook for final demand and the inability to finance excessive inventory levels compelled businesses to embark on a programme of emergency liquidation. Consistent with this narrative, the reformulated official retail sales data contain dramatic V-shapes for the implicit deflators. Thus, what appeared to be an economy in deflationary freefall a few brief months ago is revealed instead as a trauma patient whose vital signs are stabilising. The Office for National Statistics (ONS) has retracted its previous insistence on a stronger profile for retail volumes at the expense of prices.

My favourite decomposition of the retail price index is the third significant piece of evidence. Forces entirely beyond the control of domestic businesses – interest rates, house prices, oil prices, sterling, VAT rates and excise duties – have combined to deliver a temporary and perverse contribution of minus 4.7% annual inflation. Prices set in competitive UK markets have risen by 2.4% over the year to April, if fuel and light are included, and 1.7% if these items are excluded. Gas and electricity prices fell materially in April as a delayed response to the decline in input fuel prices since last summer, but the inflation rates of other private sector goods and services rose to compensate. This occurred despite the abatement in food price inflation to 8.6%. The underlying pricing climate is rebounding towards an inflationary outcome. Once the extraordinary concurrence of lower oil prices, house prices, interest rates and indirect taxes is eclipsed by monetary and fiscal realities, there is scope for UK RPI inflation to hit 4% to 5% by mid- to late-2010.

If the Bank of England’s MPC is taking the inflation target seriously, then the reign of 0.5% Bank Rate should be extremely brief. By the end of September, it should be clear that the deflationary emergency is over and that Bank Rate can be restored safely to around 2%. My vote is to hold interest rates at ½%, but to plot a course for a return to 2% by December, in conjunction with a further supplement to QE in three months’ time.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Bias to ease via QE

UK interest rates have been cut aggressively in the last six months but, as they operate with a lag, this has done little to prevent GDP in 2009 Q1 from falling by 1.9% and the level from being 4.1% lower than in the same period of 2008. Although there are increasing signs that the worst of the fall in GDP may be over for now, there is no indication of a recovery in the economy, merely of a slower pace of decline. But the latter seems enough to lead to talk of the ‘green shoots’ of economic recovery.

To some extent, the Bank of England’s May Inflation Report tended to argue against this view by referring to the UK economic recovery being likely to be long and protracted once it gets underway. However, this has not prevented the equity and commodity markets from showing a stronger profile in recent weeks. This may have been helped by government efforts to inject liquidity into financial markets, with some of this finding its way into commodity, foreign exchange and equity markets. However, actual money supply figures for the UK in April showed only a modest rise in M4, of 0.1%, with a decline in the year over year rate from over 18% in the month before to just over 17%. This monthly pace, an annualised 1.2%, is clearly not consistent with sustainable economic recovery, especially since there were signs in the detail of the data of a renewed slowdown in lending to households and companies.

All in all, this implies that the Bank of England was right in asking for access to a further £50bn of the already sanctioned £150bn of funds to purchase gilts and bonds, taking their planned spending to £125bn. Moreover, the wording from the minutes taken of the May MPC meeting makes it clear that there is likely to be a request for the remaining £25bn but also for additional funds. This would seem prudent given that signs from the PMI data and the Confederation of British Industry (CBI) surveys suggesting that manufacturing cutbacks in stock levels and production have been sufficient do not yet mean that firms are about to lift output levels.

Already weak export orders have taken a further hit from the recent rise in sterling from its lows and the rise in volume retail sales is being offset by reductions in household services and consumer durables spending. This means that monetary policy should still lean towards easing, via QE, especially as the price and wage inflation data are falling into line with the sort of rates consistent with the large negative output gap that has opened up in the UK and elsewhere in the world economy.

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.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Roger Bootle (Deloitte and Capital Economics Ltd), Tim Congdon (Founder, Lombard Street Research), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Peter Spencer (University of York), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

Following its latest quarterly meeting (held on 21st April in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) unanimously voted to leave Britain’s Bank Rate at ½% when the Bank of England’s rate setters meet on 7th May.

The unanimous SMPC vote reflected the belief that there was little immediate case for a rate increase - while activity was so weak - combined with the view that ½% was the practical lower limit where the money markets were concerned. One member believed that it was technically possible to lower Bank Rate further, using a US-style approach, but accepted that this would not make a noticeable difference to the wider economy.

The SMPC had been one of the earliest advocates of quantitative easing (QE) and expressed a strong preference for its continuation as the main monetary tool. However, the shadow committee was agreed that more specific plans for the implementation and withdrawal of QE were needed.

On the implementation side, several members said that the current £150bn QE target needed to be increased. On the issue of withdrawal, the SMPC was unanimous in believing that the UK monetary authorities needed to publish an explicit exit strategy well before QE had to be put into reverse. The SMPC was disappointed that the Bank of England had ceased publication of the statistics needed to monitor QE and that it was not publishing regular monthly figures for the ‘core’ broad money definition that it appeared to be targeting.

The SMPC gathered on the eve of the 2009 UK Budget and three days before the publication of the weak first-quarter GDP figures on 24th April. Both developments were consistent with the profound concern expressed in the SMPC minutes about the adverse fiscal backdrop and the likelihood of a fiscally-induced collapse in aggregate supply.

At its latest meeting, held at the Institute of Economic Affairs (IEA) on Tuesday 21st April the IEA’s Shadow Monetary Policy Committee (SMPC), a group of leading monetary economists that monitors developments in UK monetary policy, unanimously voted to hold Britain’s Bank Rate at its current level of ½%.

In addition to wanting to hold in May, seven out of nine members also had no immediate bias to change Bank Rate in the immediate future. This was partly because there seemed to be little case for an imminent increase - as long as international and domestic economic activity were as weak as they were - but also because most members thought that ½% was the practical floor for Bank Rate where the money markets were concerned.

However, one member, Trevor Williams believed that it was technically possible to lower Bank Rate further, by adopting the US approach, and so had a bias to ease without a strong view that it should be done. In contrast, Peter Warburton wanted to raise the official REPO rate before the year end.

The SMPC had been early advocates of the policy of quantitative easing now adopted by the Bank of England and expressed a strong preference for the continuation of direct monetary control as the main monetary tool, given that changes in Bank Rate would have little effect, at their 21st April meeting.

However, there was also agreement that this was a potentially dangerous policy and that there needed to be an explicit exit strategy available in the public domain before the policy had to be put into reverse. Otherwise, economic agents could fear that QE was simply a cloak to mask the government’s resort to crude inflationary finance in an attempt to buy votes ahead of a 2010 general election. There was widespread support for the view, advanced by Roger Bootle and Philip Booth at the 21st April gathering, that the authorities should publish an explicit exit strategy, akin to the early 1980s Medium Term Financial Strategy.

Minutes of the Meeting of 21st April 2009
Attendance: Philip Booth, Roger Bootle, John Greenwood, Andrew Lilico, Patrick Minford, Hiroshi Oka (Embassy of Japan), David Brian Smith (Chair), David Henry Smith (Sunday Times observer), Peter Warburton (Acting Secretary), Trevor Williams.

Apologies: Tim Congdon, Kent Matthews, Gordon Pepper, Peter Spencer, Mike Wickens.

Chairman’s comments
The chairman recorded the Committee’s appreciation of the contribution of Anne Sibert (Birkbeck College, London), who had been a member of the SMPC for many years. Anne had been asked to join a Monetary Policy Committee for Iceland and had resigned from the SMPC. The members wish her well with her new assignment. The timing of the next meetings was discussed and the suggested timing is Tuesday 21st July at 6pm. The chairman then asked John Greenwood to present the International and UK economic background.

The Monetary and Economic Background
The International Background
John Greenwood began by considering the shrinkage of global credit and the slowing pace of lending. He noted that most of the credit growth in the past decade had been from outside the banking system. Latterly there had been a dramatic shrinkage in non-bank credit, although bank balance sheets were growing as funds were re-intermediated back into the banking system away from capital markets. John drew the meeting’s attention to declines in the US asset-backed securities and commercial paper markets. He noted that there had been a monetary acceleration with the growth of US M1 well over 10% per annum and of US M2 of almost 10%. Meanwhile, the annual growth of US bank credit has fallen to virtually zero. The compensating factor has been the growth of bank reserves deposited at the central bank. Using the illustration of an inverted pyramid to represent leverage in the US financial system, he explained that there was rapid expansion from the base but contraction from the top of the structure.

John Greenwood added that he found it difficult to see how the authorities could succeed in stimulating the economy while house prices were still falling. Rather than a typical post-war recession, John regarded this as a balance sheet recession in the tradition of Irving Fisher. The distinctive characteristic is the prolonged build up of debt and subsequent deleveraging. A deflation of commodity prices had fed into producer and consumer prices. Deflationary trends were evident in Japan, China and Hong Kong as well as in Europe and America.

Regarding real economic activity, he noted that leading indicators were still very weak and expected the annualised decline in US GDP in 2009 Q1 to be 5%. Meanwhile, the plunge in Asian exports appears to be stabilising, following recent annual declines of between 20% and 50%. He suggested that Chinese exports may weaken further given their downstream position in Asia’s supply chain. He presented some forecasts for growth and inflation in 2009, noting the likelihood of some stability in the second half of the year but not a genuine economic recovery.

The UK background
Following the same line of argument as for the international economy, John Greenwood identified the acceleration in UK private sector debt from 2003 as the source of the current difficulties. Prominent in the evolution of UK credit expansion were financial corporations whose debt to GDP ratio had risen from little more than 600% of GDP in 2002 to over 937% on the latest data. He drew attention to the re-intermediation of borrowing by the ‘other-financial’ sector which had distorted the pattern of bank lending and deposits. He believed that headline measures of broad money growth were misleading and preferred the adjusted M4 data provided by the Bank of England. Lending to households and non-financial companies registered a 2% annual growth on the latest figures. There was every possibility that adjusted lending growth could go negative. This would be typical in the aftermath of an asset bubble burst.

The expansion of the Bank of England’s balance sheet had been very rapid in the second half of last year and had recently begun to expand again. However, the new policy of Quantitative Easing (QE) is barely visible in the statistics having only begun a few weeks ago. In the broader banking system, unsecured personal borrowing had begun to compensate for mortgage unavailability last year, but had receded sharply in recent months. John Greenwood noted the rise in the UK personal saving rate to 4.8% of disposable income and rationalised this as part of the necessary adjustment in household balance sheets. The rise in the saving rate represents a headwind for personal consumption.

John Greenwood presented a selection of output and fixed investment indicators to demonstrate the weakness of current activity and investment intentions. He observed that the annual growth rate of employment had fallen to minus 1% and private sector average earnings had slipped to a 1.4% annual rate. Inflation expectations as represented by breakeven rates calculated from the index-linked market had moderated to around 1% although the March Consumer Price Index (CPI) continued to show 2.9% inflation.

Why Quantitative Easing may not work
John Greenwood presented a sequence of charts relating to the Japanese experience of corporate sector deleverage and balance sheet recession from the late 1990s. He showed that the desire to repay debt by households and firms had a stultifying effect on the policy of QE. Through the period in which QE operated, March 2001 to March 2006, the size of Japanese bank balance sheets was broadly constant but their composition had changed. Banks acquired government securities in roughly the same quantities as they shed loans. Between December 1998 and December 2007, Japanese banks eliminated ¥100trn of credit to the private sector and added ¥107trn of credit to the government. At the same time, broad money - defined as M2 plus Certificates of Deposit (CDs) - had not accelerated at all, growing at only 1% or 2% per annum. John concluded that the policy of QE had been largely ineffective in ending the deflationary episode.

Discussion
Debate over Quantitative Easing
Patrick Minford contested the conclusions drawn from John’s analysis of the major economies. His objection was that incentives still matter, even in a time of severe economic weakness. He argued that economic agents would take advantage of new opportunities, including low interest rates. He anticipated a big inventory correction after the slump in trade flows, notably in China. More broadly, he contended that the immovable object of the credit crunch had been met by the irresistible force of aggressive policy response, particularly after the collapse of Lehman last September. He argued that prices in the global economy had become much more flexible and that the supply response would be dynamic.

Andrew Lilico suggested that QE had been a success in Japan in that it had prevented deflation. He was interested to know how Japan had calibrated its policy of QE and what lessons could be learnt for the UK. John Greenwood replied that current account balances at the Bank of Japan had been the chosen instrument rising from ¥5trn to ¥35trn. He added that, although governments do not want to see the accumulation of bank reserves, when they see banks increasing their lending to the private sector they must necessarily withdraw the quantitative easing. In addition to buying JGB’s, the Bank of Japan had purchased short-term funding bills known as Tegata. When QE was ended, the “bill mountain” of Tegata was allowed to mature, effectively withdrawing ¥17trn from the QE programme within the space of three months.

Trevor Williams opined that even £150bn of QE will not be enough. He argued that the banks’ ‘funding gap’ would swallow up the existing target for QE. Philip Booth commented that the Bank of England had ignored money for so long that it was ill-equipped to operate a policy of QE whilst providing markets with the confidence that it would know when to end the process in order that the inflation target was hit. Trevor Williams argued that the impact of QE in lowering gilt yields would be offset by the increasing size of the fiscal deficit.

Philip Booth argued that there were important differences between the current situation and Japan in the 1990s. Firstly, Japan’s economy had big structural problems in the 1990s, e.g. its insurance industry. Secondly, the saving rate in Japan was at a much higher level than currently in the US or UK. He viewed the sharp depreciation of Sterling as an equilibrating factor in the UK experience.

Roger Bootle drew a contrast between the text book and the practical versions of QE. He noted that in the text book version the policy of QE seemed irresistible because it was limitless in scale. However, in practice, there is an official reluctance to use QE because a fear of subsequent chaos restrains the scale of operations. Roger Bootle considered it a second order question, as to which assets should be bought in the market. He reckons that balance sheet size is more important than composition.

Trevor Williams raised the issue of whether the private sector would buy back the impaired assets that have been taken on by the Bank of England’s balance sheets. There had been some reluctance on the part of the Bank of England to crystallise a loss. Roger Bootle considered that there was no real difference between a government-financed bailout and a loss on the central bank balance sheet.

Andrew Lilico recognised that the lagged defects of QE gave rise to an inflationary concern. He advocated the use of a price level target rather than an inflation target, arguing that a price level target removes the uncertainty over the speed of policy withdrawal. Roger Bootle commented that there were other ways of controlling liquidity and that the authorities could force banks to buy short-term debt. David B. Smith highlighted the use of mandatory reserve asset ratios as a means of limiting the inflationary risks of QE. He added that the Financial Services Authority (FSA) had already advocated a 6% to 10% liquidity ratio for the banks on prudential grounds. This would also serve to soak up shorter-term government debt as a side effect, however.

Roger Bootle was concerned that the Bank of England (BoE) did not have a credible plan regarding the withdrawal of QE. He stressed the need for the Bank to offer a convincing strategy for the policy. Philip Booth bemoaned the fact that there has not been enough sound analysis of monetary developments and worried that the policy of QE was disconnected from the inflation target. The Sunday Times observer, David H Smith, commented that the BoE expects to lose money on QE, but has been indemnified by the Treasury. This raises an issue regarding the independence of the central bank. It implies that the Bank is operating QE only with the permission of the Treasury.

David B Smith reminded the committee of the covert institutional power struggle between the BoE and the Treasury that had existed ever since the nationalisation of the Bank in 1946. Recent events had brought the Bank back under the Treasury’s heel after its eleven year period of temporary freedom. The historic record from 1694 onwards suggested that a HM Treasury controlled Bank always pursued more inflationary policies than an independent one.

Votes
The Chairman then asked each member to make a vote on the monetary policy response, apart from Patrick Minford who had voted earlier. In addition, Ruth Lea had to vote in absentia, since she was inadvertently delayed on her way to the meeting and had not been physically present. The votes are listed alphabetically rather than in the order they were cast, since the latter simply reflected the arbitrary seating arrangements at the meeting. The Chairman traditionally votes last. On 26th April, Peter Warburton slightly modified the transcript of his 21st April vote, to incorporate his comments on the 2009 Budget.

Comment by Philip Booth
(Cass Business School)
Vote: Hold
Bias: To rein in QE

Philip Booth stated that either the BoE or the Treasury should publish a strategic document, analogous to the Medium Term Financial Strategy of the 1980s. The purpose of this document would be to connect the policy of QE to the existing inflation targets. It would set out the basis for QE and the expectation for the policy. Philip Booth further expressed his desire to see a tightening of fiscal policies alongside QE. Also, he favoured a return to the use of RPIX as the target inflation measure.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: Neutral

John Greenwood reminded the meeting that in Japan, the QE program grew to approach 30% of GDP at its peak, implying that the scale of operations in the UK would need to be increased substantially. He warned that the prolonged fiscal expansion in Japan, which carried the public sector debt from 50% to 180% in GDP, had no lasting effect on domestic recovery. He thought that the lesson to be learnt was to tighten fiscal policy and especially to reduce government expenditure. UK banks should be required to hold a higher proportion of gilts in their portfolios.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold
Bias: Neutral

The economy may or may not be showing the first green shoots of recovery. At best, there is tentative evidence that the rate of decline may slow in the second quarter of this year compared with the first. And credit conditions may be easing, not least of all those relating to secured lending for the housing market. But the economy remains mired in deep recession. Given the parlous state of the public finances, for which the Government must be held at least partly accountable, not that they appear capable of admitting to this, there is absolutely no room for fiscal easing.

So monetary policy has to be relied on to give all the help it can to the economy. Under these circumstances, interest rates should be left where they are and QE should continue – though we might well ask why the Debt Management Office does not just issue gilts directly to the Bank of England. QE appears to be under-funding by any other name. Of course the Bank needs to start to explain its exit strategy. We need far more transparency on economic policy in general.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral

Andrew Lilico reiterated the need for a clearer exit strategy from QE. He believed that the size of the QE program is sufficient for the time being but should be reviewed in the year ahead. He reckons that the inflation target has lost credibility and prefers a shift to a price level target for the duration of QE, recognising that QE has the constrained ambition of avoiding deflation. A price level target would allow more tolerance of inflation as the policy of QE was withdrawn. Andrew was extremely concerned by the projected rapid increase in the share of public expenditure in GDP and its implications for the growth of potential output in the medium term.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral

Patrick Minford voted to pursue the policy of QE in order to make sure that the deflationary tide had been turned but said policy makers should be ready to start ‘reversing engines’ within the coming year. In the meantime, he argued that QE should be given explicit objectives in the form of target reductions in spreads between Bank Rate and market rates. These spreads reflect ‘disequilibrium risk’ due to the credit/liquidity famine; the role of QE is to ease this famine. Hence the point that the objective of QE can be translated into reductions in these spreads- contrary to a widespread view (even found in Bank comments) that the spreads represent an appropriate ‘re-pricing of risk’. For example, Patrick Minford said that he would like to see a halving of the London Inter-Bank Offered Rate (LIBOR) spread - currently around 100 basis points - and a reduction, say, of 100 basis points on the spread of corporate bond rates over equivalent gilts.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Neutral

David B Smith strongly supported Philip and Roger’s call for a published medium term strategy for the use of QE and its withdrawal and hoped that such a document would be published alongside the next day’s Budget. He also called for better monetary statistics and the revival of the table showing the links between government borrowing, funding policy, credit expansion, and the change in the broad money supply.

He added that the essential point about QE was that it was an attempt to boost the stock of broad money in the hope that this would lead to increased activity. However, published M4 was up 18.6% on the year in February, and a provisional 17.6% higher in March, and clearly did not need to be increased further. Instead, official attention was apparently concentrated on M4 less the deposits held by so-called ‘other’ financial corporations (OFCs). This measure appears to have risen by around 2.8% in the year to February. For the Bank not to publish a break-adjusted back run and the latest monthly figures for this underlying monetary series was as ludicrous as having an inflation target, but not telling anyone what the target was, in his view. He was also not convinced that 100% of OFC deposits should be taken out of M4. This was an empirically testable issue.

On the basis of his own published research on this subject in the 1970s, he could think of four or five ways in which the hypothesis that 100% of OFC deposits should be excluded from M4 could be tested econometrically if consistent back runs of the data were in the public domain. He was surprised that the Bank had not published such research itself. It would be taking huge risks with inflation if the ‘true’ rate of broad monetary growth was closer to the headline 18.6% than the adjusted 2.8%.

David B Smith added that he agreed with Peter Warburton’s concern about the wider fiscal background (see: below). The extensive international literature on fiscal stabilisation policy strongly indicated that it would be impossible for any government to tax its way out of the looming fiscal crisis facing the UK, now that spending and taxes were such a large share of GDP. Any attempt to raise taxes from where we are now was likely to cause a collapse in aggregate supply and worsened Budget deficits, not smaller ones. This meant that genuine government spending cuts - or decades of stasis - were the only available options.

He was also concerned that Britain’s large budget deficits were stifling the private economy for ‘crowding-out’ and Ricardian-equivalence reasons. He believed that the supply-side implications of the present unsustainable level of public spending had been ignored by the Treasury in their estimate of future potential growth. The essential point about QE is that it represented a retrospective monetisation of past budget deficits. Simply, underfunding a proportion of the current massive budget deficit would probably have been sufficient, although it might have taken effect slightly later.

David B Smith added that there still seemed to be considerable uncertainty as to how much QE was needed in order to produce a given increase in M4 broad money. By chance, he had examined this issue in his May 2007 ERC monograph Cracks in the Foundations: A Review of the Role and Functions of the Bank of England After Ten Years of Operational Independence (www.ercouncil.org; see page 13) using the long-run steady states of the statistical relationships incorporated in his Beacon Economic Forecasting macroeconomic model. The arithmetic, based on the current model, went as follows. Firstly, a 1 percentage point cut in the twenty-year gilt yield was associated with an 8.1% increase in M4 ceteris paribus.

Second, net gilt re-purchases from the non-bank private sector of 1% of non-oil GDP seemed to cut the twenty-year yield by 18¼ basis points. Putting the two figures together implies that an arbitrary 5% boost to M4 would require a 62 basis points drop in the twenty-year gilt yield, equivalent to net gilt repurchases of 3.4% of non-oil GDP or just over £42bn in cash terms.

This suggested that the official plan to repurchase up to £75bn of public debt should add around 8.9% to M4 in the fullness of time. However, there are lags involved. In addition, it would require a continued stream of debt re-purchases to maintain broad money at its higher level. Once debt re-purchases ceased, the money supply should eventually return to its previous level, ceteris paribus, using this demand for money approach. This suggested that the re-entry problem might just take care of itself in theory. In practice, however, these effects were likely to be swamped by the need to finance the huge stream of deficits expected to be announced in the next day’s Budget. These would, in turn, lead to a severe interest-rate crowding out of private activity, especially long-term capital investment, and an atrophying of aggregate supply.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: To tighten before year end

Peter Warburton, taking a cue from Mervyn King, who ventured the opinion that it would be inappropriate for the fiscal stance to be loosened in the 2009 Budget, thought it necessary to include a judgment about fiscal policy. There is never a good time to limit public spending in the face of an enduring crisis. However, given that the Treasury has conceded that the UK budget deficit is primarily structural in character, there can be no better time to address overspending than the present. The fiscal projections presented on 22nd April pose a significant threat to sovereign credit worthiness. Irrespective of a formal downgrading of the UK’s AAA credit rating there is a risk that the costs of debt service will spiral upwards and render the task of fiscal stabilisation impossible.

It would have been much better to cut back government expenditure now, by around £30bn, in order to set the public finances on a more credible path to stability. At the same time, the scope and scale of QE should be expanded aggressively until deflationary fears have been overtaken by inflationary ones. Peter Warburton shared the concern of other SMPC members that the withdrawal of QE will be problematic. Nevertheless, given how high are the stakes, this policy combination is preferable.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: To ease

Trevor Williams said that, while there was clearly little scope for interest rates to be lowered, it was still technically possible to use money market operations to force rates a little lower, as in the US. However, it would be much more important to step up the scale of QE and broaden the range of instruments purchased from the market. It would be necessary to bolster the credibility of QE, particularly in respect of the manner in which it would be withdrawn. Trevor Williams expressed the view that, as gilt issuance was revised higher in line with the fiscal deficit, the program of gilt repurchases should be expanded accordingly.

Policy response
1. On a unanimous vote, the shadow committee voted to hold Bank Rate at its current ½% with seven out of nine members having no immediate bias. This was partly because most members thought that ½% was the practical floor for Bank Rate. However, Trevor Williams believed that it was technically possible to lower Bank Rate further and had a bias to ease. In contrast, Peter Warburton wanted to raise the official REPO rate before the year end.

2. The SMPC expressed a strong preference for the continuation of QE as the main monetary tool in the immediate future. However, there was agreement that this was a potentially dangerous policy if not followed prudently. There was a widespread support for Roger Bootle’s view that the authorities should publish an explicit exit strategy, akin to the early 1980s Medium Term Financial Strategy.

3. There was also some support for Andrew Lilico’s argument that the QE approach would be more credible if a price level target was adopted, so inflation overshoots and undershoots were not just treated as bygones. Philip Booth also suggested that credibility would be improved by a return to the old RPIX target measure. Earlier comments about the inadequacy of the Bank of England’s published statistics were also re-iterated. It is impossible for independent observers to be confident that QE is more than just a crude resort to inflationary finance without better data.

4. The SMPC gathering was held the evening before the 22nd April UK Budget. Several SMPC members were deeply concerned about the implications of the fiscal stance for funding policy and the supply-side of the British economy before the 2009 Budget measures were announced. These concerns have been exacerbated by the Budget measures themselves, according to a subsequent poll of SMPC members.

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.

SMPC membership
The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Roger Bootle (Deloitte and Capital Economics Ltd), Tim Congdon (Founder, Lombard Street Research), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Peter Spencer (University of York), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

In its latest e-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted unambiguously to leave Britain’s Bank Rate unaltered at ½% on Thursday 9th April. All nine members of the shadow committee, which is run in association with the Institute of Economic Affairs (IEA), thought that UK Bank Rate was now at its effective lower limit.

However, there was no immediate case for a rate increase in the SMPC’s view, as long as the international and domestic economies were as weak as they were at present. The SMPC believed that the quantitative easing measures announced in the 18th March Monetary Policy Committee (MPC) Minutes were now the important monetary initiative.

The IEA’s shadow committee had advocated quantitative easing for several months before the UK authorities adopted this approach. However, the SMPC has consistently argued that the adoption of quantitative easing is a major decision that could engender serious collateral damage in the wrong circumstances.

One member even suggested that quantitative easing was the monetary-policy equivalent of deciding to employ a tactical nuclear weapon, in its scope for unintended adverse consequences. There was unanimity that the unconventional measures taken to increase monetary growth needed to be rapidly unwound, once they had done their work, to avoid a longer-term inflation problem.

The SMPC also expressed concern, ahead of the 22nd April Budget, that Britain was facing the worst run of fiscal deficits in its peacetime history. These would probably crowd out private activity in the short term and risked being monetised, in the longer run, leading to accelerating inflation.

Comment by Tim Congdon
(Founder Lombard Street Research)
Vote: Hold
Bias: Neutral

Mortgage approvals in January were £9.1bn, slightly up on December’s £8.9bn. The stock of mortgage lending has been virtually flat in recent months and that seems a reasonable prognosis for the immediate future. By contrast, banks’ unused credit facilities plunged in January when they were 11% down on a year earlier. The verdict has to be that – for the next few months – bank lending to the genuine private sector (i.e., excluding intermediate Other Financial Corporations (OFCs)) will be unchanged or down slightly.

However, the £75bn of gilt buybacks over three months implies a positive impact on M4 growth from this source of over 1% a month and perhaps as much as 1½% a month. The arithmetic is as follows. The stock of M4 broad money is roughly £1,750bn, if intermediate OFCs are cut out. If £25bn a month is bought from non-banks and there are no leakages, the extra M4 because of the gilt buybacks is getting on for 1½% a month. But there will be some leakages, because of – for example – some of the buybacks being from banks and the overseas sector.

As broad money growth of about 1% to 1½% a month looks about right to me in current circumstances (as ever, cutting out intermediate OFCs), my basic stance is ‘no change’. It will be interesting to see whether the corporate liquidity ratio (i.e., M4 money held by companies divided by their M4 borrowings) does recover, as I proposed in my Council for the Study of Financial Innovation (CSFI) pamphlet How to Stop the Recession. In qualification, the Bank of England and the Debt Management Office (DMO) really ought to coordinate quantitative easing with the DMO’s debt management ‘strategy’, if strategy it be. It is idiotic for the DMO to be selling a 2049 gilt issue (which will take money out of the non-bank private sector) at the same time that the Bank is buying gilts to increase the non-bank private sector’s bank deposits.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: To hold

Interest rates are lower than necessary or appropriate at this point. But it would not be sensible to raise them at this stage. The focus now must be on quantitative easing measures and on the management of expectations. The outlook for the real economy continues to darken. Although the financial sector may at last be stabilising - and it really ought to stabilise, given the huge sums of taxpayer support provided, irrespective of whether that support was appropriate or well-directed - there have been many false dawns so far in the financial crisis and this may yet be another.

The reality where Britain’s real economy is concerned appear to me to be this. There will be contraction in GDP for the first three quarters of 2009. Then there will be either one or two quarters of tepid growth, largely as a lagged effect from interest rate cuts and fiscal loosening. But this growth will not be sustainable and will not be sustained, for three reasons:

• Firstly, fundamental real imbalances will not have fully corrected themselves. The clearest of these will be house prices, which will continue to fall at about 15% per year through 2010 and perhaps into the first part of 2011. Only once house prices have come close to their nadir will sustainable growth be possible.

• Second, there is currently a significant contraction in adjusted broad money. The annual rate of growth reported in the February inflation report was down to 3.8%, implying aggressive monthly contractions. Quantitative easing should eventually succeed in restoring some broad money growth, but even then the effect is likely to be deflationary. Current contraction will feed through into a negative real economy impact from mid-2010, and there is also now considerable uncertainty over the medium-term outlook for inflation, will all scenarios from significant deflation to double-figure inflation being plausible. This increases the inflation outlook risk, to add to the monetary contraction challenge.

• Finally, the Pre-Budget Report path for public expenditure would imply, on a recession only as bad as the early 1980s, public spending exceeding 50% of GDP in 2010-11. I hope and believe that politicians will face up to the implications of this soon, and that by early 2010 we will be seeing very significant fiscal tightening - with a short-term negative impact on growth. I thus anticipate a second dip of recession from the latter part of 2010 into the first part of 2011.

In the meantime, it would be useful to introduce a five-year average inflation (price-level) target, specifying an average annual inflation rate over the period of 3% to better manage the process of quantitative easing (which looks to me to be at about the right scale for now). Quantitative easing is subject to great uncertainty over the volume and timescale of its effects, and I believe that a price-level target would be much more appropriate in this scenario than an annual inflation target, allowing better expectations formation and a clearer exit strategy from the deflationary episode now underway.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold
Bias: To hold

The Bank of England Governor Mervyn King’s latest appearance at the Treasury Select Committee (24th March 2009) elicited a great deal of comment in the media. The focus was on his gnomic, but nevertheless quite unambiguous statement, that the public finances were in such a parlous state that further discretionary public spending was unwise. “Given how big these [public sector] deficits are”, he said, “I think it would be sensible to be cautious about going further in using discretionary measures to expand the size of those deficits.” Few surely, except for the man in Number 10 Downing Street who is wholly responsible for the wreckage of our public finances, would disagree. But we will have to wait until Budget Day, on 22nd April, to see if Mr King’s wise words have been heeded.

But it was another of Mr King’s comments that spooked the gilt-edged market. And that was that the Bank of England might not buy as much as £75bn of securities under the Asset Purchase Facility as initially announced. His explanation was not altogether convincing. He gave the impression that the Bank might buy “close to £75bn in three months…so that we would then be able to see the impact of that”. But monetary policy does not act with such a short lag. Indeed Mr King was at pains to explain to the Committee that monetary policy acts with considerable lags.

It may have been that the Bank, mindful of the worse than expected inflation numbers released on 24th March, is beginning to fret about inflation, despite collapsing demand. Rather than facing deflation the economy may be facing stagflation or worse. (There is in any case a great deal of confusion between deflation in the sense of consistently falling prices and a negative change in year-on-year RPI, which is distorted by the dramatically falling interest rates.) But given the parlous state of the real economy and the disastrous state of the public finances, the Bank really has only one choice in my view. And that is to press ahead vigorously with quantitative easing and keep interest rates low. But there is absolutely no point in cutting the Bank Rate further. In my view the last one was quite unnecessary.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral

There is something very odd about one arm of government conducting an expansionary fiscal policy and financing it by selling government bonds to the non-bank public and another arm of the same government buying bonds from the non-bank public with a view to monetizing the existing stock of government debt. The belief that massively expansionary fiscal policy can somehow drag the economy out of recession is an illusion based on the mistaken view that the New Deal helped pull the US economy out of the Great Depression. Nothing could be further from the truth. In research conducted by Dan Benjamin and myself (Benjamin D and Matthews K, US and UK Unemployment between the Wars: a Doleful Story, Hobart Paperback 31, Institute of Economic Affairs, London, 1992) we found that the New Deal policy crowded out private sector jobs (for every ten jobs created by the New Deal, nine were lost from the private sector) and helped explain why unemployment remained stubbornly even by the end of the 1930s.

The current crisis cannot be solved by massive fiscal expansion. History has shown that expansion of the government sector has irreversible effects in terms of over-regulation, productivity and low growth. The central banks of the developed world took their collective eyes off the monetary ball through their fixation with inflation targeting. In theory inflation targeting would produce the same outcome as monetary targeting provided all markets including the traded sector worked properly. While goods price inflation remained low (partly because of the export policy of dollar zone economies), asset prices told a different story. An over-leveraged non-bank private sector is unlikely to expand demand even at zero interest rates unless there is even stronger quantitative easing. Bank rate should be held at its present ½% and the monetary authorities should persevere with their quantitative easing policy.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: To hold but the Bank must publish better statistics so that the effects of quantitative easing can be assessed

The Bank of England has at last adopted direct quantitative measures to boost the money supply. I have argued repeatedly in the past that in an atmosphere of financial crisis an economy can be flooded with bank reserves and money without inflation rising because banks do not have the confidence to use reserves and neither companies nor households have the confidence to spend the money but as soon as confidence returns bank reserves and the excess money in the economy must be mopped up to prevent inflation from rising. It is now vital to monitor what is happening to the money supply to ascertain whether the boost to it is inadequate, about right or excessive. There are two current problems with the data.

The first is distortions. M4 consists of money held by the private sector excluding inter-bank deposits. Transactions that are in effect within banking groups, that is, the deposits of what are now called ‘intermediate other financial corporations’ should also be excluded but they are not. More precisely, the private sector consists of ‘households’, ‘private non-financial corporations’ and ‘other financial corporations’. The last can be divided into traditional non-banks, such as life assurance companies and pension funds, and the ‘intermediate other financial corporations’. (In even more detail, the last category covers Special Purpose Vehicles, transfers between bank holding companies and their banking subsidiaries and Central Clearing Counterparties.) An adjustment should be made for all this and it is one that is most significant. According to the Bank’s latest Inflation Report in the fourth quarter of 2008 after making the adjustment M4’s percentage change on a year earlier was under 4% compared with over 15% for the unadjusted series. Quarterly data for the adjusted series are inadequate. The Bank is believed to have monthly estimates and should publish them.

Secondly, monthly data for the so called ‘counterparts’ of M4 (to be precise, the alternative presentation ones) ceased to be published last September. Before then the ‘causes’ of monetary growth could be ascertained, for example, the contributions of the budget deficit and the amount of gilts sold to the non-bank private sector by the Debt Management Office. The explanations advanced for stopping publication are cost cutting and the transfer of Northern Rock, etc., from the banking to the public sector. These are trivial explanations compared with the importance of knowing how the banking bail outs by the government are being financed. The counterparts should again be published.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: Boldly pursue quantitative easing

At the March meeting the MPC voted unanimously to cut interest rates by ½% and commence £75bn worth of quantitative easing. Its plan to structure gilt purchases in the five to twenty-five year maturity range is clever since this makes it likely that it will purchase gilts from non-banks rather than banks. This will increase the money supply directly: to the extent that the Bank buys gilts from banks the policy would only be effective if banks lent out the new money. This is the textbook response, but seems unlikely in the current climate. This quantitative easing strategy is more akin to ‘underfunding’ than the quantitative easing strategy followed by Japan in the last decade. It seems to have been very effective, gilt and corporate bond yields have fallen back nicely since the MPC’s meeting. No wonder it is being emulated by the Federal Reserve.

The latest readout on the public finances confirms my long-held view that there is no room for manoeuvre on fiscal policy. The automatic stabilisers are working through with a vengeance given the high tax elasticity of financial sector output. The Prime Minister’s G20 ambitions must be brought down to earth – large European countries like Germany have shunned additional discretionary packages and some smaller countries like Ireland are already moving towards a discretionary tightening.

In this situation, it is vital that monetary policy supports the economy, with quantitative easing now the only option. The Bank needs to follow this policy through boldly to maintain the underlying growth of the money supply. Interest rates should be kept at or near their present level until the ‘green shoots’ begin to appear. The latest inflation figures suggest that the fall in the pound over the last eighteen months should keep the deflationary dogs from the door, but that threat remains as long as the economy remains mired in recession.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Neutral in short term, but to tighten before the year end

When viewed from a short-term fire-fighting perspective, UK monetary policy is now arguably – if belatedly – operating on the right lines. The Bank of England have given up any pretence that the peashooter of marginal changes in Bank Rate is an effective weapon against the massed Panzers of the global financial meltdown and have instead chosen to employ the tactical nuclear weapon of quantitative easing. However, employing the nuclear option involves a serious risk of unintended collateral damage to one’s own side, even if it does achieve the immediate tactical objective of stabilising the economy in the very short run. Independent commentators also face the dilemma that there is an observational equivalence between two competing explanations of the current fiscal and monetary stance in the UK.

The first, political-economy, explanation is that a desperate government is doing all that it can to hold the economic show on the road until a putative May 2010 general election. The huge fiscal deficits that have resulted have been justified using crude Keynesian arguments but this is seen as just window dressing. Instead, the government is considered to be using large deficits to buy as many votes as possible in the short-term while leaving a fiscal train smash for the next government to inherit and future generations of taxpayers to finance. This political-economy analysis would then imply that the UK monetary authorities have become complicit in this endeavour by recklessly pumping money into the economy to stimulate demand over the next year or so, while ignoring the longer-term inflation risks. The fall of almost 19% in the sterling index over the past year suggests that some overseas investors are now taking this view. One danger associated with quantitative easing is that overseas holders of gilt-edged securities take advantage of the artificially high price of gilts to sell their sterling bonds at a profit before whipping their money out of the country. Under these circumstances, quantitative easing could unintentionally end up financing a run on the pound.

The second, more conventional, explanation is that the world economy is genuinely facing an adverse economic situation as bad as the early 1930s, and that extreme fiscal and monetary measures are required – and have been boldly implemented – to restore the situation. There is clearly some support for this view, and there are certainly similarities between the current UK monetary stance and the Bank of England’s very successful monetary decisions in the early 1930s, which meant that the contraction in UK national output was noticeably less than in other major countries, and was followed by a strong rebound from 1933 onwards. However, fiscal policy was much tighter in the inter-war period, and the state was spending a smaller proportion of national output, optimising the conditions for monetary policy to be effective. This is unlike the current situation where the UK is likely to experience the longest and largest run of budget deficits in its post-war history and general-government expenditure is likely to approach 55% of the factor-cost measure of national output, compared with the 28½% or so recorded when Keynes wrote his General Theory. The UK private sector will almost certainly suffer severe financial ‘crowding out’ from the government deficit. In addition, high rates of tax - and the prospect of further rises therein - are likely to reduce both the level and the growth of aggregate supply. Aggressively pumping nominal demand into an increasingly supply-constrained economy is a recipe for stagflation not recovery.

One would feel happier about the current UK monetary stance if it was easier for independent observers to monitor what was going on. Unfortunately, the Bank of England decided, at what seems to have been the worst possible moment, to suspend publication of the long-established table setting out the links between the budget deficit, funding policy, and M4 broad money growth (see: Bank of England Bankstats Table A3.2). At the same time, the Bank is emphasising an unpublished broad money series for M4 less the deposits of other financial corporations, which is not properly in the public domain. The published M4 broad money definition was 18.7% up on the year in February. However, its retail M2 component rose by a more modest 4.3%, while wholesale deposits went up by 44.3% over the same period. Stripping OFC deposits out of total M4 would appear to reduce its annual growth rate to 2.8%, on the assumption that the levels series are consistently measured over this period. In principle, it is not difficult to check whether OFC deposits should be included in the M4 broad money supply by estimating a demand for money equation for total M4 that includes the usual variables - such as income, the rate of interest paid on deposits, the bond yield and inflation – but also includes the stock of OFC deposits. If the coefficient on OFC deposits turned out to be unity, this would justify their total exclusion, while a coefficient between zero and unity would justify their partial exclusion, and one of zero would suggest that they should be included. There was a large literature dealing with the statistical analysis of such definitional questions in the 1960s and 1970s. It is surprising that the Bank of England has not published such a study – or the data required for others to do it – given that the main justification for adopting such a potentially dangerous policy as quantitative easing at a time of unprecedented budget deficits is to stop the M4 less OFC deposit definition from collapsing.

As far as the setting of Bank rate on 9th April is concerned, this has become a near trivial issue and is likely to remain so for the next few months. Practically, Bank Rate cannot go any lower; there are some modest early signs of recovery but the private sector remains very weak; and the monetary action in the short-term clearly lies with quantitative easing – or open-market operations as they were traditionally known. However, it is clearly unsatisfactory to have the Debt Management Office and the Bank both operating in the gilt-edged market but with different objectives. Serious thought should now be given to returning the responsibility for the sterling bond market to the Bank of England. This was a responsibility that the Bank had discharged from 1694 until the disastrous tri-partite dismemberment of the ’Old Lady of Threadneedle Street’ by ‘Gordon the Ripper’ in 1997. The extent to which the UK and international contractions appear to have been driven by de-stocking, which is an inherently finite process, suggests that the upturn could prove to be embarrassingly rapid once the economy does start to recover. A clearly spelled out exit strategy from the present quantitative easing should be published around the time of the 22nd April Budget, and monetary policy should probably start being tightened in the autumn of this year. If this does not happen, political-economy considerations will probably have triumphed over sound monetary management.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: To increase Bank Rate to 2% before the end of the year

The formal adoption of quantitative easing by the UK authorities on 5th March has transformed the outlook for the nominal economy. While there is still a great deal of concern over a deflationary outlook, the successful implementation of the Asset Purchase Programme (APP) should quickly lay such fears to rest. The major positive for the economy should be the normalisation of the flow of credit to the corporate sector for inventory management purposes. The restoration of production schedules to subdued, rather than desperate, levels should lessen the need for drastic employment reductions and should contribute to a near-term bounce in industrial activity. The major negative will be the early return of inflationary pressures emerging from the rebuilding of the supply chain and in the context of the sizeable depreciation of sterling in the past year.

The advantage of a gilt purchase programme is the speed with which it can be implemented. Spencer Dale, the Bank’s chief economist, announced in a speech on 27th March that the Bank has already purchased £13bn of gilts from investors. Since the MPC’s announcement, gilt yields have fallen by around 50 basis points at the horizons which the bank is making purchases. However, the impact of the UK’s first undersubscribed gilt auction since 1995 has damaged the perception that quantitative easing will have a lasting beneficial impact on gilt yields.

National accounts data released on 27th March confirmed that Gross Domestic Product at market prices fell by 1.5% in the second half of 2008 and Gross National Income dropped by 3.2% in the same period. Having taken the difficult decision to abandon caution and throw full weight behind an anti-deflation strategy, it will be important to keep the momentum going over the next six months or so. This will almost certainly involve the doubling-up of the APP to £150bn and possibly a larger target. An important argument for ‘shock-and-awe’ tactics is the unknown requirement of ‘Other’ Financial Corporations (OFCs) for replacement funding.

OFCs have an urgent need to replace international and foreign currency funding sources with domestic sterling sources and will require increasing access to loans from UK monetary financial institutions (MFIs). The forced repatriation of OFCs international funding has absorbed the lion’s share of MFIs lending capacity since the crisis erupted in August 2007. The Bank of England’s APP should be expanded, extended and refocused to recognise this reality. Otherwise, there is a danger that the banks will use up their additional lending capacity with OFC loans rather than supporting real economic activity by lending to private non-financial corporations and unincorporated businesses.

The primary mechanism for revitalising aggregate nominal spending in the economy is the provision of a significant quantitative boost to the broad money supply (M4). Bank of England hopes that small scale interventions will improve market functioning via a ‘demonstration effect’ are likely to be disappointed. One of the side effects of cutting Bank Rate from 5% to ½% has been to decimate the effect of interest accumulations on bank deposits. The quantitative expansion of the money supply will need to compensate for the loss of interest credited as a source of new bank deposits.

National accounts data reveal a £4.2bn decline in inventories for the fourth quarter of last year. Manufacturing industries were responsible for destocking of £1.5bn in 2008 Q4 following £0.6bn in Q3. The retail sector shed £1.15bn in 2008 Q4 and other industries, £2.18bn. The sharpness of these declines indicates that production and distribution activity has been pitched well below the level of current sales. The prospect of a relatively short and severe episode of inventory liquidation raises hopes of a partial improvement in economic activity during the second half of 2009, but also an early rebound in inflation.

Inflation figures for February delivered a wake-up call to those of a deflationary persuasion. Headline CPI inflation – the basis of the formal inflation target – was expected by the forecasting consensus to moderate from 3% in January to 2.6% in February, but it rose instead to 3.2%, forcing another ‘Dear Alistair’ letter from the governor of the Bank of England. The tabloids were primed with their deflation banner headlines as the RPI inflation rate was tipped to fall from 0.1% to -0.7% under the weight of falling mortgage interest payments. It fell, but only to a zero rate. To add to the ‘Shock, horror’, annual inflation rates rose in almost every category of spending on goods and services provided in the context of domestic competitive markets. Household food inflation rose from 9.9% to 11.3%; household goods from 4.2% to 5.0%; household services from 1.5% to 2.1%; personal goods and services from 2.5% to 3.2%; catering from 3.6% to 3.9%. Deflation in clothing and footwear lessened from 7.1% to 6.4% and in motoring expenditures (ex-petrol and oil), from 6.1% to 5.4%. There may well be some softer inflation data over the next six months, but under the cover of a favourable base for the annual comparison, underlying inflationary pressures are building.

If the Bank of England’s MPC is taking the inflation target seriously, then the reign of ½% Bank Rate should be extremely brief. Within three months, it should be clear that the deflationary emergency is over and that a restoration of Bank Rate to around 2% should be accomplished before the end of the year. My vote is to hold interest rates at their present level, but to plot a course for an increase back to 2% by December.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Neutral, until economy shows signs of sustained recovery, then tighten

The UK economy is continuing to weaken sharply, and the global backdrop is deteriorating equally rapidly. The trough of the global and UK economic downturns is still some way off. Meanwhile, the financial market crisis continues to rumble on, with the latest efforts to stabilise credit markets not yet showing consistently positive outcomes and financial markets still exhibiting extreme volatility. Efforts to take the bad debts – or ‘toxic assets’ - off financial firms’ balance sheets have become more robust recently, though they have not yet resulted in any near term resolution of the crisis. However, this crisis is one that does not have a single magical solution – otherwise it would have implemented already. The crisis was also a long time in the making and the solution will take time. It does rather look as if the solution will involve a range of initiatives pulling in the same direction.

With this economic background, quantitative easing is an option the authorities had little choice but to embark upon. The amounts being spent are certainly sizeable enough to give them a chance of success, that is, to boost M4 money supply growth so as to provide enough liquidity in the economy to mitigate corporate and household bankruptcy and to help improve liquidity for those that have the appetite to borrow and to lend. It has already brought gilt yields lower, but household savings rates are rising, up to 4.8% in 2008 Q4 from 1.7% in the quarter before. Companies have also put more aside, with the net financial balance rising to £8bn in 2008 Q4 from £5.9bn in Q3, as they cut costs via lower inventories, output and employment and slower growth in pay.

The £100bn to be spent on purchasing gilts is some one-third of the stock of conventional gilts. The £150bn total of quantitative easing, of which £50bn is earmarked to purchase commercial bills, is 9.6% of last year’s gross domestic product in the UK, which was £1.44 trillion. It also accounts for 7.5% of total M4 outstanding at end-January 2009, which was just under £2 trillion. Will this amount of monetary injection be enough? Time will tell.

The Bank of England is now in new territory, with a zero interest rate policy and quantitative easing in place as its reaction to the financial and economic crisis that is in full swing. It may have to spend more on quantitative easing than it has so far, although it is still too early to say if it will have to. But the Bank has said, quite rightly, that it is ready to spend more. However, the proviso for all this is that it will have to reverse the interest rate cuts and quantitative easing once a sustainable economic recovery is underway, in a manner that does not undermine recovery but squashes future inflation. On current trends, however, this point does not look like it will be next year, with no return to 2% plus trend rates of growth until second half 2011 at the earliest. In the near term, monetary policy will remain very loose.

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.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Roger Bootle (Deloitte and Capital Economics Ltd), Tim Congdon (Founder, Lombard Street Research), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Peter Spencer (University of York), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

In its latest e-mail poll (in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) narrowly voted to leave Bank Rate unaltered at its present 1% on Thursday 5th March. In particular, five members of the Institute of Economic Affairs’ shadow committee voted to hold Bank Rate, while four members advocated a reduction of ½%.

Before last autumn, such a close vote on the part of the SMPC might have been considered a ‘cliffhanger’. However, times have changed and none of the shadow committee’s members thought that further reductions in Bank Rate were likely to have a powerful stimulatory effect on the wider economy.

Instead, the SMPC membership generally believed that the real monetary action lay with the implementation of the quantitative easing measures announced in the February Bank of England Inflation Report and the attempt to re-structure the commercial banking system so that normal lending practices could be restored.

The IEA’s shadow committee has advocated the adoption of quantitative easing for some time, and may have been ahead of the authorities in this respect. However, the SMPC has consistently stressed that any unconventional measures to increase monetary growth needed to be rapidly unwound, once they had done their work, to avoid a longer-term inflation problem. Concern was also expressed that the prospect of the largest and longest run of budget deficits in Britain’s peacetime history meant that the UK economy had now sailed off the fiscal charts as well as the monetary ones.

Comment by Tim Congdon
(Founder Lombard Street Research)
Vote: Hold
Bias: Neutral

Mortgage approvals in December were only £8.7bn, compared with £25.8bn a year earlier. Given that the figure for mortgage approvals is gross, the implication is that the stock of mortgage debt – which was virtually static in the second half of 2008 – could fall slightly in early 2009. Meanwhile many company announcements indicate a wish to deleverage balance sheets. A reasonable view is that, even with base rates of only 1%, the stock of bank lending to the private sector will at best be constant in early 2009.

A positive rate of real money growth is needed to help a recovery in domestic demand. A range of operations is available to sustain money growth if bank credit to the private sector is flat. The Bank of England has indicated that it is preparing asset purchases to boost the quantity of money. These would have the desired monetary effects, as long as the purchases are from non-banks and on a large enough scale. My view is that they can and should be calibrated to deliver a 5% to 10% jump in broad money in a three- to six-month period. For reasons set out in my Council for the Study of Financial Innovation (CSFI) pamphlet, How to Stop the Recession, due to come out in the next week or two, I favour government borrowing from the banks to finance the PSBR (i.e., ‘under-funding’, as it is usually known) or to buy assets, and am less enthusiastic about central bank asset purchases. (My reasons are largely non-economic.) Nevertheless, I accept that central bank purchases of assets from non-banks are very stimulatory. I am indifferent between a base rate of zero and 1 per cent, and am open to persuasion that one or the other is better.

Finally, I am horrified by officialdom’s emphasis – which is echoed in the media – on an increase in bank lending to the private sector as a precondition of recovery. The lending-determines-spending doctrine is false and dangerous, and is largely to blame for the current mess. The state sector (i.e., the government and central bank combined) can increase the non-bank private sector’s money holdings very simply by making larger payments to the non-bank private sector than the non-bank private sector is making to it. The payments can be either to finance the budget deficit and maturing debt or to buy assets. If it is the government that is making the payments, they should come from money balances created by borrowing from the central bank or (more responsibly and with more sustainability) from the commercial banks. The various operations may seem complicated, but it is in fact technically a cinch for the government and central bank to expand the quantity of money on a massive scale. If the quantity of money were to rise sharply in a short period, the recession would end quickly. No increase in bank lending to the private sector whatsoever is necessary.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Cut by ½%
Bias: To hold

After a period of credit addiction there comes a period of credit revulsion. Private sector demand for credit is falling, and it is pointless for the authorities to mandate specified levels of lending for individual institutions. However, maintaining the overall growth of money and credit at about 5% to 7% is a very different matter, and vitally important.

Having borrowed too much in relation to their income, assets, or capital, UK households and financial institutions are now seeing the value of the assets they bought with the borrowed funds declining. The decline in asset prices together with (largely fixed) excess borrowings means that some face negative equity or technical insolvency (liabilities exceeding assets). As long as asset prices are declining, or as long as balance sheets are not fully repaired by paying down debt (or raising new capital in the case of institutions), individuals or institutions in this situation will want to reduce their debt, rather than add to it, and they will want to restrain their spending not increase it. In this ‘debt minimisation’ frame of mind, over-indebted households and financial firms will not be enticed to borrow more, no matter how far interest rates are lowered.

There are therefore distinct limits on what the Bank of England should expect from Quantitative Easing. Since purchases of government debt by the Bank – even at progressively lower yields - offer no assurance that households or firms will be induced to borrow no matter how low rates fall (due to their focus on balance sheet repair) the authorities should concentrate on other methods of compensating for weak private sector credit demand. While there is no doubt that Quantitative Easing can expand the monetary base, there is no certainty that it will expand or accelerate the broader money supply, especially in the absence of a demand for credit by the private sector. (This is exactly why QE failed in Japan between March 2001 and March 2006.)

The main focus of monetary policy should therefore be to ensure that overall money and credit continue to grow at about 5% to 7% each year - either by having the government borrow directly from the commercial banks, or by inducing the banks to buy gilt-edged securities. Either strategy would replace private sector borrowing with public sector borrowing on the books of the banks, and thereby ensure that bank balance sheets and hence monetary growth continue at rates that are consistent with the avoidance of too low a rate of money growth and thus deflation. In the meantime lowering rates by a further ½% will widen banks’ margins (the spread between their borrowing and lending rates), and thereby accelerate the repair of bank balance sheets, but this is about as far as the authorities should go with interest rate cuts.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold
Bias: To hold

At the February Inflation Report press conference Mervyn King sounded like an old-fashioned monetarist. He said “the problem we face at the moment is that the supply of money is not rising quickly enough. For many decades we had the opposite problem. The problem now is that the supply of money is growing too slowly.” And when allowance is made for the distortions to M4 by the activities of intermediate ‘Other Financial Corporations’ (OFCs), such as mortgage and housing credit corporations, non-bank credit grantors, bank holding companies, and other activities auxiliary to financial intermediation, it is clear that this is the case.

The quarterly M4 growth rate in 2008 Q4 for private non-financial corporations and households was a mere 0.3% (quarter on quarter, just over 1% annualized) compared with 2% to 2½% (8% to 10% annualised) in mid-2006. This is an inadequate level of growth to sustain any recovery in economic activity and is, in itself, a strong reason for quantitative easing.

The minutes of the MPC’s February meeting show the committee agreed to push ahead with quantitative easing whereby the Bank “purchases government debt and other securities, financed by the creation of central bank money”, providing the Chancellor agrees, as an instrument of monetary policy. This is the right move. And the MPC should agree to start implementing the policy at the March meeting. There is little point in cutting interest rates further. Indeed it could prove to be counterproductive as, insofar as the lenders cut the rates on their savings products, it could reduce their deposits thus weakening their ability to lend. The Bank Rate should not be cut any further.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ½%
Bias: Neutral

In the UK the growth of loans by banks to non-banks has plunged to around 4%. To a large extent this is due to the cessation of loans from banks such as Northern Rock that have exited from the market. It is taking time to get the remaining banks to step into this breach. In the US loan growth stalled after Lehman. In the euro-zone credit growth (for which M3 is a proxy) has fallen sharply; actually it is the least badly affected region of the developed world but even so it is bad. The euro-zone’s worst problem is the collapse of its export markets with the implosion of world trade in recent months - but the credit slowdown is not helping.

Our Cardiff forecasts have been revised downwards in the light of the latest Q4 data. Nevertheless we are forecasting a levelling out of GDP in later 2009 followed by some recovery in 2010. The background to this lies in the extreme actions being taken by governments around the world. They came too late to avert the nosedive in the world economy that followed the Lehman collapse, coming on top of the credit crunch conditions already in place since August 2007. But these actions are now beginning to stabilise the market in intermediation - various spreads have come down.

How much more action is needed? The quantitative easing undertaken by the US Federal Reserve can be clearly seen in the M0 figures for the US; US M0 is now some 100% up on a year ago. So far both the Bank of England and the European Central Bank (ECB) have refused to take these measures. The Bank of England has received permission to expand its balance sheet to do this and is thinking about it. The ECB has so far made discouraging noises about it; but it too must be thinking hard. In my view these actions cannot come too early. While we are forecasting some levelling off in GDP later in the year, the risks on the downside are still considerable - these could trigger deflation which would really upset recovery prospects for some years. Risks also are there on the upside - but at this stage, as noted before, that is a problem we would love to have.

Arrangements to insure bad bank assets are being negotiated- a ‘bad bank’- both here and in the US. It is hard to see how this could be avoided, since banks facing the threat of melting balance sheets will only be willing to conserve cash. Governments have been on a learning curve in this crisis and not surprisingly have made a lot of mistakes. But they are now realizing the priority of stimulating lending and ignoring the risks to their own balance sheets - past experience shows that after some years the assets they take over bloom again (think of the US Resolution Trust Corporation of 1989 that got back every cent of the 5% of GDP it put up). This is because today we are facing a macroeconomic collapse that has driven a wedge between social and private risk; such collapses occur rarely so that we can usually make use of equilibrium macroeconomic analysis in which social and private risk coincide. But today we have a collapse of the basic credit mechanism. Socially, we know that the economy will eventually recover and that investments will pay off; privately everyone is afraid of these. This is what justifies the extreme measures being pursued.

In the current circumstances I would cut base rate by a further ½%. But the most pressing need is for the Bank to purchase risky private assets, such as mortgages and corporate debt, in the effort to ‘reach the parts’ that interest rate cuts cannot reach. This direct injection of money into the financial markets will help the other efforts in hand to get credit flowing again at a price reflecting social and not private risk.

Comment by Peter Spencer
(University of York)
Vote: Cut by ½%
Bias: To reduce to close to zero

The MPC voted unanimously at its February meeting to write to the Chancellor to seek his consent to implement Quantitative Easing (QE). I believe that it is crucial that the Bank implement this policy swiftly and boldly given the dramatic fall in the underlying growth of the money supply. Credit starvation is the biggest problem facing the UK economy and increasing the supply of central bank money via purchases of government securities should help to loosen these restrictions and boost the supply of money and credit.
However, with sterling stabilising and market expectations of a cut building I see no reason not to cut interest rates back further towards zero. I think it is appropriate to reduce by another ½% in March. This will help to support spending for corporate and other borrowers with floating rate debt, particularly those with tracker mortgages. I accept that another rate cut would further squeeze banks’ profitability and might reduce their incentive to lend. However, bank profitability is a secondary consideration given the plight of the economy. Moreover, market rates still remain very high relative to Bank Rate.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Neutral

The operation of British monetary policy has undergone a revolution over the past eighteen months. Bank Rate has been effectively dethroned as the centrepiece of monetary policy and now has an almost purely ceremonial function. Instead, the effective power to influence economic behaviour rests with two newer policy initiatives. The first is the use of quantitative easing to try and directly shore up broad money and credit. The second is the policy measures taken to support and re-capitalise the banking system so that it can start lending again. This was made explicit in the February MPC minutes, released on 18th February, which stated that “the MPC’s ability to influence the value of nominal spending and inflation in the economy ultimately came from the Bank of England’s role as the monopoly supplier of sterling central bank money: banknotes and reserves held by the banking system at the Bank”. This statement marks a decisive shift from trying to control the price of central bank money to an attempt to control its quantity. However, the experience of the US in the 1930s and Japan since the early 1990s indicate that boosting the monetary base may be a necessary condition for stimulating the economy, but it is not a sufficient one. It is only if the commercial banks respond by creating more broad money and credit that the real economy will be stimulated.

However, the interpretation of the broad money stock is not easy at the best of times and is particularly difficult at present for two reasons. The first is that there is now a huge and apparently growing discrepancy between the growth of published M4 broad money – which went up by 16.1% in the year to December 2008 – and M4 excluding the bank deposits of intermediate OFCs, such as: mortgage and housing credit corporations; non-bank credit grantors; bank holding companies; and other activities auxiliary to financial intermediation, where the year-on-year growth rate seems to be stabilising at around 4%.

Unfortunately, it does not increase one’s confidence in the quality of the latter data to read footnotes such as “Bank staff have also adjusted these measures for some additional intra-group business, based on anecdotal information provided by a small sample of banks”. There is a serious risk that people attempting to monitor broad money are being asked to buy a statistical ‘pig in a poke’ where the modified M4 series is concerned. The Bank’s statisticians should speedily publish a long break-adjusted time series for their preferred M4 less OFC deposits so that independent observers can apply statistical tests to check that the officially preferred definition is a better measure than published M4 and that it correlates with the wider economy. (For more on the definitional issue, see Burgess and Janssen, ‘Proposals to Modify the Measurement of Broad Money in the United Kingdom: a User Consultation’, Bank of England Quarterly Bulletin, Vol. 47, No. 3, pages 402–14.)

The other issue is what is happening to the demand for broad money – however defined - now that the nominal and real returns from holding deposits with the banking system have fallen sharply. The bulk of M4 pays interest, much of it at money market rates, and the demand for broad money falls when the real interest returns from holding it become less attractive. It is possible to have rapid monetary growth accompanied by the symptoms of a severe monetary squeeze if the real return from holding money on deposit is rising – this happened in the early 1980s, for example – but it is also possible for slow monetary growth to appear in conjunction with strong demand conditions if the demand for money is falling and the pre-existing stock of money is high relative to private sector output. This is the more likely situation at present. The authorities need to be aware that slow monetary growth could reflect demand as well as supply factors, and need not be inconsistent with economic recovery in the longer term.

The strong likelihood that the next half decade will see the largest and longest run of Budget deficits in Britain’s peace time history accompanied by a huge increase in the ratio of public debt to national output means that the UK economy has now sailed off the fiscal charts, as well as the monetary policy ones. It is correspondingly hard to know what the ultimate result of the current massive monetary stimulus and fiscal interventions will be. There is a clear risk that the worst stagflation since the 1970s will be the ultimate outcome.

However, there is a huge margin of spare capacity in the international and British economies. This could hold down inflationary pressures for several years and produce a mini golden age of rapid growth accompanied by low inflation, as happened in Britain from 1934 onwards, for example. Which outcome eventually predominates will largely depend on what current policies do to aggregate supply. A heavy handed regulatory approach and interventionist fiscal policies will cutback productive potential, leaving the economy with less spare capacity and result in the stagflation outcome. Bold policies of market liberalisation and public spending discipline, on the other hand, would crowd in private activity and make the hopeful scenario more likely.

The conclusion is that there was little to be gained from further changes in Bank Rate and that the real monetary action now lies elsewhere, with quantitative easing and the attempt to re-capitalise the banking system. There are also signs that UK inflation is continuing to surprise the financial markets on the upside. This may be because the weakness of sterling is having more powerful knock-on effects than the consensus view is allowing for. The time lags involved also make it all too easy for the authorities to end up over-steering. The main priority now is to make sure that there is an effective exit plan for when the quantitative easing measures now being introduced have to be rapidly reversed, in a year or eighteen months’ time. The authorities – or the Conservative opposition – also need to be paying serious attention to the fiscal stabilisation package that will have to be implemented in the foreseeable future, if the government’s debt servicing costs are to be kept under control in the medium term.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: Neutral

Another dramatic month has passed, containing the return of headline consumer price inflation to 3%, a steadying of sterling at very weak levels and the release of data which confirm that UK economic activity suffered a disastrous fourth quarter. Policy responses have come thick and fast in the past five weeks: another cut in Bank Rate, the imminent arrival of quantitative easing (e.g. Bank of England direct purchases of gilts) and the Asset Protection Scheme that was announced on 19 January.

Contrary to common perception, once the severity and complexity of the crisis dawned on the UK authorities last September, they have not been idle and their interventions have not been timid. There remain some agonising delays in implementation and a few wrong turns, but their engagement with the core issues – the customer funding gap (CFG), the denial of credit to the supply chain and the corporate liquidity crisis – is beyond question. The principal explanation of the procrastination of the Treasury and Bank of England is their deep-seated reluctance to travel down this road. This is not so much the ‘road less travelled’ as the ‘road sealed off for safety reasons’. Now that we have embarked upon it, the only question of importance is: ‘where does it lead?’

The UK financial authorities have followed their US counterparts in providing huge financing facilities and credit guarantees to the banks, building societies and the opaque ‘other financial corporations’ (OFCs). As a result, both governments have embarked on a funding odyssey which will lead them to innovate furiously to ensure that their obligations are held without blowing funding costs out of the water. They will monetise a large proportion of this replacement funding, sending rates of broad, as well as narrow, money growth spiralling higher.

There is a popular diagram of the financial system that looks like an inverted pyramid, with base or high-powered money at its pointed foundation. This is a deeply flawed illustration for our times: broad money growth does not depend upon narrow money growth in any meaningful sense. Under the present regulatory regimes, banks have almost complete control over the expansion or contraction of their own balance sheets. In the UK, government will use its hugely enhanced influence over the banks to head off a prudential contraction of their assets and liabilities.

A Late Surge in Capital Issuance

One of the most frustrating aspects of the UK government response to the credit and monetary crisis has been its desire to keep the use of its various facilities a secret. The Special Liquidity Scheme, introduced in April 2008 had a six-month news blackout attached. The Credit Guarantee Scheme introduced at the same time, is similarly veiled. As an aside, I must correct the impression that the CGS had been used only to the extent of £20.5bn by mid-December; this figure related only to publicly issued debt instruments. The total figure is rumoured to be around £100bn, although the Debt Management Office would not confirm this estimate.

While the confidentiality of the issuer and of individual amounts is perfectly reasonable, secrecy regarding the aggregate usage of schemes and facilities is unjustified and detrimental to the market understanding of the scale and effectiveness of policy interventions. The Asset Purchase Facility (APF) announced recently has a more promising genesis. Mervyn King’s response to the Chancellor’s letter last week confirmed that a new company is being established to undertake the APF transactions. “This will provide a clear, transparent mechanism for monitoring the operations conducted under the facility.” “The Bank will publish a quarterly report on the transactions undertaken as part of the facility, shortly after the end of the quarter.”

However, there is a back door route to the appreciation of the extent to which the schemes and facilities are being used, in the form of capital issuance data released monthly by the Bank of England. Net capital issuance by UK residents in all currencies tripled from £143.8bn in 2007 to £432.3bn in 2008, with almost all issuance occurring since April. Net capital issuance by the banks jumped from £86.6bn to £190.2bn. Issuance by OFCs rocketed from £52.8bn to £221.1bn in 2008. Making up the remainder, building societies’ net issuance rose from £5.2bn to £16.4bn while the private non-financial corporate sector issued £7.7bn in the first half of 2007, redeemed a net £8.4bn in the second half of that year and issued a net £7.7bn in 2008. This latter is almost completely accounted for by the power and water utilities sector. The key message of this data is that a revolution in scheme usage is underway.

To reiterate, Bank Rate changes are largely an irrelevance to the current debate. If the idea is to induce banks to lend to the private sector rather than to each other, then it is the LIBOR premium that needs to be addressed, not the Bank Rate. There are dramatic developments in the realm of capital issuance, government asset purchase and monetary growth which are likely to prove far more significant than the level of Bank Rate. These measures have the capacity to transform the financial landscape within the next six months. Hence my vote is to leave Bank Rate at 1%.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold
Bias: Neutral

Last month, I voted to hold Bank Rate at 1½% but I do not think it now appropriate to raise them back to that level. Clearly, monetary policy is mutating – though too slowly - to something rather different from the past with its exclusive emphasis on interest rates. But I think that this is mistaken. Instead of going down the route currently proposed - in which the Bank of England expands the money supply at the behest of the Treasury - the Government should buy up the remaining shares of Royal Bank of Scotland Group and the newly merged Lloyds-HBOS, then set aside their toxic debt and run these banks as conventional banks lending to the private sector. This should avoid the need for such a large expansion of the money supply as at present I envisage. The current bail-out arrangements are far too expensive for the tax payer and too ineffective.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Cut by ½%
Bias: Cut to zero

My vote is to cut Bank Rate to ½% from its present 1%. Crucially, the MPC should at the same time also announce a range for Bank Rate of zero to ½%. This would be a similar approach to that taken by the US Federal Reserve. It would also avoid the mistake made by Japan in cutting rates to zero, which prevents the proper operation of money markets and must be avoided. The Bank of England should also announce a timetable for moving to quantitative easing, and do so as quickly as possible. The economic situation is deteriorating rapidly and could get worse as the second-round effects of the cut in output by companies, and the resultant rise in unemployment, has not yet hit consumption. In other words, policy rates must be cut as low as then can be without damaging the money markets. This will hit savers - and marginally damage bank profits - but the point is to encourage spending and lower debt servicing costs.

The monetary side of all of this is that the dislocation in financial markets is persisting and, realistically, will take much longer to resolve than thought hitherto. This is because the plethora of policies announced so far are simply not working but still had to be tried. Money supply growth is at such low rates as to be consistent with a deeper downturn, around the world, than has been seen so far. There needs to be official effort to increase liquidity such that those firms and individuals with sufficiently strong balance sheets can access credit. This means boosting money creation through central bank purchase of private sector securities and of government bills. Thankfully, the MPC seems prepared to do all of these things. But it needs to do as quickly as possible to minimise the economic downturn this year and to prevent it from getting worse and continuing into 2010.

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.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Roger Bootle (Deloitte and Capital Economics Ltd), Tim Congdon (Founder, Lombard Street Research), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Spencer (University of York), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

A guest piece in my Sunday Times slot by Ben Broadbent and Kevin Daly of Goldman Sachs.

This month the Pontin’s holiday company announced that, in response to a 20% increase in summer bookings, it is embarking on a £50m expansion of its British facilities. Meanwhile, Butlins - Pontin’s biggest rival - is opening a 200-room “boutique hotel” at its Bognor Regis complex as it expands into the middle market.

Many people saw this as a sign of hard times - families that would normally have travelled abroad are looking to save money on their holidays. There may be some truth in this. However, this is not just a story about people trading down in response to the recession - many high-end holiday cottages in Cornwall are also reported to be fully booked for the summer. The evidence remains largely anecdotal for now, but it appears that British tourism may be heading for a strong summer.

We think this is the start of a wider trend, driven by the weakness of sterling, whose benefits are likely to be witnessed first in sectors such as tourism but which will ultimately boost the whole of the British economy.

It is hard to overstate how big the collapse in sterling has been. On a trade-weighted basis, the exchange rate is down more than a quarter from the peak in mid-2007, at the start of the credit crisis - more than twice as big as the drop after sterling’s forced exit from the European exchange-rate mechanism in 1992, and close to the biggest-ever depreciation in 1931, when Britain abandoned the gold standard.

Why has this happened? It is tempting to attribute the fall to the perilous state of Britain’s economy - after all, our housing boom was one of the biggest in Europe and our spending imbalance one of the worst. The International Monetary Fund (IMF), for one, is forecasting that Britain will suffer the deepest recession of any big industrialised economy.

Appealing as this explanation may be, however, it is not consistent with the latest evidence of the economies’ relative strengths. UK businesses are pessimistic but, compared with their counterparts in the eurozone or America, they are somewhat less gloomy. Official statistics tell a similar story - eurozone GDP fell 1.5% in the fourth quarter of last year, the same as in Britain. Indeed, the global downturn has been remarkable not just for its severity but for its synchronicity.

We think a more plausible explanation for sterling’s weakness is the relationship between Britain’s net overseas investment and variations in global financial markets. Britain’s overseas assets are skewed towards equities (and other equity-style investments) while overseas investors are net holders of UK debt. Therefore, when global equities perform badly relative to bonds - as they do when investors become more risk-averse - the value of Britain’s net overseas assets tends to decline. This, in turn, induces a corrective fall in the currency.

Whatever the cause, sterling’s fall is a big stimulus for the economy. One way of measuring its significance is to translate it into equivalent changes in interest rates. There used to be a rule of thumb that a 1% fall in the exchange rate has the same effect on output as a 0.25 percentage-point cut in interest rates. Our own estimates suggest the effect is somewhat smaller than this - about 0.17 points. But even on this basis, the 27% decline in sterling since the start of the credit crunch is equivalent to an additional cut in interest rates of between 4 and 5 percentage points.

The easing implied by the decline in sterling, together with the drop in interest rates, is phenomenal. The chart above shows monetary conditions indexes for Britain and the eurozone (these combine short and long-term interest rates, together with the trade-weighted exchange rate, into a single indicator, with weights that reflect the importance of each input in driving year-ahead growth). Since the start of the credit crunch, UK monetary conditions have eased by more than 6 percentage points on the back of sterling’s decline.

These effects take some time to come through. They are also being dominated, for the moment, by the huge hit to global trade wrought by the credit crunch. Everyone’s exports are shrinking.

However, as the expansions announced by Pontin’s and Butlins indicate, the boost from sterling’s weakness can just as effectively come from import substitution as higher exports. Moreover, global downturns, even this one, have ends. While it would be premature to look for a significant impact from sterling’s fall any time soon, history suggests that this effect will eventually come through.

In 1991 and 1992, despite a continental boom induced by the reunification of Germany, British exports barely grew. Between 1993 and 1997, following a depreciation that was less than half as big as this one, they rose by almost 10% a year. And in 1931, the last time we saw a fall in the exchange rate of this magnitude, sterling’s decline contributed to economic expansion in Britain at a time when much of the rest of the world was still suffering in the middle of the Great Depression.

Britain is well placed relative to the eurozone in this regard. Eurozone monetary conditions have tightened by about 1.5 percentage points since the start of the credit crunch owing, in part, to a stronger euro. Even in normal times, a tightening of this order would slow growth significantly over a year. To face such a tightening in the middle of the worst financial crisis since the war is precisely what the eurozone does not need. We disagree with the IMF’s view that Britain will fare worst among industrialised economies.

Sterling’s collapse is no panacea. The benefits of a weaker currency are unevenly distributed and it clearly makes life a lot tougher for those who buy imports, including those who like to take their holidays abroad. But, while there will inevitably be rainy days for those holidaying in Britain this summer, economic prospects should gradually brighten as the year progresses.

PS: What role, you might ask, has budgetary policy to play in supporting British growth? Much political heat has been expended over the government’s decision to ease fiscal policy this year through a temporary cut in Vat. The opposition criticised the move as “irresponsible”, the German government called it “crass Keynesianism”, while France’s Nicolas Sarkozy has said that the Vat cut has “clearly not worked”.

So the real problem is not that it involves Vat - retail spending rose strongly in December - but, thanks to a poor starting position for the public finances, the government can afford only a small easing in fiscal policy. Compared with the 6% boost implied by the sharp easing in UK monetary conditions, fiscal policy in the UK is likely to play a minor role in supporting growth.

From The Sunday Times, February 22 2009

Following its latest quarterly meeting (in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted to leave Bank Rate unaltered at 1½% on Thursday 5th February.

In particular, six members of the Institute of Economic Affairs’ shadow committee voted to hold Bank Rate in February, while three members advocated another reduction of ½%.

There was a widespread view on the SMPC that further reductions in Bank Rate would only have a limited further stimulatory effect on activity. Instead, a majority of the shadow committee’s members thought that direct action should be taken to ensure that a collapse in the broad money stock did not lead to a depression.

However, the SMPC also stressed that any unconventional measures to directly increase monetary growth needed to be rapidly unwound, once they had done their work, to avoid a longer-term inflation problem. There was concern that political considerations, and co-ordination problems between the Bank, HM Treasury, and the Debt Management Office, might make it difficult to achieve this unwinding in practice, however.

Chairman’s Comments
David B Smith began the meeting by paying tribute to the late Sir Alan Walters who had been a founder member of the SMPC in 1997 and a regular contributor until illness stopped him from attending. He also welcomed Professor Mike Wickens to the committee at his first meeting. He then asked Peter Warburton to provide his briefing on the international and domestic monetary situation.

The Monetary Situation

The International Situation – Plummeting Global Activity.

Peter Warburton stated that the charts (which are available from rosa@economicperspectives.co.uk) were self explanatory and said that he would go through them to give an update on the international situation. He said that the past six months has seen global activity plummeting, with Asia being disproportionately affected, and particularly economies with large external sectors.

The figures indicate a sharp downturn, with growth in China falling to 4% to 6% per annum. With the rest of Asia showing a sharp downturn in export orders, goods are being stacked up as involuntary inventories accumulate. In the USA, nominal consumer spending has fallen in the second and third quarters. Indicators of durables spending have seen a sharp drop and jobless figures have risen sharply. Similarly the Euro-zone, which has lagged the USA, has also experienced a sharp rise in joblessness along with a steep downturn in GDP. World broad money growth has fallen during 2008 led by US broad money growth, which accounts for 28% of the share.

Tim Congdon questioned Peter Warburton’s figures for US broad money growth. The Lombard Street Research figures showed a much steeper fall. There followed a discussion about the measures of broad money. David B Smith said that Peter Warburton’s figures were consistent with the estimates of broad money supply growth in the developed economies as a whole supplied by the Organisation for Economic Co-operation and Development (OECD). Peter Warburton then discussed the chart of US corporate bond spreads showing that these had widened sharply. The current spreads are similar to those prevailing in 1932.

The UK Economy – Slowing Nominal GDP Growth

Peter Warburton next stated that nominal GDP growth in Britain has fallen to its lowest rate since 1992. Transactional activity has declined sharply and consumer confidence has plunged in the autumn and winter. Growth in the aggregate measure of M4 does not show a problem but its decomposition shows that retail deposits are growing much more slowly.

The growth rates in sterling lending to Private Non-Financial Corporations (PNFCs) and Households have slowed but lending to Financial Corporations has been remarkably strong. There then followed a discussion about why sterling lending to Other Financial Corporations (OFCs) had shown such a sharp rise.

The issue was important because the annual growth of broad money and credit was falling sharply after OFCs were taken out of the figures. However, the effective exchange rate has fallen back to the levels last seen in the mid 1990s, following the pound’s eviction from the Exchange Rate Mechanism (ERM) in 1992. The decomposition of retail price inflation shows that, in competitive domestic markets, the inflation rate (ex-fuel and light) has eased back to 1.5%.

Summary of Presentation

Peter Warburton summarised his view of the outlook as follows: the economy is facing a depression rather than a recession scenario as global credit remains in crisis. While the focus of the SMPC is properly on monetary developments and remedies, it is imperative that monetary measures are accompanied by measures to restore the functioning of the credit system. Fiscal stimulus is largely a waste of time, as saving is merely transferred from the public to the private sector. A progressive monetisation of credit is underway in the financial sector, bringing a significant inflationary threat in future years. The economy is reacting to a negative shock to both supply and demand.

Discussion

Quantitative Easing to Avert Depression

The Chairman thanked Peter Warburton for his presentation and threw the meeting open to discussion. In response, Roger Bootle said that the movement of the exchange rate is significant as the trade-weighted index is now where it was immediately post the ERM crisis. This will make a huge difference to the UK economy. Eventually world markets, which were depended less than the UK on bank credit, would pull UK exports up. The real issue was how we are to tide ourselves over until the stimulus to exports arrived.

David B Smith said that he was cautious about the gains from the depreciation in sterling. His empirical work suggested that the competitiveness elasticities of exports and imports had been falling over the past two or three decades As a result, he thought that the Marshall-Lerner conditions for a devaluation to improve the balance of payments no longer held. One supply-side reason was that the UK was now a relatively highly socialised economy. He could not see the public sector freeing the labour and other resources that the tradables sector required at this point in the electoral cycle.

Mike Wickens said that he was reminded of the 1980-81 recession when most commentators believed that the rise in sterling was killing exports. Trevor Williams said that the difference was that exports markets are more weighted to Europe and that the lack of trade finance in the current situation has a stronger effect. Roger Bootle had to leave the meeting early and registered his vote there and then (see: Votes below). Andrew Lilico said that if the economy were to undergo the significant structural change implied by Roger's assessment that would almost certainly imply a recession during the transition phase.

David B Smith added that the structural change is partly caused by the government sector, which has absorbed labour resources that will not be released to the export sector. In 1964, for example, there were 3½m people working in general government and 8m in manufacturing. Today almost 5½m people worked for the government and just over 2¾m in manufacturing. Trevor Williams said that financial services will release labour resources. Financial services respond to the exchange rate but will grow at a lower rate in the future.

Andrew Lilico then referred to a Reinhart and Rogoff paper looking at the history of previous bank crises (The Aftermath of Financial Crises (http://www.economics.harvard.edu/faculty/rogoff/files/Aftermath.pdf). This shows that the average fall in real GDP per capita, from peak to trough, was 9.3%. Tim Congdon said that no post-war recession has behaved anything like that. Peter Warburton said that the crisis has affected aggregate supply and that this will have had lasting output effects. David B Smith said that the Pre-Budget Report assumptions of a 4% one-off reduction in potential output, followed by a trend rate of growth of 2¾% thereafter, used in the official calculation of future public borrowing were both highly uncertain. It was even conceivable that the minus 4% figure was too pessimistic in the long run but he had no firm views on the matter. He would direct a lot of intellectual resources to this crucial issue if he were in charge of HM Treasury.

Mike Wickens said that oil price inflation is falling out of the system and goods price inflation is falling to zero. He asked what was happening to inflation in the service sector. Andrew Lilico said that the presumption is deflation. David B Smith said that alongside the credit crisis a supply side contraction may also have occurred and that there may be less of an output gap that appeared superficially. Gordon Pepper said that the supply side was relevant. However, the severity of the immediate crisis warranted the measures for quantitative easing which are outlined in his note (See: Appendix to Minutes).

Gordon Pepper added that the subject of quantitative easing needed to be discussed by the committee. He said that the committee has to answer the simplistic press reports that equate quantitative easing with printing money.

Trevor Williams said that it appeared from responses that quantitative easing was not something that the Bank of England was particularly keen on early on. The problem may be that the Bank is dominated by economists rather than bankers and so was worried by ‘moral hazard’. That concern is now unlikely to hold them back given the worsening situation.

David B Smith said that the Bank had suspended the publication of the credit counterparts to the growth of broad money that used to appear as Table 3.2 in the official Bankstats after July 2008 because the nationalisation of Northern Rock and Bradford and Bingley created confusion as to where the border between the public and banking sectors was situated. He was somewhat reluctant to advocate deliberate underfunding – because of its potential inflationary consequences if misused for political reasons – in the absence of regular and reliable published statistics that allowed people to monitor what was going on. Gordon Pepper and Tim Congdon said that the reason given by the Bank’s statisticians was a numerically trivial issue and that the counterparts data should be restored.

Trevor Williams said that the London Inter-Bank Offered Rate (LIBOR) was down to 2.5% (Editorial Note: this subsequently eased to 2.15% on 23rd January) but the government continued to insist on a 12.5% return on their preference stock. No profit can be made from this by the banks. The Bank of England should also be accepting longer dated collateral. Andrew Lilico said that quantitative easing had to be complemented with a credible exit strategy so as not to leave open the build up of inflation expectations in the future. Gordon Pepper said that in nine months time the DMO could be reversing the underfunding and mopping up the excess liquidity so as not to create an inflationary problem.

Votes

The Chairman then asked each member to make a vote on the monetary policy response, apart from Roger Bootle who had voted earlier. On this occasion there was no need for votes in absentia, since nine SMPC members had been present at the meeting. The votes are listed alphabetically rather than in the order they were cast, since the latter simply reflected the arbitrary seating arrangements at the meeting. The Chairman traditionally votes last.

Comment by Roger Bootle
(Deloitte and Capital Economics Ltd.)
Vote: Cut by ½%
Bias: To cut further

The economy is in freefall. Meanwhile, inflation is plunging and will soon turn negative. Although the effectiveness of monetary policy is now reduced, it is vital that the Bank of England does whatever it can to support the economy. It should cut rates immediately by ½% and proceed as quickly as possible to bring rates to zero.

Comment by Tim Congdon
(Founder Lombard Street Research)
Vote: Cut by ½%
Bias: Wait and see

Tim Congdon said that he was of the same opinion as Trevor Williams (see below) with one difference. Where Trevor Williams is talking about the Bank buying private securities he would add the government buying long-dated debt from the non-bank sector.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: To hold

Andrew Lilico said he thought interest rate cuts had already gone further than was productive and supported the use of quantitative easing measures instead, but he contended that these are unlikely to deliver escape from deflation without leading to a considerable rise in inflation on the exit path unless there is a clear exit-path strategy. He contended that a simple re-assertion of an annual 2% inflation target would be far too tough for the exit path (so tough as to lack credibility). Instead, he proposed the use of an average inflation (‘price-level’ or ‘price path’) target (if the price-level path is for average inflation of 2%, this would imply that inflation well above 2% would be tolerated/desired on the exit path). He voted to hold Bank Rate at its present 1½%."

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral

Kent Matthews said that it is increasingly clear that cuts in interest rate are not feeding through to borrowing rates. He said that he agreed with the policy of quantitative easing either through underfunding or through the Bank of England purchasing private securities. But he also said that the policy of quantitative easing had to be accompanied with a non-discretionary policy announcement that would anchor inflation expectations. This would work best through the setting of a monetary target. The inflation target worked imperfectly because for a number of reasons actual inflation did not signal the degree of underlying inflation in the system. Since a monetary target is not an option, the reassertion of the inflation target is the best that can be done. He voted to hold with a neutral bias.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold but the government should purchase assets from the non-bank private sector
Bias: Hold

Gordon Pepper observed that last month every member voting bar one had recommended quantitative measures of one sort or another. He had prepared a note about the various types (reproduced in the Appendix to Minutes). The aim might be to boost banks’ capital, banks’ reserves or the money supply. All the evidence indicated that quantitative measures to boost bank capital and reserves were ineffective in a deep recession if monetary growth remained inadequate.

Adequate capital and reserves were a necessary but not a sufficient condition to stop a recession turning into a depression. Monetary growth must be adequate for policy to be a success. Government borrowing from banks was the most important way of ensuring that monetary growth was adequate. Government purchases of assets from the non-bank privates sector had the most immediate impact.

He then turned to the recent leaders in The Times that argued against the government printing money because it would be inflationary. He disagreed. In an atmosphere of financial crisis it was generally true that an economy could be flooded with bank reserves and money without inflation rising. This was because banks would not have the confidence to use reserves and neither companies nor households would have the confidence to spend the money.

As soon as confidence returns, the excess money in the economy should be quietly mopped up to prevent inflation from rising. A disadvantage of employing fiscal policy to fight a recession was the lag before it became effective. It took time for capital projects, for example, to be brought forward. The lesson of the 1960s and 1970s was that the lags were such that the boost to activity occurred after the economy had started to recover. Fiscal policy was destabilising rather than stabilising. He argued that quantitative monetary measures, in contrast, could be deployed very quickly to combat a recession and reversed much more quickly when the economy starts to recover given the political will and expertise to do so.

Quantitative measures could be used to stop inflation from rising after confidence returns. The sixty-four-thousand-dollar question was whether the UK authorities would have the knowledge, expertise and political will to do so. Having ignored quantitative measures when the recession was gathering momentum, would they ignore them when the danger of inflation was again rearing its ugly head?

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Neutral

David B Smith said that the long time lags before rate changes influence the real economy mean that the 3½ percentage points cut in Bank Rate announced since early November would not have its peak impact until the end of this year and the early part of 2010. With the negative output consequences of last year’s sharp rise in the price of oil also likely to be reversing around then, further Bank Rate cuts risked over-steering, especially now that all the world’s monetary authorities were pursuing similar expansionary policies.

He did not deny that a nasty recession was in train and expected UK GDP to contract in 2008 Q4 and 2009 Q1 and Q2 before stabilising in the second half of this year. However, it was now too late to do anything to avert this. He was not opposed to quantitative easing in principle and had spent the last decade arguing that the removal of the gilt-edged market from the Bank made it nearly impossible to run a subtle and effective monetary policy. However, the most pressing need was to stop the regulatory authorities and politicians from pursuing damaging and logically incoherent policies with respect to the banking system. Peter Warburton was right to argue that restoring health to the banking system was the priority.

He also thought that quantitative easing was not a panacea and potentially highly dangerous when viewed from a political economy perspective. Overall, he thought that: Bank Rate was low enough for the time being, but that the institutional barriers to future quantitative easing, such as the DMO’s remit should be removed. The Bank’s statisticians should also be ordered to start re-publishing the money supply formation table. He concluded by pointing out that the average UK growth rate between 1933 and 1937 was 4¼%. Major recessions do appear to be followed by periods of catch up growth and it was not sensible to extrapolate current negative trends indefinitely. (Editorial Note: an analysis of the Institutional Lessons from the Financial Crisis in Britain and two tables summarising the UK experience between 1928 and 1938 can be obtained from: xxxbeaconxxx@btinternet.com).

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold
Bias: Neutral

Mike Wickens said that, given the forecast decline in inflation over the next year, monetary policy should aim to stabilise the real economy. Cutting interest rates won’t matter to inflation but it would discourage further savings which are required to help finance lending needed to help the real economy. Monetary policy through quantitative easing should aim to close the gap between Bank Rate and the inter-bank rate in order to make interest rate policy effective once more.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: Neutral

Peter Warburton stressed the importance of restoring corporate and household liquidity over further reductions in Bank Rate. He noted the limited scope for lenders to pass on rate cuts and the risk that savers would desert the banks in favour of better-yielding National Savings products. He said that the DMO should reverse its policy of overfunding and strengthen measures to improve the functionality of the credit markets. He voted to hold.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Cut by ½%
Bias: Cut to zero

Trevor Williams said that rate cuts still help banks to recapitalise. The DMO should underfund and the Bank should buy private securities to help unlock credit markets. He voted to cut by ½% with a bias to cut to zero interest rate.

Policy response
1. On a vote of six to three the committee voted to hold Bank Rate at its current 1½%.
2. Three members voted to cut the base rate by ½% with a bias to further cuts.
3. The committee expressed a strong preference for a policy of quantitative easing (the meaning of quantitative easing is explained in the appendix)
4. Two members felt that a policy of quantitative easing had to be accompanied with the reassertion of the inflation target as a means of anchoring expectations in the medium term.

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

In its latest E-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted that UK Bank Rate should be held on 8th January. In particular, six members of the Institute of Economic Affair’s shadow committee voted to leave Bank Rate unaltered at 2%, two SMPC members favoured a cut to 1%, and one argued for a ½ percentage point reduction.

There was a general view that the benefits from further cuts in Bank Rate were subject to rapidly diminishing returns and that there was a need for additional monetary instruments. One suggestion was that the remit of the Debt Management Office (DMO) should be altered to allow the government to borrow directly from the banking sector, in order to boost bank liquidity and the broad money supply.

Several SMPC members criticised the government’s incoherent and damaging approach to the banking system. In particular, senior politicians’ populist demands for lower borrowing costs were logically incompatible with the need to re-capitalise the sector. The SMPC poll was closed on Tuesday 30th December.

Comment by Tim Congdon
(Founder, Lombard Street Research)
Vote: Hold
Bias: Neutral

The events of 2008 have shown that monetary policy-making consists of much more than the setting of interest rates by a committee of the great and the good. For many years British banks did not give a thought to cash and liquidity as constraints on their operations, while capital grew steadily out of profit retentions. But in 2008 liquidity and solvency have become major issues for British banks’ managements, and the level of the nominal short-term interest rate associated with moderate growth of credit and money (and so with wider macro- equilibrium) has collapsed.

Do interest rates need to go to zero to prevent deflation? In my view British banks are not undercapitalised, and 2009 will see some writing-back of losses taken on mortgage-backed securities as well as increased loan losses on mainstream UK banking business. The banks could well be over-capitalised by 2011 or 2012. The result, if interest rates are cut too much now, will be yet another silly cycle.

My strong preference now is for the UK authorities to ensure that the government borrows from the banks and increases the amount of money (i.e. bank deposits) that way. I believe that, handled properly, debt management operations of this kind could add 5% to deposits in the first quarter of 2009, ending the liquidity squeeze and the worst of the recession.

My position on interest rates is “no change”, with a future bias towards “no change”.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Cut by ½%
Bias: To ease

The challenge facing British monetary policy-makers today is to get back to the pre-2005 conditions when both bank and non-bank financial institution balance sheets (in aggregate) were growing at moderate, single-digit rates.

Today there are highly divergent trends within the financial system. On the one hand the balance sheets of non-bank financial institutions or shadow banks are either shrinking or not growing at all as the financial system attempts to reduce leverage. On the other hand the M4 components and counterparts of banks’ balance sheets are temporarily growing very rapidly as banks accommodate the urgent credit demands of other financial corporations (OFCs) which are no longer able to borrow from the capital markets or other non-bank sources. Both of these trends are short-term phenomena reflecting the abrupt adjustment of the economy to slower overall credit growth. They are not long-term equilibrium positions.

This kind of re-intermediation of credit back to the banks is the explanation for the surge in M4 broad money growth in November to 16.3% (year-on-year). Based on the October data most of this surge in bank balance sheets is due to loans to OFCs (+42.8%) and balances held by OFCs (+44.1%). Meanwhile, money held by households and non-financial corporations (retail M4) has slowed abruptly to 5.2% in October, and non-financial corporate and household borrowing from the banks has slowed to 6.3%. In short, it seems possible that non-financial borrowers are being crowded out by financial sector borrowers. These stresses may well be exacerbated as the government’s borrowings increase in line with its budget deficit. However, this view is too simplistic.

The basic problem is that on the supply side, banks and non-bank financial institutions are severely capital-constrained, and market concerns about capital erosion will escalate as the recession deepens, keeping inter-bank rates at a premium to Bank Rate. To ensure that banks are still able to generate new credit and are willing to lend in the interbank markets at minimal premia to Bank Rate, they need to be very strongly capitalised. The quickest and cleanest way to achieve this is to remove all bad or toxic loans from banks’ balance sheets, placing them in a government-owned, special purpose asset management company for gradual disposal. In exchange, the banks would receive government bonds at a price reflecting the valuation of their toxic assets, and be obliged to accept a matching infusion of capital from the government. The remaining elements of each bank will then be largely problem-free, more able to raise capital, and more willing to supply credit to private sector or public sector borrowers as required. Over time the government would sell down its bank share-holdings.

On the demand side, non-bank financial companies and households (and to a lesser extent non-financial companies) have all built up over-indebted balance sheets, and therefore do not wish to borrow while asset prices are falling. The solution for these entities lies in allowing them the maximum opportunity to repair their balance sheets (e.g. by selling assets to pay down debt, or raising new capital), while at the same time attempting to ensure that the cost of funds is minimised. Base Rate should therefore be reduced further.

This balance sheet-based analysis makes it clear first that demand for credit from the non-financial sector is likely to be very weak over the next year or two as households, industrial and commercial companies, and non-bank financial institutions reduce their gearing further. It follows that the authorities should curtail their demands for banks to increase lending. Second, it also demonstrates that in future the authorities need to pay attention to overall credit growth, not simply the growth of bank credit or money created by the banks and building societies together (M4). In the meantime, the best the authorities can do is to try to ensure that money balances held by households and industrial and commercial companies continue to grow at a positive, single-digit pace. One way to help attain this result would be to ensure that banks expand their balance sheets by buying government debt, or lend directly to the government.

Both the supply side and demand side problems in the credit markets would be alleviated by a further reduction in Bank Rate, but this is not a panacea. More assistance is needed in sorting out the balance sheet problems of both lenders and borrowers across the economy.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: To cut

Eventually, Bank Rate will need to be cut to ½% or below. In the coming year the economy will probably shrink by 2.5%-3%, with perhaps a slight temporary recovery in the final quarter of 2009 or the first quarter of 2010 as the large interest rate cuts of recent months have their effect. Unemployment is likely to exceed three million, and the combination of unemployment and deflation will drive mass bankruptcies. The government's complete lack of realism over its growth and tax receipt forecasts has badly undermined confidence in the pound. It is vital that more plausible growth forecasts and a more achievable rectification path for the budget deficit be produced soon. House prices will fall rapidly through the next year and into 2010, probably by more than 35% peak-to-trough - placing many people in negative equity and undermining labour mobility. The situation is the worst for many decades.

For the moment, however, I believe that enough work has been done in terms of cutting interest rates, and the focus should switch to alternative ways to boost the money supply. Direct money printing to fund the deficit should be being planned for as part of the 2009/10 Budget. Some borrowings from commercial banks may also have a role to play. Once the nature and extent of these monetary measures is clearer, we will be better placed to judge the next moves on interest rates. For the moment, I would hold back, temporarily, to await developments.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Cut by 1%
Bias: To hold

The economic data continue to worsen across the globe. What makes this recession so insidious is the combination of global recession (thus inevitably muting any fillip the British economy should get from the weaker pound) and the dysfunctional financial markets. In the UK the latest figures confirm a consistently deteriorating situation. The third quarter GDP fall was marginally extended (from 0.5% to 0.6%) but, of more relevance, the expectations are currently for a fall of around 1% in the fourth quarter, given NIESR’s estimate of a decrease of 1% in the three months to November. The housing market continues to weaken. According to the British Bankers’ Association (BBA) mortgage lending by the major banks continues to fall sharply, with approvals for house purchases in November 60% down year-on-year. Unemployment is now rising very sharply.

Given the deepening recession, banks appear unwilling to lend, as they seek to repair their balance sheets and (logically) adopt a risk-averse stance in the face of rising defaults. Moreover, they are not ‘passing on the full cuts’ in official rates to their customers, despite exhortations from the Prime Minister, not least of all because the cost of money to them, either through the inter-bank market or from depositors, is higher than Bank Rate. The continued disruption to the wholesale markets and the tighter regulatory requirements by the Financial Services Authority (FSA) add to their inability to deliver the lending munificence that the Government would doubtless like to see. On the other side of the equation, companies and individuals are probably wishing to cut back their indebtedness (the saving ratio rose to 1.8% in the third quarter compared with minus 1.3% in the first quarter of 2008).

Given these circumstances, further cuts in interest rates can only have a muted effect on lending and other instruments, including quantitative easing and Government loan guarantees, are increasingly taking centre-stage. In addition the FSA could help banks by being more flexible with the way in which capital market assets are valued and relax the rules that enforce ‘procyclicality’. But, having said that further cuts will be of limited value, there is still purpose in cutting them. And I vote for a 1% cut in January – but hold thereafter.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: No Change
Bias: Neutral

It is getting increasingly clear that cuts in Bank Rate have played as far as they could go in monetary easing. The spread of the London Inter-Bank Offerred Rate (LIBOR) over Bank Rate remains stubbornly high but this is not the real issue. Anecdotal evidence suggests that inter-bank credit is not available in many cases and that quoted LIBOR is very much an irrelevance to many but the largest and best rated financial institutions. If this is true it means that the credit crunch has reached the stage of market based credit rationing, with the market defining quantitative restrictions. Therefore making credit cheaper does not necessarily mean making credit more available. Endogenous quantitative restrictions will have to be met with quantitative policy reactions aimed at increasing liquidity. Monetisation of borrowing by the government and even monetisation of existing debt are potential avenues for the Bank of England and HM Treasury to consider. Interest rates have gone as far as they can go and quantitative policy easing has to be considered in the short term.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold but the DMO should suspend sales of gilt-edged stock
Bias: Towards further quantitative expansion measures

At the end of June 2007, just before the current crisis broke, commercial banks’ holdings of gilt-edged stock were minus £13.6bn. This is a spectacular illustration of the way in which banks had run out of eligible assets for conducting sale and repurchase agreements (REPOs) with the Bank of England under the eligibility rules at the time. They had run out of reserves. From the banking point of view, the background was that banks were very happy at the time to hold zero reserves. The Bank stood willing to supply whatever quantity of reserves banks wanted each day (subject to the price - that is, the rate of interest - of the Bank’s own choosing). In other words, the Bank was an openly declared unlimited lender-of-first resort, which satisfied the requirements for reserves of banks as a whole. Providing the inter-bank market was functioning efficiently, money would flow from banks flush with reserves to those short of them and an individual bank could be confident that it could obtain finance when it was needed and had no need to hold reserves in advance of need. Indeed, banks made a profit out of holding assets with a higher return.

The other half of the explanation is that there are three sources from which the government can borrow to finance a deficit, namely: (i) banks; (ii) the non-bank private sector; and (iii) non-residents. It follows that borrowing from banks - that is, mainly changes in banks’ holdings of treasury bills and gilts - is equal to the public sector net cash requirement (PSNCR) less sales of gilts, etc. to the non-bank private sector and to non-residents. In the mid 1980s, banks’ holdings of government debt fell when sales of gilts to non-banks exceeded the PSNCR because the then Chancellor, Nigel Lawson, was following a policy of overfunding to control the money supply. At the time the discount market existed and commercial bills guaranteed by a discount house and ‘accepted’ by an acceptance house (i.e. guaranteed by two banks) became eligible for discount at the Bank. Such reserve assets could be manufactured at will by banks persuading their customers to issue a bill rather than draw down on a loan facility. Their customers would be happy to do so if issuing a bill were cheaper. In the mid-1980s the Bank purchased a huge quantity of eligible bills to relieve the squeeze caused by over-funding. The Bank’s ‘bill mountain’ of the time thus acted as a safety valve.

The discount market and eligible bills no longer exist. They have been replaced by REPOs. This time round, non-resident purchases of gilts have been greater than the PSNCR. In the twelve months to end June 2007, non-residents bought no less than £42bn gilts compared with a PSNCR of £28bn. In the previous year they bought £31bn gilts. It is no wonder that banks had run out of assets eligible for REPO. The safety valve was borrowed stock. This is why banks’ holding of gilts were so massively negative at the end of June 2007. Two questions arise from this analysis. Firstly, why was the Bank so slow to extend the range of assets that qualified for REPO when the crisis broke? Second, did the Bank not understand what had happened?

1) The Story

The non-residents who purchased the huge quantities of gilts were either investors who thought that sterling and gilts were attractive or central banks that wanted to earn interest on their holdings of foreign exchange. The latter are likely to account for the bulk of the rise. A story can now be pieced together. The Peoples Bank of China intervened in the foreign exchange markets to stop the Yuan from rising and China’s foreign exchange reserves rose by a huge amount. To earn interest on the reserves they were held partly on deposit with banks and partly invested in government debt. The former provided the finance for banks in the US and the UK to lend like mad whereas the latter sucked reserves out of their banking systems. When the bubble bursts, as it was bound to eventually, confidence collapsed in the inter-bank market. Banks then went from being happy with no reserves to wanting them, perhaps to the extent of 10% of their liabilities. And the starting position in the UK was one of large-scale borrowed stock. It is no wonder that banks have been reluctant to lend in spite of the injection of capital from the government.

2) Required Action

When the government makes a payment to someone by cheque the person’s deposit with his or her bank increases, at the time the cheque is cleared, as does the bank’s balance with the Bank of England. This boosts bank reserves and is exactly what is wanted in the present extraordinary circumstances. For the time being the Debt Management Office (DMO) should suspend sales of gilts and further measures of quantitative easing should be prepared if this proves inadequate.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Wait and see but enough stimulus has probably been applied for the time being

There comes a point in every monetary easing cycle when it is appropriate to pause for breath and consider what the ultimate effects of the preceeding rate reductions will be, after allowing for the long and variable lags involved. The reason Keynesian demand-management policies fell out of favour in the 1970s, for example, is that it became obvious that the information and implementation lags were such that discretionary policies were exacerbating the underlying business cycle. Likewise, global monetary policy has arguably been perversely de-stabilising since the bail out of Long-Term Capital Management a decade ago. US policy makers, in particular, have aggressively cut rates at the first imagined sight of bogey men in the financial markets. The result has been that they lost control over credit and broad money and created the financial bubble that they should have popped at a much earlier stage. Macro-economic modellers have long known that discretionary monetary policies, that vary the real REPO rate in response to the output gap, can end up de-stabilising the economy under the wrong circumstances. Simple rules – such as setting the REPO rate at inflation plus, say, 2% - often give better results in model simulations when more interventionist policies seem to generate cyclical fluctuations of their own. This is just a standard problem in control theory, of course. The authorities clearly hoped that putting policy onto a forward-looking basis using a formal predictive framework would prevent some of these destabilsing tendencies. Unfortunately, the failure of almost everybody in officialdom, politics, or the private sector to correctly anticipate developments from mid 2007 onwards implies that forward-looking policies are based on such uncertain foundations that they can prove as potentially de-stabilising as the old backward looking kind.

Britain has a small open economy and the effects of a given policy stance on domestic developments is heavily conditioned by the wider global background. There are several causes of the present global recession, which is not just the result of the ‘credit crunch’. Most commentators have concentrated on demand effects. However, there has probably been an additional element of supply-side degradation in both the US and Britain, where the share of government spending in national output has risen markedly over the past decade. Applying the normal statistical rule of thumb – that a 1% increase in the share of non-productive public spending in GDP reduces the growth of per capita real GDP by 0.15 to 0.2 percentage points – suggests that increased public expenditure will have reduced the sustainable growth rate in the US and the UK by some 1 to 1¼ percentage points since the turn of the century. Reduced aggregate supply would explain the weakness of equity markets, whose level reflects the net present value of the future stream of real corporate earnings, despite low real bond yields, which are themselves partly determined by the sustainable rate of economic growth.

Turning to the more conventional influences on activity, one forecasting problem is that the world economy has suffered not one, but two, adverse shocks in recent years. This makes it difficult to disentangle their relative significance. The first was the rise in the price of a barrel of Brent Crude oil from US$54 in January 2007 to US$134 in July 2008. Model simulations indicate that this would have had a major adverse impact on global activity, even in the absence of a credit crunch. The second adverse factor has been the ‘credit crunch’ itself. A credit crunch can be regarded as a situation where credit is rationed by availability rather than the rate of interest. The latest ‘crunch’ occurred at the same time as the oil price shock and may have been partly caused by it. However, the oil price has since fallen to US$40.5 (on 29th December). One could argue, therefore, that the world economy will be rebounding strongly by late 2009, after allowing for the normal lags involved, if the previous oil price shock had been a substantial contributor to the global downturn.

Any attempt to analyse the impact of the credit crunch encounters the problem that none of the macroeconomic forecasting models employed by the leading central banks, ministries of finance, or academia incorporate credit rationing effects (the same is true of the Beacon Economic Forecasting model). The recession is almost certainly being built into published forecasts by the use of large negative adjustments to the underlying model predictions (it would be interesting to know how much of the change in the Bank of England’s Inflation Report forecasts between August and November 2008 was the result of such adjustments, for example). Such downwards adjustments may well be realistic. However, they also mean that virtually the entire global model-building community is flying blind. The critical forecasting issues then are: (i) when and whether such downwards adjustments should be removed; and (ii) what happens once the negative adjustments come off. If the models have not broken down entirely – which is clearly conceivable – one could be looking at a strong rebound in late 2009 and 2010, just when the lagged effects of current low interest rates and fiscal relaxation are building up to their peak.
In the November 2008 Pre-Budget Report, HM Treasury assumed that there will be a permanent loss of output of 4% of GDP as a result of the global credit crunch but it is really too early to say. From a theoretical perspective, a credit crunch presumably acts like an unanticipated negative monetary shock in a monetary model, or an adverse relative price shock in a real business cycle model. Both approaches suggest that the economy should eventually return to its underlying growth trend and there should be no permanent loss of output beyond that already caused by Gordon Brown’s manic interventionism, unless the quack measures now being introduced by politicians make matters worse rather than better. This happened with Roosevelt’s New Deal and is likely to happen in the US, Britain and other modern economies. Fortunately, there is evidence from both the 1930s and subsequent recessions that the speed of recovery is greater, the deeper the previous recession. For example, the sequence of growth rates in UK GDP between 1930 and 1938 reads: 1930 minus 0.7%, 1931 minus 5.1%, 1932 plus 0.8%, 1933 +2.9%, 1934 +6.6%, 1935 +3.8%, 1936 +4.5%, 1937 +3.5% and 1938 +1.2%.

As far as the 8th January rate decision is concerned, the MPC have now probably done enough for the time being and should hold Bank Rate at the 2% announced on 4th December. One reason for caution is that the trade-weighted sterling index was 24½% down on a year earlier on 29th December. This should provide some succour to Britain’s excessively small tradables sector. However, it also represents a potential inflation risk, given that imports account for roughly one third of the basic-price measure of UK GDP. The pound’s weakness may explain why annual CPI inflation in the UK only decelerated by 0.4 percentage points between October and November 2008, while US inflation eased by 2.6 percentage points (3.7% to 1.1%), and Euro-zone inflation declined by 1.1 percentage points (3.2% to 2.1%). However, an alternative explanation may be that the UK CPI is compiled relatively early in the month. Fortunately, the falls in the prices of oil and non-oil commodities, and the emergence of a substantial negative output gap in the OECD area as a whole, will limit the upside risks to UK inflation throughout 2009. It is possible that the second half of 2009 will see small – but not economically damaging – negative figures for the year-on-year CPI inflation rate, before there is a rebound back to positive inflation in 2010.

More generally, the most pressing monetary policy need is not to cut Bank Rate further but to ensure that the politicians, the Bank of England, HM Treasury and the FSA get their combined act together with respect to their interventions in the UK banking sector. Present official initiatives are a damaging and logically inconsistent mess with the different official players frequently going off at tangents to – and occasionally briefing against - each other. The Prime Minister’s demand for low borrowing costs is palpably inconsistent with the recognised need to re-capitalise the banking system. It is not difficult to understand why one UK clearing bank allegedly considered Libya’s Colonel Gadaffi a better bet than Gordon Brown as a potential re-capitalisation partner.

Comment by Peter J Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: Neutral

It is deeply regrettable that, sixteen months after the eruption of the credit crisis, the government is still fumbling for an effective response. Plainly, its advisors did not expect the crisis to have a material impact on the macro-economy, did not forecast a recession nor did they prepare the government’s finances for such an eventuality. Banks must be allowed to rebuild their historic intermediary functions on a profitable basis as a stepping stone to systemic recovery. The incoherence in the response of the UK authorities to the credit and financial crisis emanates from a neglect of the study of the evolving transmissions between the financial and real (output and employment) sectors of the economy. The adoption of inflation targeting in 1992 fostered a black-box approach to monetary policy which has proved costly in current circumstances. Interest in the behaviour of credit and monetary aggregates waned accordingly and important skill-sets have been lost to the Bank of England and the financial sector in general. Hence the policy responses to the crisis have been piecemeal and often ill-considered. They do not fit together as a coherent strategy.

Six desirable outcomes for economic policy are outlined below, with some suggestions as to how they might be achieved.

1) Normalisation of the Inter-bank Market

On this score, there is no magic solution but rather a progressive determination to provide as much central bank liquidity as is necessary through as many different channels as is helpful. Three-month sterling LIBOR is quoted at 2.87% versus a 2% Bank Rate while three-month Euro LIBOR trades at 49 basis points over the REPO rate. The UK appears to be lagging in the normalisation stakes.

2) Suspension of Inappropriate Capital Adequacy Rules

Basel 2 capital adequacy rules, introduced at the start of 2008, require banks to recompute the amount of their risk-weighted assets each quarter. When property asset values are falling at an annual pace of 10% or more, this causes more of a bank’s mortgage assets to migrate into higher loan-to-value categories. This insists that banks post more capital against their loans at a time when their profitability is low and they need to make increasing loan loss provisions. Until the rules can be redesigned to work counter-cyclically, my suggestion is that banks’ capital requirements revert to and are frozen at their end-June 2007 levels.

3) Restoration of Profitability to the Banks

If the objective is to enable the banks to write down their impaired assets to prevailing market valuations, where these exist, then the restoration of bank profitability is an imperative. The higher the profits, the faster the write-downs can be achieved and the sooner the self-healing properties of markets can take over. Currently, the banks are under official pressure to pass on Bank Rate reductions to the private sector. However, their cost of funding in the inter-bank market has not fallen as rapidly or as far as Bank Rate. And banks are reticent to pay a zero interest rate on bank deposits, which would be another way to make a significant profit in a low bank rate environment. If the purpose of ultra-low Bank Rate was to invite the banks to take a turn on the official yield curve, this isn’t working either. At 2.52%, five-year gilts yield less than three-month LIBOR (2.87%). The situation is aggravated by the more attractive saving rates offered by Northern Rock and National Savings and Investments products. The authorities give support to the banks with one hand and seek to punish them with the other. This ambiguity needs to be removed to allow banks to rebuild their profitability.

4) Re-direction of Banks’ Lending Capacity towards Non-financial Companies and Households

Following the remarks in the earlier sections, the key to this re-direction lies in the “dialysis” of banks’ maturing obligations. While it is helpful for banks to be able to issue new asset-backed securities into the Special Liquidity Scheme (SLS), a much bigger problem is the pipeline of maturing issues than cannot be refinanced in current market conditions. While the flow of new credit to the private sector is hindered as much as by demand as supply, there are reasonable grounds to suppose that a partial normalisation in credit volumes would occur if banks were less concerned to protect their financial subsidiaries and connected activities.

5) Reversal of the Ludicrous “Over-funding” of the Budget Deficit

In the circumstances of the credit crisis, the 1998 remit of the DMO makes no sense. Since the summer, the DMO has been issuing additional gilts opportunistically into a strong market, that is, a flight-to-safety market. As a result of incremental gilt issuance and the popularity of National Savings products, the DMO has garnered over £20bn more than would be required to fund public sector borrowing. In other words, the DMO has been covertly “overfunding” the public sector’s net cash requirement. Essentially, it has been draining bank deposits from the private sector. This policy will reverse naturally as the PSNCR explodes, but it is important that DMO’s remit is amended to permit significant “under-funding” in the coming years.

6) Discouragement of Flows into National Savings and Other Tax-free Savings Vehicles

The government must not abuse its privileged position to outbid the banks for deposits as has begun to happen over the summer. The stock of bank deposits held by private non-financial corporations and households dipped in October as businesses suffered negative cash-flow in aggregate and households switched from bank accounts to National Savings and other forms of saving. A loss of deposits must surely curtail banks’ willingness and capacity to lend. A suggested way to bolster bank deposits is either for the government to borrow directly from the banks, or to ensure that banks buy large amounts of Treasury bills and gilts.

I believe that the restoration of bank profitability is served better by working to normalise the interbank rate curve and to reverse the outflows from private sector bank deposits than by a further reduction in Bank Rate. Hence my vote is to leave Bank Rate at 2%.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Cut by 1%
Bias: To ease

My vote is for a cut of 1% in Bank Rate in January 2009, with a bias to ease further in later months. Such a cut would mean that the MPC is in a position where monetary policy is loose enough to buy it some time to decide whether the situation effectively warrants zero interest rates and what kind of quantitative easing it should pursue. That the MPC must use its tools to pursue policies that expand money supply at a time that liquidity is scarce, is almost a certainty. The economic situation is deteriorating very quickly, and it is now certain that without even more dramatic action it will get a lot worse. Britain’s GDP is likely to have dropped by over 1% in the final quarter of last year. Further rate cuts will not prevent a fall in UK GDP of around 2% or more in 2009. However, central action to get money to firms that require it through firstly, purchasing commercial bills and, second, cutting rates to about zero will mitigate the downturn. This means big risks are being taken. Unfortunately, the excessively lax policy stance of the past decade means that an even looser one is now required to prevent a worse economic outcome.

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (Founder, Lombard Street Research), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group), and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

In its latest E-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted that UK Bank Rate should be reduced by a further 1 percentage point on 4th December.

One SMPC member wanted a Bank Rate drop of 1½ percentage points, four members favoured a cut of 1 percentage point, two argued for a ½% percentage point reduction, and two wanted to hold Bank Rate at the 3% set on 6th November.

These somewhat divergent recommendations would deliver a 1% reduction according to the voting procedures employed by the Monetary Policy Committee (MPC). The initial SMPC poll was carried out before the 24th November Pre-Budget Report. However, the poll was re-opened on Tuesday 25th November.

Five SMPC members amended their texts - but no one changed their vote - in consequence. Several members of the IEA’s shadow committee were concerned about the size of the fiscal imbalances announced by Mr Darling. However, most SMPC members thought that the need to fight the meltdown in the financial sector and maintain a positive growth rate in the money holdings of the non-bank private sector had the greatest priority.

Comment by Roger Bootle
(Deloitte and Capital Economics Ltd.)
Vote: Cut by 1%
Bias: Cut rates more

The economic situation is now so serious that the Bank of England should be on course to cut rates all the way to zero. Monetary policy may not be enough to save us from a deflationary depression but it should be pushed all the way. The Bank must not make the Japanese mistake of taking action too late, when deflationary expectations have set in. The question is then how to proceed from 3%. I favour another big cut which will have shock value. I suggest 1%. But even if they cut by 1% at the December meeting they should not wait long before cutting rates again.

Although lower rates will not be a panacea, and will be less effective in this environment than normal, they will help in several ways. They will have some effect on the cost of borrowing, but in addition, they will cut the cost of government finance by tending to drag down bond yields; they will thereby tend to raise the values of other assets; and they will help to raise bank profitability

Comment by Tim Congdon
(Founder, Lombard Street Research)
Vote: Hold
Bias: Neutral

The lack of confidence in policy-makers is so severe that any forecast and policy prescription is an act of faith. My two main points are:

i. The authorities must try to return to a world in which solvent banks receive lender-of-last-resort loans when they have a funding problem and are not bullied into confidence-destroying recapitalisation efforts.

ii. If banks' lending to the private sector starts to contract and the genuine quantity of money (i.e., the money, mostly bank deposits, held by genuine non-banks) falls, the government must borrow from the commercial banks to keep the quantity of money growing at a low, non-inflationary and stable rate.

These are the considerations that matter at present, rather than a particular view on interest rates. If you want a view on rates, it's no change for the time being and no change as my bias.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Cut by ½%
Bias: To ease

The fall of 0.5% in the third quarter’s GDP was significantly worse than expected and presaged a nasty recession. I now expect GDP to fall by 2% next year and show only slow recovery in 2010. Unemployment (on the claimant count measure) is now rising at around 35,000 a month and is set to accelerate as the recession progresses.

Meanwhile inflationary pressures are collapsing spectacularly. Oil prices have collapsed from around $147 per barrel in the first half of July to less than $50 per barrel. Even after allowing for the weakness of sterling against the dollar, prices have still halved from £70 per barrel in early July to around £33 per barrel. Annual consumer price index (CPI) inflation fell to 4.5% in October and is set to fall dramatically in the second half of next year. Talk is now of deflation rather than inflation, with falling prices seen as a possible deterrent to consumer spending. If, however, these declining prices are in ‘necessities’ such as fuel, food and gas and electricity bills, then hard-pressed consumers, who have experienced a real incomes squeeze for much of this year, are likely to regard falling prices as a happy respite from the squeeze rather than a signal they should defer their spending.

Money and credit conditions remain tight as banks shore up their balance sheets, reluctant to lend to businesses and individuals. Several factors are bearing down upon them – including tighter regulations, the devastating effect of falling asset prices on their balance sheets, the relative dependence on overseas institutions which are calling in their loans and the increased risks of lending to households and companies as the recession intensifies - thus intensifying the pressures on these sectors. Excluding transactions within the financial sector, the growth rate of real broad money has fallen dramatically. The economic impact of the Bank’s aggressive cuts in interest rates is inevitably blunted by the continuing difficulties in the financial sector.

The Bank discussed the size of the possible fiscal stimulus in the then forthcoming Pre-Budget Report as one reason for not cutting Bank Rate by, at least, 200 basis points at its 6th November meeting, opting instead for a 150 basis point cut. Suffice to say at this point that the overall stimulus to the economy of £9.3bn in 2008-09 and £16.3bn in 2009-10 announced by Mr Darling was more than I had expected and the borrowing levels are unsustainable, in my view. But I would still opt for a ½% cut in Bank Rate in December, despite the irresponsible fiscal background, with a bias towards further easing in subsequent months.

Comment by Andrew Lilico
(Europe Economics)
Vote: Cut by 1%
Bias: To cut further - in due course, all the way

Broad money growth is now below the rate of inflation. Oil prices now appear to be decisively below $50 a barrel. And the break-even inflation rate for UK 2011 index-linked bonds was a negative 1.64% as of 21st November, and falling rapidly. Deflation is nailed on. The question is whether we lose control of it. Interest rate cuts should certainly be attempted - very aggressively. However, I fear that we do not have enough scope for interest rate cuts to prevent a fall into deflation, even if the monetary transmission mechanism were operating normally. Since interest rate cuts are unlikely to be converted into additional bank lending because of financial market problems, rate reductions will be largely ineffective - as they have been over the past year.

Even were lending to increase in response to interest rate cuts, it is highly doubtful that additional private lending is desirable given the highly over-geared position of UK households and the danger that deflation will lead to mass defaults as households become unable to service their debts. Interest rate cuts will, nonetheless, be worthwhile (assuming that banks are not overly pressured into unwise additional lending or inappropriate ‘passing on’ of rate cuts). This is because lower rates should enable banks to increase profitability and have some helpful cash flow and servicing-cost impact upon the lower-risk borrowers that will benefit from rate reductions.

It is perhaps worth noting that, given the near-certainty of deflation, tampering with the rate of Value Added Tax (VAT) at this time is very risky. Deflationary episodes can gather their own momentum, and if VAT reductions are indeed ‘passed on’ to consumers, that might tend to accelerate the slump into deflation. Given that the VAT rate has been changed (I would have vastly preferred to see income tax rebates and temporary corporation tax cuts) I would urge strongly that firms be allowed to take the effect of VAT reduction in the form of higher profits rather than being subject to political pressure to reduce prices in an already dangerously unstable situation.

Interest rates should be cut now by another 1%. But we should also be preparing for non-conventional (or, perhaps in some ways, more traditional) monetary policy measures. Specifically, I believe that the current legal restriction requiring budget deficits to be fully funded by debt should be removed. The urgency of readying this weapon has been enhanced by the manifestly over-optimistic growth projections in the Pre-Budget Report and the extremely ambitious proposals to tighten public expenditure growth - I find it difficult to believe, given the government's previous record, that a 1.1% rate of increase in total expenditure is really deliverable.

I am also greatly disturbed to see that the government has persisted in its view that the sustainable growth rate of the UK economy is 2¾% - unchanged despite the epic events in financial markets, the nationalisation of the banks, plans for more restrictive regulation in the future, and a huge increase in the government's debt to GDP ratio. Can it really be credible to suggest that none of these events leads us to re-assess the trend growth rate of our economy? Overall, it seems to me that, unless taxes are to be raised substantially in what may be a low growth environment with ugly deflation, it will be necessary to monetize a material proportion of the government's annual deficits between 2010 and 2015. We do not yet need to print money to fund government deficits in order to fight deflation, but I believe that the weapon should now be prepared.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Cut by ½%
Bias: To ease

The 19% depreciation of the sterling effective exchange rate over the past twelve months is the combination of real and nominal factors. The collapse in domestic demand and the global downturn in international financial services have necessitated a depreciation of the real exchange rate so that the external sector can take up the slack. Admittedly it is difficult to know how much of the depreciation of the effective exchange rate is due to the change in the fundamental equilibrium real exchange rate and how much is due to current and expected monetary factors. The expected fiscal stimulus from the Pre-Budget Report may have contributed to the precipitous fall in the value of sterling but the drop in domestic demand has muted any inflationary implication. Whatever is announced in the Pre-Budget Report in the form of tax cuts, there is little chance that such a transitory increase in disposable income will do anything other than result in the repayment of debt. Spending by the private sector will remain weak. The one positive effect will be to improve the balance sheets of the banks and their liquidity position and help to reduce the spread between Bank Rate and London Inter-bank Offered rate (LIBOR). It is therefore important that Bank Rate be cut aggressively so that the fall in domestic demand does not develop into too serious a recessionary outcome.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by a further 1½%
Bias: Subsequently reduce to 1%

The events of the weeks since the unfortunate demise of Lehman have unnerved the world. Had poor Mr. Paulson understood how allowing Lehman to go bankrupt would cause him to devote many more billions of US government money to the banking sector, starting with the insurer AIG in the very next week, no doubt he would have found a way to avoid it on that fateful weekend of 13th September. At any rate the Lehman-sparked collapse in stock and money markets forced the hands of governments all around the OECD. We have seen a range of taxpayer packages to put capital into tottering banking systems - modelled mostly on that of Gordon Brown to take direct equity stakes on some sort of preference share basis.

The panic that inspired that involvement of taxpayers still echoes round the markets and the economies of the West. Like a man who has just looked over a cliff edge while clinging to the topmost ledge, they are still trembling with fear and anticipation of disaster. However, this assessment is wrong. The recession now in train is the result of a year of extreme credit tightness - perhaps the equivalent of 6% on the basic or repo rate. Businesses and consumers have cut back spending as they have found it either impossible or highly expensive to get credit.

During this period only the US Federal Reserve tried to offset the effects of the credit crunch by cutting interest rates drastically. Even it failed to do so totally, because of the scale of the US credit disaster. However, astonishingly neither the European Central Bank (ECB) nor the Bank of England, nor indeed most of the other OECD central banks, made much if any attempt to offset the crunch. They did so because of the commodity price boom; but they could have argued - rightly - like the Fed that this was an exogenous deterioration in the terms of trade that would lead to cutbacks in real wages and not to inflation.

That is now history, though as a result of it there will probably be a worse recession this side of the Atlantic than in the US. What matters now is that policy has reversed engines everywhere. Interest rates are being cut sharply and the taxpayer packages are restoring confidence in bank solvency and liquidity. Already the infamous inter-bank three-month spread is coming down; in the UK for example it peaked at over 150 basis points but is now down to about 120. To get the present pattern of interest rate movements into perspective one should recall those of the last major recession of 1990-92; interest rates were raised to double digits at the end of 1988 and were kept there until the end of 1992, reaching a peak of 15% during 1990. That made four years of monetary squeeze deliberately inflicted to bring down the resurgence of inflation in 1988. Today any such ‘resurgence’ turned out to be a chimera and those central banks worried by it have turned tail after a year, repentantly hosing money into the economy. Hence, dire as the situation now appears to be, with recession taking hold rapidly, it is most likely that a turnaround will come during late 2009 if not before under the impact of the massive monetary loosening now going on. Initially, yes, it will not do much to thaw out the monetary freeze we have recently had, but gradually it will take effect.

What further steps should central banks take? Base and repo rates have been cut to low levels. In the US they are down to less than 0.5%. In Europe and the UK they are around 3%. The latter can drop further and are widely expected to: 1% seems a likely resting point quite soon. However the main focus should now be on getting the inter-bank spread down. This is gradually occurring as confidence in banks returns. The process could be speeded up if central banks supply longer-term liquidity, as in the Bank’s Special Liquidity Scheme, but not at penalty rates as now in that scheme, where the Bank charges the inter-bank spread whatever this may be! The object of central bank policy should be to narrow the spread; to do this it needs to charge Bank Rate for providing this longer term liquidity. After all, if the taxpayer is taking on the risk of supporting banks, what risk is a central bank taking in such lending? None at all and so it can pass on its low borrowing rate to these banks. Hence I hope to see further sharp cuts in base/repo rates to around 1% accompanied by the aggressive provision of longer-term liquidity to banks at those very same base/repo rates.

Meanwhile it is important that governments do not lose their heads and attempt large scale fiscal ‘pump-priming’. There is every reason to doubt that this will be effective as taxpayers know they will have to pay it back after a short interval through higher taxes. It therefore produces inefficient outcomes - varying taxes and wasteful spending on make-work projects. There is also a risk that some governments will generate worries about future solvency; in countries where taxpayers may be averse to higher taxes, lenders will worry that future inflation or devaluation will be used to make public ends meet. These worries would raise long-term interest rates, undoing the stimulus from monetary policy.

The latest Darling/Brown package falls short on these criteria, although HM Treasury at least managed to restrain it somewhat. It is a hostage to fortune, in the sense that if the recession lasts longer and tax revenues fall even shorter than HM Treasury has assumed, or if the bank bail-out costs the taxpayer more than the zero now projected, solvency worries would surface about the British government’s finances. These would complicate the task of monetary policy, already a hard one due to past Monetary Policy Committee (MPC) incompetence. As it is, my forecasts are for a poor 2009, with a moderate recession- negative growth of 1% or less across most OECD countries. But 2010 should see a moderate recovery as monetary loosening works through. By then it will be necessary to drain money growth out of western economies once more and to push interest rates up again. My vote is for another cut in the base rate of 1.5%, with a bias to cut further to 1%; also to eliminate the risk-premium fee in the Bank’s Special Liquidity Scheme.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Wait and see but a tightening bias may be appropriate by this time next year

There are notoriously long and variable lags between a policy easing and its effects being felt on the wider economy. Both the scale and speed of these effects can also vary with the international background. A synchronised international easing of the sort that is now being attempted induces positive trade feedbacks from one country to another and reduces the risk that extra home demand becomes dissipated in higher imports. However, it also increases the risk of over-steering at the level of the system as a whole. By historic standards, the UK authorities have now poured a breath-taking range of monetary and fiscal stimuli into the British economy. These expansionary forces have been reinforced by the 18½% drop in the external value of sterling over the past year. If stimuli of this magnitude do not revive the patient one can only conclude that the economy is dead, arguably crushed to death by the sharply increased tax and spending burdens of the past decade or strangled by red tape.

There is clearly a risk that the stimulus has been overdone and that the UK authorities have repeated the mistakes of the British Heath administration in 1972, which was panicked by a partly weather-related rise in unemployment, did an extreme policy ‘U-turn’, and adopted the hyper-lax fiscal and monetary policies that led to the stagflation of the mid 1970s. In order to minimise this danger it is important that the recent panic expansionary measures should be capable of rapid reversal if the economy proves to be seriously more robust - or stagflationary – than people are currently anticipating. The good news is that the collapse in the price of oil from a peak of US$144 on 11th July to US$49 on 21st November will both stimulate activity and act as a disinflationary shock in its own right, partly offsetting the immediate inflationary consequences of the weaker pound. On its own, the reduced price of oil made it likely that annual CPI inflation would ease from the 4.5% recorded in October to around 1¾% in the second half of next year, before averaging 2¼% in 2010 and just over 2% in 2011.

After allowing, in addition, for the temporary 2½% cut in the rate of VAT announced in the Pre-Budget Report, year-on-year CPI inflation is now likely to decline to reach a low-point of just over ½% in the third quarter of next year, before rising to just over 1% in the final quarter of 2009, according to the latest predictions of the Beacon Economic Forecasting (BEF) macroeconomic model. However, CPI inflation is expected to bounce back subsequently to average just over 3% in 2010, after the VAT cut is reversed, before easing to 1¾% in 2011. This is because the changes to VAT will have exaggerated the natural, and partly oil-price induced, cycle in CPI inflation. The likely consequence is that the Governor of the Bank of England will be writing a letter in the autumn of 2009 explaining an inflation undershoot, and another in 2010, explaining an overshoot.

A more fundamental criticism of Mr Darling’s measures is that they have ignored everything that economists know about the best and worst ‘buys’ when it comes to taxation. Because VAT is a flat rate, non-distortionary, consumption tax, it is one of the least economically damaging ways of raising revenue. National insurance contributions, in contrast, represent the most damaging tax where output and employment are concerned and one where raising the rate seems particularly likely to induce adverse ‘Laffer-curve’ effects (see: Chapter 4 of my 2006 IEA monograph Living with Leviathan (www.iea.org) for details). That is why Germany used a sharp rise in VAT to reduce employers’ social overhead charges and achieved a marked reduction in unemployment as a result. The Pre-Budget Report measures are likely to prove permanently job destroying on this evidence. Fortunately, lower energy costs should stimulate both global and domestic activity, just as the sharp rise in the oil price undermined it. This effect is likely to offset some of the adverse consequences of the global credit crunch and the misguided Pre-Budget Report measures. There is possibly excessive gloom about international and British growth prospects over the next few years.

As far as monetary policy specifically is concerned, the 1½% Bank Rate cut announced on 6th November appears to have ‘worked’ in the sense that the three-month LIBOR rate fell from 5.65% the day before to 3.94% on 21st November. This contrasts with the ½% cut announced on 8th October, after which LIBOR remained unchanged at 6.25%. The implication is that monetary policy has now regained some traction over the money market yield curve. However, there is a strong likelihood that the huge government borrowing announced in the Pre-Budget Report will lead to higher bond yields and undo the gains from lower money-market rates. There is powerful evidence that budget deficits crowd out at least an equivalent volume of household consumption and private-sector investment. This means that the recession in the private sector of the economy will be exacerbated, not alleviated, by the Chancellor’s fiscal fecklessness. As a consequence, official policies will have perversely amplified the natural cycles in output, as well as in inflation, in recent years. There now seems to be a good case for the MPC pausing for breath, until there has been an opportunity to see the effect of the fiscal and monetary measures taken already. This suggests that Bank Rate should be held in November. Beyond that, decisions will have to be determined by events, including the foreign-exchange and bond markets’ considered reactions to the Chancellor’s Hugo Chavez economics.

Comment by Peter Spencer
(University of York)
Vote: Cut base rate by 1%
Bias: To cut further if necessary

The balance of risk between inflation and recession shifted dramatically following the collapse of Lehman in September and in recognition of this the MPC has been cutting base rates aggressively. There is every reason to continue this aggressive programme in December. The market is looking for another ½% cut this month, but I can see no reason for holding back now. I would cut the base rate by another 1%, taking it down to the historic low of 2%.

It is clear that the economy moved into recession in the third quarter, probably before the Lehman collapse. Now, the intensification of the financial crisis will deal the economy a further blow. Despite the Chancellor’s rescue package the inter-bank market remains paralyzed. There is already anecdotal evidence of credit starvation in the small company sector. The stock market, which held up remarkably well until Lehman failed, has also collapsed. M4 growth has been inflated by financial transactions but looks very weak if suitable allowances are made for this. Survey evidence suggests that output is sliding fast, particularly in the all-important service sector.

Commodity prices have collapsed and inflation is set to fall dramatically now, as indicated by the fan chart in the Bank of England’s November Inflation Report. This suggested that CPI inflation would fall below the 2% target and that negative inflation was a frighteningly real possibility. Rate cuts and falling house prices will mean the fall in RPI inflation is much steeper. There is a real risk of a debt deflation spiral developing here, which would be extremely difficult to escape given the high level of debt in the household sector. The MPC voted unanimously to cut interest rates by 150 basis points at the November meeting. A larger rate cut was considered, with the minutes stating that “the projections in the Inflation Report implied that a very significant reduction in Bank Rate – possibly in excess of 200 basis points – might be required in order to meet the inflation target in the medium term”. Yet it decided to cut rates by less as it was concerned about the impact on sterling of surprising financial markets and wanted to assess the scale of fiscal loosening to be announced in the Pre-Budget Report.

The fall in sterling over the last month surely tells us that the markets have priced in the effect of future Bank Rate cuts. Moreover, the inflationary effect of any further falls will be outweighed by the effect of falling commodity prices, leaving the risks skewed to the downside. With the Pre-Budget Report now out of the way, there is no reason from holding back from another aggressive rate cut this month.

Market and administered rates remain well above policy rates. The three-month LIBOR at the time of writing was still 110 basis points above the base rate. There is a lot of pessimism about the ability of monetary policy to deal with this situation and the risk is that fiscal policy will remain top of the policy agenda. I do not share this pessimism. However we must give monetary policy its best shot lest we find ourselves embarking on yet more fiscal give-aways.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Cut by 1%
Bias: To ease

The UK economy has taken a decided turn for the worse since September. This has been due to a combination of higher than expected inflation in the summer, which hit real incomes sharply, and the demise of Lehman Brothers, which hit financial market and business confidence hard, worsening economic growth in the third quarter. And this has continued in the fourth quarter of this year. As a result, manufacturing output remains in steep decline and the year-on-year volume growth in retail sales has slowed sharply, with the reduction in credit availability, tighter credit standards and wider spreads significantly exacerbating these negative forces. In addition, the global economic backdrop has worsened considerably, with any global leveraged position being badly hit as capital retreats to safe haven investments. Purchasing Managers’ Indices, business and consumer confidence, unemployment, and the housing market continue to worsen, implying that the downturn is still steep with worse to come.

After the drop of 0.5% in economic output in the third quarter, a sharp cut in interest rates was justified, especially as the fall in commodity prices and the likelihood of them staying low for some months suggest scope to cut rates sharply. We should not be afraid of changing our monetary stance if the data justify it, and this is what the Bank of England did in the last Inflation Report and in the October and November MPC meetings. A further cut is now justified, to 2% in December. This would be in order to loosen policy in real terms to ‘get ahead of the curve’, and to signal that decisive action is being taken so helping to maintain faith in the central banks’ management of the crisis. As Roosevelt once said, “there is nothing to fear so much as fear itself”.

Fiscal policy measures should also be pointed towards offsetting the credit crisis and the risk of global recession. But this also means that as soon as the economy recovers, interest rates have to return to a neutral rate and fiscal policy must also return to sustainable basis so that international confidence in the pound is not undermined. The measures announced in the Pre-Budget Report added £20bn to the economy over the year ahead, equivalent to some 1.5% of national output and - by allowing the automatic stabilisers to work unimpeded - foresaw a big rise in borrowing, with the Budget deficit at 8% of GDP in fiscal 2009-10. There was little option but to do this. However, there must be a route mapped out after the economic recovery is underway to bring the public finances under firmer control.

In the meantime, this does not mean that monetary policy should not continue to lean against the slowdown and help to alleviate the credit crisis. If UK Bank rate is not cut in December, given the way that financial markets are positioned for one, there could be a severe market reaction, offsetting much of the fall that has taken place in the three-month interbank spread and wasting the cut of 1.5% in November. The October rise in money supply is reflecting strains in the money markets, but one would look for a fall in the months ahead. If not, then it implies that there is a long term inflation threat if monetary and fiscal policies do not return to neutrality as soon as the recession is either over - or about to recede - and the risk to credit markets is contained.

Note to Editors

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (Founder, Lombard Street Research), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group), and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

In its latest monthly E-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted by seven votes to two that UK Bank Rate should be reduced on Thursday 9th October.

Four members of the shadow committee were in favour of cutting Bank Rate by ½% in October while three favoured a more cautious ¼% reduction. This would deliver a ¼% reduction according to the voting procedures employed by the Monetary Policy Committee (MPC).

The two dissenters both favoured holding Bank Rate at 5% in October although one of the pair had a bias to ease in November. All but one of the rate cutters – who preferred to wait and see how the official takeover of Bradford and Bingley was financed – also had a bias to ease further in subsequent months and no one had a tightening bias.

There was a widespread view that the major financial failures of recent weeks, and some easing in the price of oil, had significantly altered the output inflation trade off facing the authorities but also that the traditional instruments of monetary policy were less effective under these circumstances. One member suggested that changes in the official discount rate were now of as much use as a peashooter in a major tank battle.

Comment by Tim Congdon
(Financial Markets Group, London School of Economics)
Vote: Cut by ¼%
Bias: To ease

The year since August 2007 saw banks reappraise balance-sheet management radically. The closure of the inter-bank market made holdings of cash and liquid assets relevant to management decisions in a way that had not been true for decades, while the fall in the market value of available-for-sale securities – along with more meaningful losses in parts of the so-called ‘banking industry’ (i.e., in the investment banks) – made the capital constraint on growth more serious than for some years. In these circumstances the decision framework for ‘monetary policy’ is broader than usual. Short-term interest rates are not the whole story. Base rates were 5% in late 2006 and early 2007, when credit and money growth were very high, and demand was growing at an above-trend rate; base rates are 5% today, credit and money growth have stopped, and the economy is about to enter a recession.

The intensity of the current crisis may be being exaggerated in the media. Nevertheless, both bank credit to and the bank deposits held by genuine non-banks are no longer growing, while corporate sector money has declined in the last year. If these trends continue, and output and employment start falling, I am in favour of

1. a temporary suspension, as well as a more long-term official review, of the Basle rules and International Accounting Standards Board (IASB) accounting rules which are (in my view) causing banks to ‘see ghosts’ in their balance sheets, and leading to an unnecessary crisis of supposed capital inadequacy, and

2. official readiness for the state sector (i.e., the government as well as the central bank) to purchase assets, ideally government paper, from both the banks (which would add to banks’ cash in the first instance) and non-banks (which would boost broad money directly), as well as

3. lower interest rates.

Note that the US government is in the midst of a major move (the US$700 billion bailout) similar to the second of these. But – instead of buying back government debt (i.e., debt management/funding policy) with cash – they are going to purchase some of the triple-A paper, largely held by commercial banks (including UK commercial banks), issued in the recent boom in structured finance, and replace this paper with government securities. I am normally in favour of action via government debt (as that has far less political significance), but in these circumstances the US Government’s actions will boost the prices of the triple-A securities and so help with the (supposed or actual) capital problem in the banks. (I take it the focus of the bailout will be mostly in triple-A paper, which – according to most serious commentators – is now under-priced relative to default risks. I doubt the Fed will buy the triple B stuff, etc.)

Lots to say. I’m in favour of a ¼% cut before the end of the year and further moves to lower rates in 2009, but a central objective of monetary policy now must be to stop the quantity of money (i.e., bank deposits held by individuals companies and genuinely non-bank financial institutions) from falling.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Cut by ¼%
Bias: To ease

The credit crunch has now clearly shown up in the UK monetary data as a sharp slowdown of bank lending to the non-financial private sector (which has slowed to 5.6% at a quarterly annualised rate) from double-digit rates in the recent past. Mortgage approvals have plunged to less than one third of their level a year ago. Money held by non-financial corporations has declined over the past year. The high spreads of inter-bank lending rates over Bank Rate imply even lower money and credit growth in the weeks ahead.

Elsewhere in the economy the downturn is intensifying rapidly. Jobless claims surged by 32,500 in August. The discomfort of consumers was increased by the jump in the headline CPI to 4.7% in August, and the continuing fall in house prices. The Nationwide and Halifax house price indices declined by 1.9% and 1.8% respectively for the month of August, and by over 10% year-on-year. In 2008 Q2, real gross domestic product (GDP) stalled, showing a zero increase on the first quarter. Forward-looking indicators such as the Distributive Trades Survey carried out by the Confederation of British Industry (CBI) suggest further significant weakening in the months ahead. It is therefore entirely possible that real GDP will see actual declines in the third and fourth quarters.

What are the authorities to do?

The UK Treasury, having presided over increases in government expenditure as a share of national income from 37% in 2000 to 45% in 2008, is now hamstrung by its own rules on borrowing and on the size of its debt. These rules should now be ditched, and the Treasury should be preparing contingency plans for a comprehensive stabilisation of the financial system. Over the past decade the Financial Services Authority (FSA) has passively allowed British banks and non-bank financial institutions to become excessively leveraged, the most visible counterpart being the massive borrowing ratios of UK households - higher even than US households. Yet, despite successive problems with Northern Rock, HBOS, and Bradford & Bingley, the Treasury and the FSA seem likely to pursue piecemeal nationalisation until a systemic breakdown threatens.

This leaves the ball firmly in the court of the Monetary Policy Committee (MPC) at the Bank of England. There is now no excuse for keeping rates at 5%. The commodity price bubble is over, and is unlikely to exert much further upward pressure on the consumer price index (CPI) in this cycle. Basically commodities are following the path taken by housing, commercial real estate, and equities. Each in turn was inflated by the credit bubble, but once they had reached unsustainable levels and/or credit had tightened appreciably, they lost value.

Yet the surge in commodity prices has made the MPC acutely nervous of a repeat of the 1970s style of cost-push inflation. However, such an extrapolation of recent events is likely to prove wide of the mark. First, monetary conditions in the 1970s were far more accommodative than they were even in the lead-up to the current episode of CPI inflation. Second, labour markets are now much less unionised. Third, the recent commodity price increases were simply the final stage of the transmission of earlier expansionary monetary policy through a series of asset markets starting with the credit and capital markets, then equities, and real estate to commodities. There could be some further impact on CPI measures (e.g. due to electricity price hikes), but these are residual effects, not the early stages of a new episode of inflation. In any case they are likely to be offset by falls in other prices as demand weakens.

With the sharp downturn in the growth of money and credit (in the bank and shadow banking system taken together), the abrupt slowdown in the economy, and the imminent slowdown in inflation, the Bank of England needs to take action to prevent economic prospects becoming even worse. Spillover effects from the broader, global economy are mounting -- from housing, from the credit crunch, from wealth effects, and from the reverse multiplier effects of financial sector de-leveraging. It is time for the MPC to cut rates.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Cut by ½%
Bias: To ease

The recent events in the financial markets defy hyperbole. The collapse in confidence and the freezing-up of the credit market call for radical policy responses. And US Treasury Secretary Paulson has been right to vigorously promote his proposed $700bn bail-out for the US banking system, whatever its shortcomings. Piecemeal fire-fighting is no longer an option and, quite simply, the banking system has a uniquely important function in an economy and cannot be allowed to collapse.

The rapid increase in inter-bank lending rates (and associated rise in the cost and availability of credit to business and households) since the onset of the financial crisis on 15th September has more than reversed the recent easing in the UK. And access to credit for some household (including funding for mortgages) and corporate borrowers has become more restricted and expensive. Unless there is a rapid return to financial ‘normality’, which seems highly unlikely, this strikes me as essential.

Of course, CPI inflation is still rising, not least of all because of the increases in gas and electricity prices in our chronically vulnerable energy sector, and the weakness of the pound adds to inflationary pressures. But commodity prices, especially oil prices, have now fallen and there is no sign that a “wage-price” spiral is emerging.

Unemployment is now rising quite significantly. CPI inflation should peak over the next two to three months and then fall quite rapidly in 2009. Moreover, Mervyn King has made it abundantly clear that the “MPC is aiming to return inflation to the 2% target within its normal forecast horizon of around two years”. The MPC has time to achieve their target without losing credibility.

The threat to the economy is now recession, not rip-roaring inflation. And this has been exacerbated by the current exceptional events in the financial markets. Whilst I would normally be reluctant to cut rates when CPI inflation is rising, I now favour a ½% cut, and have a bias to further easing.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: To ease

‘If you wanted to get to Dublin I wouldn’t start from here’ is the type of advice currently being given by those who believe that interest rates have to stay on hold further (or even rise) to restore the Bank’s credibility. The financial system is on the edge of a precipice and if confidence is not restored rapidly it is only a matter of time that the apparent slowdown in the real economy develops into a painful recession. The economy is slowing, sales have flattened out and output has declined on a three-month basis.

Forward rates do not suggest a loss of inflation control in the medium term and indeed medium-term inflation expectations derived from gilt yields have fallen since the previous month. The only other forward indicator of inflation is sterling which admittedly has depreciated 15% over the past twelve months but this could also be explained by real factors that require a rebalancing of the economy away from domestic demand. Spreads in the interbank market have widened despite the concerted efforts of the Bank to inject liquidity and are unlikely to come down while commercial banks conserve cash. It is still not too late for the Bank to be ahead of the curve by signalling a willingness to manage a smooth slowdown. My recommendation is to cut by ¼% in October with a bias to further cut before the end of the year.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ½%
Bias: To ease

Forget all the hand-wringing, cries of ‘greed’ and other point-scoring. This is just another of the many historical episodes of capitalist bust. The bust happens to be in the financial sector; but then so was for example the collapse of the US thrifts (aka home mortgage companies of that time) that resulted in the 1989 Resolution Trust Corporation (RTC). Even the numbers are not dissimilar; the US put some 5% of GDP into the RTC, today Paulson’s proposed sum of $700 billion is about the same percentage of GDP. As it happens, the US government made no serious loss on the RTC which managed to dispose of its assets advantageously over calmer times. The same could occur again. Underpinning the attitude of the Fed and the US government lies their predecessors’ experience of another great financial bust: the crash of 1929 and its sequel in the collapse of one third of the US banking system and the Great Depression. Just as Walter Bagehot concluded from 19th century experience that lender of last resort action by the central bank was necessary, so today’s US authorities have concluded that the financial system cannot be allowed to collapse. The fact that that system has extended so widely to embrace a host of new financial intermediaries has merely extended the scope of today’s lender of last resort requirements.

This tells us that finance and banking are too important to the rest of the economy to be allowed to collapse like any other sector - be it dotcoms, telecoms, railways, or bits of manufacturing. Partly this is due to modern politics: ordinary people’s deposits, savings and yes houses must somehow be kept safe by the politicians. The implicit political compact of democratic capitalism is that markets can be free, the high rollers of the market economy free too to make and lose large amounts, but in return the ordinary voter must have some basic guarantees, among them that their finances will be protected. Partly it is due to the key role of finance in the capitalist machine. As we see currently in the UK housing market, if finance withdraws from a market more or less totally (apart from existing contracts), the market freezes up; if this went on for very long, the market would have to reorganise itself on a quite different model, with only large players or wealthy people holding housing and the rest renting. This is very far from the ideal model of ‘complete contracts’ in which people can smooth consumption across contingencies.

One could imagine a world of free financial markets without any implicit public guarantees; it would be one in which there was a restoration of massive caution with financial firms selling themselves on safety to a preeminent degree. However there is not much point in thinking long about it since it is not on offer. Given then that we have had this financial crash and that modern political economy mandates governmental involvement, then as Macbeth puts it, ‘If ‘twere done, ‘twere best done quickly.’

Whatever the detailed faults of the Paulson plan, and no doubt there are many such, it has the merit of speed and totality. It offers the hope that the financial system, its currently blighted assets removed, can get back to normal business fairly soon. That business is lending and taking calculated risks, approximating to a competitive market with a lot of players. Because many of the competitors have fallen recently by the wayside, that approach will require government to twist the arms of those who have been helped to survive to simulate competition until competition arrives again over a matter of years.

In the UK the authorities have a weak record over this crisis. There need now at last to be cuts in interest rates. Furthermore, the remaining financial firms need to be bullied into behaving as if there was competition. Lloyds TSB has now swallowed HBOS, against competition advice from the past - the crisis impelled it. But it cannot be allowed to sit back, raise its margins and curb lending business. The Bank of England’s liquidity scheme has been extended; it may need to be widened and taken over by the Treasury on the US model.

The point really is that the UK government too needs to be more proactive in this crisis. The costs to the taxpayer and the economy will ironically only be the greater if it sits on its hands, moaning about ‘moral hazard’. That way lies the continued freezing up of the housing market, of small firm participation in the economy and of innovative activity generally. One only needs to look at Japan since 1990 to see a model of this sort, not on any account to be followed.

The outlook in the UK is now dominated by the freezing-up of the credit market. If this is allowed to drift on for some time, a serious recession is unavoidable. With cuts in interest rates and pressure on the remaining banks to lend more normally, together with a government package enabling the banks to do so, recession would be quite avoidable.

My basic forecast assumes that something approximating this occurs. However, the reactions so far from the Bank of England and the UK Treasury suggest that policy may well not move along this trajectory. Instead we may have a prolonged credit freeze, with market rates remaining high and large numbers of borrowers with out physical collateral simply denied credit altogether. I have accordingly done an an alternative forecast on these assumptions. This shows a sharp recession in 2009. At this stage the main forecast is still the most probable - just, say 40% against 60% for the main one. In the next few weeks it will become much clearer which way the dice will fall.

Finally, some repeat of previous comments on inflation. First, the general world slowdown and the tightening of monetary policy in emerging market countries are reversing the commodity price explosion and bringing world inflation at last under some control. Secondly, wage growth remains muted as I have argued it would - both because of embedded expectations about monetary policy and because external terms of trade shocks cannot be offset by wage increases. Hence my forecast for inflation is that it will fall in 2009 back towards 2% rather fast. My proposal for interest rates is: a ½% cut, with a bias to cut further.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Cut by ½%
Bias: Wait and see how the nationalisation of Bradford & Bingley is financed.

British monetarists have traditionally argued that it is money and not credit that matters. When someone borrows to purchase an asset two transactions take place. First they borrow to obtain the finance. Second they use the money so obtained to purchase the asset. When they spend the money it is not destroyed but merely passes to the seller of the asset. Money is like the hot potato of the children’s game - one person can pass it to another but the group as a whole cannot get rid of it. The result of the credit boom prior to 2007 was excessive growth of the money supply, which led to asset-price inflation and a financial bubble. Since mid-2007 the whole process has gone into reverse. Worse still, a downswing is not symmetrical with the previous upswing. The process becomes asymmetrical when the value of asset prices falls to a level at which the value of collateral in general is no longer sufficient to cover the bank loans being secured. The result is called debt-deflation.

There are various weapons the authorities can deploy but there are two ‘liquidity traps’. First the MPC can cut interest rates but they cannot be reduced below zero. Second the Bank of England can make sure that banks have abundant reserves but banks may not have the confidence to use them even if capital requirements are eased. The third weapon is for the government to underfund, that is, sell less debt than is needed to cover the budget deficit, which boosts the money supply directly. The weapon of last resort is for the government to purchase assets and not issue gilt-edged stock to pay for the purchases (see: ‘Money, Bubbles and Crashes: Should a Central Bank Target Asset Prices’, Gordon T Pepper and Michael J Oliver, Chapter 10 of ‘Issues in Monetary Policy’, eds. Matthews K. and Booth P., Wiley, 2006.)

Currently monetary growth after allowing for distortions has collapsed during the last three months. The growth in nominal terms has been virtually zero In real terms, that is, after allowing for inflation, the money supply is now falling. If this continues the outlook for the UK economy will be dreadful. The time has come to take urgent action.

If interest rates were the only weapon being deployed I would be arguing for an immediate cut of 1% combined with a pre-announced series of two ½% reductions, unless evidence to the contrary occurred. Bradford and Bingley is however being nationalised. At the time of writing we do not know how the nationalisation will be financed. In the old days a gilt-edged stock was issued to finance each industry being nationalised. Currently the weapon of last resort would be being deployed if the government does not issue gilt-edged stock to pay for the nationalisation of Bradford and Bingley. It would then be printing money to offset banks’ failure to supply credit. My conclusion therefore is to argue for an immediate ½% cut in interest rates and then waiting and seeing until we know how the Bradford and Bingley takeover is financed.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: To ease

With the banking sector in crisis and market rates now 120 basis points above Bank Rate the market has further tightened monetary policy. There is a good argument for cutting the base rate to offset this tightening and ease the pressure on the profitability of mortgage lenders and other money market borrowers. Yet with CPI inflation well above the target range and rising, this could still give the wrong signal, indicating that the Bank was relaxing its grip on inflation. I am also concerned that the core inflation rate has increased to 2% and is following the headline rate up. This suggests that, despite the sharp slowdown in the economy, many firms are still finding it possible to pass on cost increases.

This situation is extremely difficult, but I am inclined against a rate cut this month, on the view that the authorities should first try to resolve the crisis in the banking markets by other means, for example by allowing the stronger banks to take over the weaker ones. Nationalisation is another option as is an extension of the Special Liquidity Scheme (SLS). A base rate cut should only be used as a last resort at this juncture. However, the economy is slowing rapidly and inflation is likely to peak over the next month or two, allowing Bank Rate to be eased back safely in November.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Neutral

The collapse of several financial institutions on both sides of the Atlantic since last month, some modest further easing in the price of oil, and the apparent stabilization of the external value of sterling – albeit at a level some 10½% lower than a year earlier – suggest that the balance of risks has changed radically from one where constraining inflation should be the overriding priority to one where fire fighting the problems in the financial markets has to take precedence. However, it is well known that the efforts of firefighters to tackle a blaze often do more collateral damage than the fire itself.

The long-term economic (and, arguably, constitutional) consequences of giving untrammeled powers to politicians and bureaucrats in the US and Britain as a response to the immediate financial crisis need to be borne in mind. Politicians (and even clergymen) are now arguing that the global financial meltdown is the result of unregulated financial capitalism. However, what makes current market events so frightening is that no-one knows the true value of the underlying assets involved because of the packaging of numerous small loans into marketed securities. This happened because the Basle agreement provided perverse incentives to push lending off balance sheet to evade its capital requirements.

The original 1988 Basle agreement was partly responsible for the global recession of the early 1990s - because it made it less profitable for the world’s banks to lend money to the private sector and induced a global credit crunch. Thus, it is arguable that both the previous and the looming global downturn were caused by misguided regulation as much as they were by the excesses of financial markets. One must also wonder why central banks did not tighten policy two or three years ago - when confronted with accelerating money and credit growth and other symptoms of an excess supply of money - and also why they did not consider devices such as the imposition of mandatory liquidity ratio requirements on deposit taking institutions.

This is all water under the bridge. Even so, while just about any measures might be justified in the short-term to stabilise the financial situation, it is important to consider whether internationally co-ordinated regulatory initiatives do more harm than good. The other lesson is that changes in the official discount rate have proved to be about as much use as a pea shooter in a major tank battle. The US Federal Reserve’s decision to hold Federal Funds rate unaltered at 2% on 16th September, while the US Treasury was simultaneously putting together the huge bail out package announced on the 18th implied that the Federal Funds rate was now of little practical relevance. It also suggested a decisive shift in power from the US Federal Reserve to the US Treasury.

Likewise, the nationalisation of Bradford and Bingley (announced on 27th September) together with the earlier takeover of Northern Rock suggests that senior politicians and HM Treasury are now the dominant players in UK monetary policy and that the MPC’s decisions have almost become a sideshow.

Under these circumstances, Bank Rate has become a dignified part of Britain’s monetary constitution as distinct from an efficient one. Its main purpose seems to be to signal the relative importance that the authorities attach to stabilising the financial markets compared with fighting inflation. If the former is the main priority, then there seems little point in making trimming adjustments and a ½% or even a 1% cut in Bank Rate on 9th October would appear to be the most sensible course.

However, UK inflation has consistently exceeded market expectations in recent months with the result that annual CPI inflation is now more than twice the 2.2% consensus forecast for 2008 Q4 made at the start of this year. Furthermore, Britain was one of the few countries that saw its CPI inflation rate accelerate in August (from 4.4% in July to 4.7% in August) while elsewhere there were modest decelerations – from 4% to 3.8% in the case of the Euro-zone and 5.6% to 5.4% in the US, for example. This may be partly because of timing effects, particularly where energy costs are concerned. But it may also reflect the fact that domestic inflation is accelerating away from that in the rest of the world because of the weak pound.

Lower house prices meant that ‘headline’ inflation eased from 5.3% in July to 5.2% in August, while the annual increase in RPIX fell from 5.0% to 4.8%. However, ‘double-core’ retail price inflation, which excludes both mortgage interest payments and house prices, was unchanged at 5.5% in August. On balance, I would rather hold Bank Rate than reduce it until there is more evidence that Britain’s inflation rate has lost the capacity to spring nasty surprises. Longer-term, the uncertainties are such that ‘wait and see’ appears the only viable policy and there seems little point in having an explicit bias. Events are now in command, not the monetary authorities.

Comment by Peter J Warburton
(Economic Perspectives Ltd)
Vote: Cut by ½%
Bias: To ease

In recent weeks, the global financial crisis has deepened and the approach of the end of the third quarter has set the scene for another spike in interbank interest rates. The Sterling three month London Inter-Bank Offered Rate (LIBOR) rose to 6.27% on 25th September, compared to 5.7% just prior to the collapse of Lehman Brothers earlier in the month. The recent merger of Lloyds TSB and HBOS is another stunning development in the UK banking system. However, respected banking analysts consider this new group to be significantly under-capitalised. The Chancellor of the Exchequer has revealed that the Special Liquidity Scheme has been used to a much larger degree than expected at its inception last April. The Governor of the Bank of England agrees that the scheme must be continued and has proposed a permanent liquidity insurance facility. Finally, at the time of writing, the US Treasury’s proposal that up to US$700bn be used to purchase troubled assets awaits approval by Congress. Leading UK banks would be eligible to participate in the Troubled Asset Relief Program (TARP) to the tune of US$175bn.

Despite the dramatic events that have unfolded during September, the main thrust of official responses to the crisis is the provision of temporary relief through the use of liquidity injections or the temporary nationalisation of troubled institutions. There is a wholesale reluctance to acknowledge that large swathes of the non-bank financial sector are either insolvent or likely to become insolvent in the near future. Almost every initiative to provide temporary support since the crisis became public in August of last year has been renewed and extended in size and scope. If this were primarily a crisis of liquidity and confidence, then these large infusions of funds would surely have stabilised the financial system by now. Instead, this pulsating credit crunch has undermined more and more contexts within the global financial system.

The most urgent remedy must surely be the recapitalisation of commercial banks and other strategic financial institutions. Specifically, the Bank of England should expand its balance sheet in order to inject capital into these institutions. While the quantitative dimension of monetary policy has become the more important, a lower Bank Rate should surely accompany such measures. In reducing the cost of retail funds to the banks, an important and obvious means of improving their profitability is achieved. As property and equity prices fall further, there is a clear expectation that banks and other financial institutions will need to write down the value of assets on their balance sheets for some quarters ahead. If the UK is not to suffer the freezing up of its retail and wholesale deposit systems, then this recapitalisation process must begin urgently.

UK monetary policy has been inadvertently and unintentionally restrictive for more than a year. Bizarrely, the minutes of recent MPC meetings present the inflationary and deflationary risks as finely balanced, even as the domestic credit system atrophies. The number of loans approved for house purchase fell to 33,000 in July from 114,000 a year ago. The scarcity of time deposits has bid up their interest rates from 5.12% last July to 6.32% this July. An immediate cut in Bank Rate of ½% is justified, with further cuts in the near future.

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (Visiting Fellow, London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group), and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

In its latest monthly E-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted by seven votes to two that UK Bank Rate should be held at its current 5% on Thursday 4th September.

The two dissenting members both favoured a ½% reduction to 4½%. The bare vote understates the underlying ‘dovishness’ of the shadow committee, however, since both cutters had a bias to ease further, five holders believed that the next move in rates should be downwards, and only two of the holders had a bias to tighten.

Several SMPC members drew attention to the downwards revision to UK national output in the second quarter, which suggested growth was weaker than earlier believed. However, there was also concern that the Bank of England’s credibility would suffer if interest rates were reduced at a time when it was still uncertain when - and at what level - inflation would peak.

One member was concerned about the limitations that the UK’s lax fiscal stance placed on the MPC’s freedom of manoeuvre. There was a general acceptance that this was an unusually tricky period for monetary policy makers and that the inflation outlook was heavily dependent on the essentially unknowable future price of oil.

Comment by Tim Congdon
(Financial Markets Group, London School of Economics)
Vote: Hold
Bias: To ease

Money supply growth – after adjusting for deposits created by lending between banks and within banking groups – is falling sharply. The result is a severe squeeze on UK companies’ liquidity, similar in character – if not yet in intensity – to that in the mid-1970s, the early 1980s and the early 1990s. Takeover activity has slowed dramatically, and companies are shedding land and subsidiaries to keep their balance sheets under control. Falls in share prices and property values are exerting adverse wealth effects on demand, and the outcome is likely to be at least two quarters of falling domestic demand and (depending on net exports) output.

But a recession isn’t really needed. Even in late 2007, which was the peak of activity in the cycle now coming to an end, labour shortages were mild. Output must be roughly in line with trend and, given the latest money numbers and business survey indicators, will be 1% - 2% beneath trend by late 2009/early 2010.

Inflation must now be near its peak. I accept that an immediate cut might have some untoward effect on inflation expectations and the public’s perception of the Bank of England’s seriousness. Nevertheless, unless the pound weakens dramatically in the next two or three months, I am in favour of at least one 25 basis point rate cut before the end of 2008, and believe that Bank Rate should average about 4% in 2009.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: To ease

Having mistakenly allowed banks, non-bank financial companies, non-financial corporations, and households to leverage up their balance sheets in the period 2004-07, the Bank of England now finds itself in the uncomfortable position of having to supervise the deleveraging of all those balance sheets - an inherently deflationary process - while trying to prevent too sharp a contraction in nominal spending.

Fundamentally there are only three ways to deleverage or repair balance sheets. First, banks and companies can raise capital (although households cannot). However, banks’ and companies’ ability to raise capital depends on potential subscribers having a positive view of their prospects – a view that is not widely shared in financial markets at the onset of a recession. In addition, with all the major domestic sectors over-leveraged, the only obvious source of net new capital will be overseas. In any case, aside from the Governor urging banks to raise capital as he did earlier this year, there is little the authorities can do to accelerate the raising of new capital.

Second, assets can be sold and the proceeds used to pay down debt. But firms and households generally resist asset liquidation because nobody wants to sell assets into falling markets. Although they may be able to procrastinate for a while, eventually denial turns into acceptance, and the process is reluctantly started. Again, the authorities have little to contribute to the process and can only watch passively.

Third, balance sheets can be repaired by generating earnings. For households, repairing their balance sheets by earning their way out essentially means cutting consumption and/or raising savings. Both will exacerbate the economic downturn. Banks and companies can earn their way out by generating profits that strengthen their balance sheets, but this takes years and requires a strongly positive yield curve to enable them to generate earnings substantially greater than their cost of funds. Here the authorities can facilitate the process by cutting short-term interest rates, but they must be careful not to trigger a renewed round of increased leveraging and spending that would exacerbate inflation. When will it be safe to cut rates without triggering such effects?

In my judgement, it is too early to assume that easier credit conditions will not result in adverse “second round” effects on inflation (e.g. via higher wage demands) and inflation expectations. Although, based on the latest (June) figures, money and credit growth have shown some deceleration (particularly non-financial corporate holdings of M4), inflation from the earlier period of rapid money and credit growth is still working its way through the system, and there are as yet few signs of excess capacity either in capacity utilisation or in the labour market. Accordingly, the Bank should keep rates on hold until there are more widespread signs of a larger output gap (actual output below potential output).

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Hold
Bias: Strong bias towards easing

The economic mood has darkened considerably over the past month. The Bank of England’s August forecast was much gloomier than in May (which, in turn, was much gloomier than in February). The Bank expects output to be broadly flat (year-on-year) in the first half of 2009 – which clearly suggests that there may be a couple of quarters of falling output.

The UK Office for National Statistics (ONS) made a significant downward revision to its 2008 second quarter GDP figure – from a preliminary estimate of a 0.2% quarterly increase to no change. The latest ONS data show that domestic output fell in both the first and second quarters of this year and only a drop in imports had prevented GDP going into negative territory. Fixed capital formation fell over 5% in the second quarter. Granted, these figures are likely to get revised again at the time of this year’s ONS Blue Book (September), so there is an element of “flying blind” in analysing the economy, but the downward revision cannot wholly be dismissed. The economy is clearing skirting recession and there is a rising probability that output will indeed fall in the second half of this year.

Even though consumer price index (CPI) inflation is expected to rise to around 5% in the second half of this year, there are few signs that wages inflation is picking up. Indeed earnings inflation is, if anything easing. With unemployment picking up and trade union power limited in its potency, employees appear to be accepting falling living standards. Oil prices have eased significantly in dollar terms and, even though the impact of oil prices will be dampened in sterling terms as the pound falls against the dollar, this should help the overall CPI numbers in the coming months. I would be reluctant to cut rates when CPI inflation is rising and the pound is falling. But I would have no hesitation to cut by ½% if the economic data continue to worsen.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: To ease

The current inflation spike will pass, and within a couple of years we may be worrying about misses of the inflation target at the bottom end, especially given the fall-off in (adjusted) broad money growth, the rapid slowdown in aggregate demand as the economy goes into probable recession, and the disinflationary effect of rapidly falling house prices. In that sense the money-quantitative work is already done, and policy could afford to be up to 100 basis points looser. However, inflation is currently far above target, and likely to rise further yet. In my view, a cut at this stage would tend to raise already-elevated inflationary expectations still further and undermine what little confidence remains in the public sense that the Bank of England is in control of events. This might potentially lead to wage rises over this winter that could be disastrous in terms of their impact on unemployment in an economy perhaps in recession, causing recession to be deeper and the negative effect on aggregate demand - and hence on the risk of deflation - worse.

Consequently, I am still of the view that it is too early to cut. Indeed, I would still not dismiss altogether the case for a quickly-reversible interest rate rise, implemented for pure signalling reasons at some point in the autumn if the headline inflation rate continues to rise markedly. Once the peak in inflation is passed, however, I shall very probably favour deep and rapid cuts, with a preference for rates reaching 4% in the Spring and perhaps 3.5% or even 3% by the end of 2009.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ½%
Bias: To ease

It now looks as if monetary tightening is taking effect in many emerging market countries; this has been helped by the recent strengthening of the dollar which means these countries no longer need to buy dollars and print more money in the process. Indeed they may even do the opposite which will assist tightening. Credit conditions have tightened in the developed world of course. Hence world monetary conditions are now unambiguously tightening; and this is starting to reverse the commodity price boom and slow world inflation.

The dilemma as seen by the Bank has been that there has seemed until recently to be little sign of any let-up in world inflation. Faced with this prospect, the Bank was uncertain how domestic inflation would respond; this uncertainty was most clearly articulated by Tim Besley, the one Monetary Policy Committee (MPC) member who voted for a rate increase in the last meeting. Now matters are a bit clearer. Wage increases have actually fallen - to 3.4% - and are therefore signalling that domestic inflation is unlikely to respond. In addition world monetary tightening has begun to reverse commodity prices which are now falling.

I have argued before that there was little likelihood that domestic inflation would respond because of wide understanding of the inflation targeting regime. In practice UK monetary tightening has further guaranteed that it would not - policy has been cautious because of the perceived uncertainty just described. Under inflation targeting we should not be misled by the sharp terms of trade movements that have occurred because of world overheating. It is well understood that these will raise consumer prices and lower living standards - what else could they do? But rational working households are unlikely to want to compound their misery by losing their jobs and demanding offsetting wage increases- even less so when the cost of credit is high and rising. Thus, and contrary to forecasts based on 'broad money' however defined, there has not actually been any domestic inflationary rise. As the Bank notes in its last Inflation Report indicators of long-term inflation expectations have not moved from 2%.

It is now time for the Bank to reduce the cost of credit to avert the risk of a severe downturn in the UK economy. Everyone has now fully discounted the prospect that the CPI inflation rate will rise to around 5% before it starts to drop back down to the 2% target. Real interest rates - eg the real mortgage rate - if one adjusts by the underlying inflation prospect, are now running at 5% or so, and that is to good-quality borrowers. Availability to lower-quality borrowers, whom a properly-functioning market ought to cater for, seems to have dried up entirely except at quite penal rates.

In its latest press conference, the Bank appears to have suggested it lacks any capacity to control the economy: that the prospect of recession is one it has no power over. This is frankly incredible and threatens to undermine the Bank's independence. Politicians of both left and right will argue that if the Bank will not use its powers responsibly as the Act suggests to reach its inflation target without damaging growth, if that can be done, then it is not fit and proper to be in charge of monetary policy. With growth having stalled in the second quarter and domestic demand apparently falling, it is time now to take some counteracting action on interest rates, given that the inflation risks are diminishing. I would support a cut of ½% now, with a bias to cut further.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Stand ready to lower interest rates sharply.

The seeds of inflation or disinflation are sown about two years before the inflation or disinflation materialises. Two years ago monetary growth correctly warned that a rise in inflation was on its way but, as usual, not the precise timing or the exact way in which it would occur. The MPC can be severely criticised for not paying attention to the warning from the behaviour of the monetary aggregates and, predictably, for raising interest rates by too little too late when the first signs of rising inflation occurred.

Currently, the published data for the monetary aggregates are not suggesting that substantial disinflation is in the pipe line. The data are however seriously distorted by special factors. The situation is somewhat similar to the second half of 1980 after the constraint on banks’ growth of interest-bearing-eligible liabilities (the so called ‘corset’) was scrapped. The published data for the money supply were distorted upward as the previous distortions caused by the corset unwound and the Treasury thought that money supply policy was expansionary when it was in fact tight. Currently, there has been a sharp fall in underlying monetary growth, indicating that there is no need for interest rates to be raised further. The credit crunch is doing the MPC’s dirty work for it. The result will most probably be overkill.

The immediate task now is to minimise the pain of the coming recession. The trade unions are almost bound to claim higher wages in an attempt to protect their members’ real incomes. The more they succeed the worse and more prolonged will be the pain. A reduction in interest rates now would be likely to encourage trade union militancy and therefore increase the pain. Interest rates should accordingly be left on hold for the moment but the MPC should stand ready to reduce them sharply. There is a danger that last year’s mistake will be repeated and rates will be changed by too little too late on the way down as they were on the way up.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Tightening

There have been four developments since last month that have potential consequences for British interest rates.The first is the downward revision of 0.2% to the level of UK real GDP in the second quarter and of 0.3% to OECD GDP in 2008 Q1. These revisions suggest that the outlook for both domestic and international growth is weaker than it appeared previously. The current figures show that the year-on-year growth of UK real GDP fell from 3% in 2007 to 2.3% in 2008 Q1 and 1.4% in Q2, while OECD growth slowed from an annual average of 2.7% last year to 2.5% in the first quarter of 2008 and 1.9% in the second quarter. In the light of the revised data, it now seems likely that UK growth will average around 1½% this year, 2% next year and not quite 2% in 2011 and 2012. However, the ONS has not re-balanced the national accounts since mid-2006 (this used to happen annually in late June). There is correspondingly a strong possibility that the whole UK forecasting profession, including the Bank of England’s staff, will be wrong footed when the re-worked national accounts are released on 30th September.

The second major development has been the publication of dissapointingly high ‘headline’ inflation numbers for a number of countries. Annual US CPI inflation accelerated to 5.6% in July, when Euro-zone inflation was 4%, and even ‘deflationary’ Japan experienced an inflation rate of 2% in June.The acceleration in UK CPI inflation to 4.4% in July once again seems to have caught the London financial markets by surprise. But it does not look so out of line in an international context. OECD inflation was also 4.4% in June - the July figure will appear on 2nd September. However, the acceleration in UK ‘headline’ RPI inflation to 5% in July, and the pick up in RPIX inflation to 5.3% looks rather more excessive. The ‘double-core’ RPI, which excludes both mortgage interest rates and house price depreciation and is the most consistently defined UK inflation measure over time, showed an annual rise of 5.5% in July, compared with 4.9% in June. Fortunately, the third major piece of news has been the declines in the price of oil – which fell from a peak of US$146.1 for a barrel of Brent crude on 3rd July to US$114.6 on 26th August – and non-oil commodity prices, with the weekly US$ index published by The Economist magazine dropping by 12.5% between its 1st July peak and 19th August. These developments suggest that inflationary pressures could abate once lower input costs have worked their way down the production pipeline.

The fourth important development was the revelation that UK public sector net borrowing (PSNB) was £11.0bn more adverse in the first four months of fiscal 2008-09 than it had been a year earlier and the cumulated public sector net cash requirement (PSNCR) was worse by £13.0bn. Annualising these differences and adding them to the 2007-08 outcomes would yield a PSNB extrapolation of £68bn for 2008-09 and a PSNCR of £66.4bn. This is almost certainly too gloomy and the latest Beacon Economic Forecasting (BEF) model-based forecasts are for a £51¼bn PSNB and a £50½bn PSNCR this year. Nevertheless, these remain horrifying borrowing figures for an economy which has only experienced the early stages of recession so far. The enormity of the budget deficit implies that the policy inconsistency between the lax fiscal stance and the MPC’s inflation target is a constraint on future rate cuts. The fact that monetary policy and fiscal policy are institutionally separated in Britain does not mean that they are economically separated, or that the MPC can ignore the adverse consequences of high tax and regulatory burdens for the supply side of the economy.

The continued downwards drift of sterling, which was 13.1% lower on 26th August than it had been a year earlier, suggests that international investors are becoming increasingly wary of investing in the UK. One reason appears to be the fear that the political background will lead to even more fiscal debauchery over the next two years. The fact that Britain has a small open economy also means that the inflation consequences of any sustained depreciation of the currency are likely to be stronger than would be the case with a large continental economy such as the US or the Euro-zone. Overall, it seems reasonable to keep UK borrowing costs on hold this month. However, there is little justification for a cut until it is clear that inflation is nearing its peak and it is possible to have some feel for how high that peak is likely to be. Reported ‘double-core’ RPI inflation has accelerated by 2.1 percentage points since UK Bank Rate was cut to 5% on 10th April and CPI inflation has risen by 1.9 percentage points. This represents a substantial cut in the real rate of interest. As such it probably represents an adequate easing in monetary conditions, especially as the trade-weighted sterling index has come off by 1.8% since 10th April. Longer-term, my bias to tighten remains. Even so, the recent fall in the price of oil has improved both UK and international inflation prospects. On the cautious assumption of a US$119 oil price, CPI inflation is expected to ease to just over 3½% in the final quarter of 2009, 3% in late 2010, and just over 2½% in late 2011. That would represent three years of target busting price increases, however, and one must have reservations about the credibility of the current institutional framework under these circumstances.

Comment by Peter J Warburton
(Economic Perspectives Ltd)
Vote: Cut by ½%
Bias: To cut

Every week that passes brings confirmation of the debilitating effects of the credit spasm on the UK economy. The release of the output, income and expenditure accounts for the second quarter of 2008 lays bare its constricting impact. In the nominal accounts, GDP at market prices rose at a 3.5% annualised rate in the first half of 2008, down from 6.0% in 2007, emphasising the deflationary impact of the crisis. The proper focus of domestic monetary policy is the current and prospective inflationary climate of the whole economy, not merely the consumer sector. It is true that consumers’ expenditure shows a 6% annualised pace of growth in the first half, higher than the 5.6% increase for 2007. But, for domestic final expenditure in total, the equivalent comparison is 2.5%, down from 6.2%.

It is deeply regrettable that the MPC should regard the prevailing annual inflation rate of the CPI as an obstacle to the immediate easing of policy. The 4.4% rate of CPI for July, possibly to become 5% at its imminent peak, is spilt milk and not worth crying over. What we have learnt in the past twelve months is that an inflation target is no substitute for a controlled expansion of broad credit and broad money. The bitter twist is that such control can no longer be achieved reliably within a national context. Until the global credit system is exposed either to market discipline (preferable) or regulatory discipline, inflation targeting has no future.

The MPC should not worry about its loss of credibility in relation to the 2% inflation target. It will suffer far greater criticism, justifiably, if it fails to react to the intensification of the credit crisis. Nor should it fret over the forthcoming negotiations over public and private sector pay awards: the economic pressures are so great as to deny the feasibility of faster earnings inflation. Public sector finances have deteriorated alarmingly in the past six months, leaving no scope for concessions. Public sector employees should expect to take a real pay cut in these circumstances.

The August Inflation Report highlighted several disturbing aspects of the economic constriction. The abrupt loss of household confidence in employment and earnings prospects and the sharp deceleration in corporate money balances underline the severity of the situation and the urgency of response. Domestic credit conditions are demonstrably tight, with the cost of borrowing generally higher for households than a year ago and little changed for corporations. A Bank Rate cut of 100-150 basis points over the next three months would seem to be the appropriate scale of adjustment if a material impact on end-user borrowing costs is to be achieved. To reiterate, the deceleration of the nominal economy that is in progress will be more than sufficient to deliver the CPI inflation target by end-2009. The MPC’s indecision risks a far more destructive outcome for real activity.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: To tighten

The debate about what to do with interest rates is getting even more intense, with the MPC itself split three ways. But the facts seem to speak for themselves. Growth in the economy is slowing sharply but it is not yet in recession, though it does seem possible there could be a modest fall in the third and fourth quarters of this year, meeting the definition of technical recession. The credit crisis continues, with banks tightening credit spreads and hoarding cash and not lending to each other as freely so keeping interbank rates well above central Bank Rate. This has hit mortgage markets much more than any other sector. Company surveys suggest that the availability of credit is not as much of a concern as weak demand conditions and the general economy. But industrial output has slowed sharply in the last few months, explaining why overall economic growth has slowed.

Firms appear to have taken the fall in the currency in profits margins rather than trying to expand market share in overseas markets, but domestically retail sales have also weakened in the last two months. However, inflation is still the main risk facing the economy and has increased, not abated, in recent months. Weak - below trend - economic growth is required and necessary to keep inflation from rising even faster. Annual money supply growth has stopped declining and published M4 grew by 11.2% in the year to July. With inflation yet to peak and core CPI rising and set to rise even further into next year rather than decline as many seem to expect, interest rates have to be maintained at what are still relatively low levels in order to keep inflation expectations down. Although unemployment is rising and wage inflation is low, this is necessary to prevent a rise in rates and is not a reason for cutting them.

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (Visiting Fellow, London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group and Global Vision), and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

Following its latest quarterly meeting (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted to leave Bank Rate unchanged on Thursday 7th August. In particular, six members of the shadow committee voted for rates to remain on hold, while three members voted to cut the official interest rate by ¼%.

The bare vote understates the underlying ‘dovishness’ of the shadow committee, however, since all three cutters had a bias towards further reductions, three of the holders had a bias to cut aggressively in future months, and a further holder had a bias to ease. In contrast, only two of the SMPC members who voted to hold Bank Rate on 7th August had a bias to tighten in subsequent months.

The SMPC is a group of independent economists, who assemble quarterly at the Institute of Economic Affairs (IEA) in Westminster to monitor UK monetary policy. The inaugural SMPC meeting was held in July 1997 and the Committee has met regularly since then. That it is the longest established such body in Britain, and that it meets physically to discuss the deeper issues involved, distinguishes the IEA’s SMPC from the similar exercises now carried out by a number of publications.

At its latest meeting, the IEA’s Shadow Monetary Policy Committee (SMPC) voted by six votes to three to keep UK Bank Rate at 5% on 7th August. All the members of the SMPC were concerned about the current UK economic situation. Rising inflation and collapsing indicators of real activity presented the MPC with a difficult dilemma – though most members regarded this as a dilemma largely of the MPC’s own making.

The grim prospects for future inflation led most members to want to hold interest rates. However, there was a significant minority who wanted to cut rates now as a result of the worsening situation. One of the “cutters”, Patrick Minford described the Bank of England as showing a “total lack of leadership”.

The majority who wanted rates to be held were concerned at the signals a cut in interest rates would send to the markets when the inflation outlook was worsening. A cut in interest rates now, it was argued, would lead to inflationary expectations rising and, if this in turn led to a rise in wages, any recession would be made worse. Trevor Williams, Chief Economist, Lloyds TSB Corporate Markets, argued strongly that the Bank needed to restore credibility and keep rates at their current levels.

Most of those who wanted to hold interest rates now wished to cut Bank Rate in the near future – some of them aggressively. Collapsing monetary aggregates, after making appropriate adjustments for problems in the inter-bank market, were viewed with great concern by several members of the committee. This view was summed up by John Greenwood, Chief Economist at Invesco, who commented, “The money numbers are starting to fall. Bank Rate should remain unchanged in August but with a bias to cut aggressively further out.”

The Monetary Situation - Balance sheets in repair in the USA – inflation now but deflation next.

John Greenwood referred to the presentation charts (Editorial Note: these are available from john_greenwood@ldn.invesco.com). He said that in the USA non-bank credit had grown faster than bank credit from 2002 until it started to unravel last year. It is difficult to get a higher frequency picture. However, by aggregating weekly commercial paper issues with weekly bank credit growth it can be seen that - while bank balance sheets continue to grow - total credit growth including non-bank credit has experienced a sharp fall since last August.

The latest data show that the credit crunch has migrated from capital markets to banks with bank credit growth showing an absolute decline of 8% (at a thirteen weeks annualised rate). However, the conventional monetary aggregates omit much of what is going on. Base money has not been increasing despite the Fed having allegedly pumped in more liquidity. MZM growth (money of zero maturity) has been rising rapidly as a result of the re-intermediation of funds back into the banking system after August 2007.

Commodity price inflation is not new. It is another bubble triggered by the same past monetary ease. Deflationary conditions will dominate in the USA and it would be wrong to raise interest rates even as commodity price inflation rises. A shift from stagflation back to a ‘Goldilocks’ steady state can only occur after the economy passes through a period of slower growth which may take eighteen months. What was the cause of the credit expansion in the first place? A positive feedback loop started the cycle with banks increasing leverage, increasing balance sheets, which then encouraged further leverage. What we are now witnessing is the process in reverse with banks reducing leverage, contracting balance sheets, asset price declines, weakening balance sheets and further de-leveraging. There are only three ways to repair balance sheets. The first is to raise capital. The second is to sell assets and use the proceeds to repay debt. The third way is to earn your way out. We are in a classic balance sheet recession and all three approaches to balance sheet repair take time.

John Greenwood added that house prices in the USA have fallen by 15% as a result of lending tightness and look set to fall by a further 15%. The outlook for the USA is grim for the next eighteen months. The slowdown in the USA will spread to the Euro-zone. Sentiment in Europe is weakening with black spots showing up like the build up of capacity in the Spanish property market. Many emerging economies have a fixed or quasi-fixed exchange rate with the US$ so monetary policy is being imported. The money supply is growing rapidly in India and Turkey. China has not raised rates and has responded by a mixture of appreciation of the exchange rate and sterilisation. Inflation in the emerging economies has been rising sharply. Central banks in these economies are behind the curve and need to tighten more. The slowdown in the developed economies will be followed by some slowing in the emerging economies. High oil prices have taken their toll on domestic consumption and are now at unsustainable levels. Oil prices will possibly fall back to around US$80 to US$100. The global situation is one of balance sheet repair and de-leveraging which is inherently deflationary.

The Domestic Economy – UK at the onset of recession

The UK banks are tightening credit standards. As in the USA, non-bank credit had grown rapidly in recent years. Excess balances remain in the system and it is not clear where this will end up but it may cushion the impending downturn. A rise in the saving ratio must occur but it has not happened as yet. The latest Royal Institution of Chartered Surveyors (RICS) house price survey show that 92.9% of estate agents expect house prices to weaken, in contrast with 65.3% in June 1990. Unsecured borrowing growth continues to rise but this likely to be short term. Household mortgage interest and repayments as a percentage of personal disposable income reached a peak of 18.5% in 2007 Q4. This was higher than the peak of 17.8% recorded in 1990 Q3 following the Lawson boom.

Investment intentions and capacity constraints surveys indicate a sharply cooling business sector. The labour market remains a lagging indicator. While import and materials prices have increased sharply, wage costs have remained under control. Unemployment remains remarkably low. Consumer Price Index (CPI) inflation is being driven by past excess money growth and will take another year to properly unwind.

In his summary, John Greenwood stated that the effects of the credit crunch were now moving into the wider economy. The real economy was showing signs of contraction. De-leveraging was fundamentally a deflationary process. Money and loan growth was slowing rapidly. Although inflation is showing up in commodity prices, input prices and import prices, the problem facing the Monetary Policy Committee (MPC) was how to deal with deflation, not inflation. The MPC will have to think about rate cuts soon if they are to avoid overkill.

David B Smith thanked John Greenwood for his presentation and opened the meeting for discussion.

Discussion – Balance sheet repair

The Chairman started by asking Tim Congdon to cast his vote as Tim had to leave the meeting early. (Editorial Note: this appears with the votes in the next section). In his introduction to the debate, David B Smith said that the June producer price figures released that morning (14th July) had been well ahead of market expectations, with input costs up 30.3% on the year rather than the expected 28.4% and output prices up 10% rather than the anticipated 9.7%. In his experience, City forecasters usually underestimated the speed with which inflation pressure built up once these were rising.

He suspected that the next morning’s June CPI release would also show higher inflation than the consensus forecast of 3.6% (Editorial Note: the outcome was 3.8%). The world economy was more integrated now than previously and global monetary pressure has been the main driver of world inflation. There was no sign that OECD broad money growth was collapsing. Indeed, the reverse applied and there had been a marked acceleration to around 8¾% to 9% annual growth in the recent data. Furthermore, the attempts of countries such as China and the Middle-Eastern oil producers to hold down their currencies against the weakening US$ meant that they were losing control of their monetary aggregates in an upwards direction.

Patrick Minford agreed that the emerging economies were sitting on their currencies and will go on trying to stop their currencies from appreciating. With their money growth continuing at the current fast rate, they are not sterilising in the traditional sense.

Trevor Williams said that capital inflows to China are $132 billion. It would be difficult to sterilise that magnitude of inflow. John Greenwood said that the US$ has stopped falling because of tightened credit conditions. The emerging economies are tied to the US$ which will soon be a strengthening currency. Andrew Lilico raised the rescue of Indy Mac and the problems relating to Freddie Mac and Fannie Mae. He asked to what extent policy action can do anything in such circumstances.

John Greenwood said that most business cycle slowdowns have been caused by central banks tightening to stop inflation but UK inflation has not really got out of control compared with past episodes. The problem is that households and financial firms were over-leveraged. Financial institutions had made strong attempts to de-leverage. But cutting interest rates will not help households repair balance sheets. This was the situation of Japan in the 1990s and USA in the 1930s. They were not periods of high inflation but situations of balance sheet adjustment.

Peter Warburton said that what was different this time was that in the past households and businesses had precautionary balances to fall back on. This buffer no longer exists. Unused credit facilities have been withdrawn. Households are illiquid and trying to cope and often had to pay exorbitant rates of interest rates in consequence. David B Smith said that lenders offering so-called ‘log-book’ loans secured against the value of a vehicle were currently charging an APR of 298% (sic) which was an indication of the financial stress some people were under. Andrew Lilico said that if agents are rebuilding their balance sheets, which will drive down economic activity, perhaps the rate of interest should stay at 5% so it can be cut aggressively when the downturn comes.

Patrick Minford said that as far as the ordinary punter is concerned credit conditions are already tight. Ruth Lea said that the bubble in oil prices will collapse at some stage. She said that she was looking for threads of optimism in the discussion so far. If oil prices fell to the levels suggested by John Greenwood, then producer price inflation will fall. She said that she cannot see interest rates being reduced while inflation continues to rise. It was important to hold rates as a signal to pay settlements.

Patrick Minford said that there was no indication of a slowdown in emerging markets. He asked in what sense will oil demand slowdown. Kent Matthews said that much of the export sector of China operates on very thin margins. Any slowdown in world demand will have a strong effect on exports and growth in the emerging economies. John Greenwood said that Indonesia, Malaysia, India and China have started to raise oil prices by reducing their subsidies. Now there is a more realistic relative price of oil in these economies which will create stronger responsiveness.

Votes

David B Smith then asked the members of the committee apart from Tim Congdon, who had voted earlier, to vote on a rate recommendation. On this occasion there was no requirement for votes in absentia, since nine full SMPC members had been present at the meeting as well as Philip Booth, who is technically a non-voting IEA observer but is awarded a vote when numbers are short. The votes are listed alphabetically rather than in the order in which they were cast, since the latter was on a round the table basis that simply reflected the arbitrary seating arrangements at the meeting.

Comment by Tim Congdon
(Financial Markets Group, London School of Economics)
Vote: Hold
Bias: To ease

Tim Congdon said that output will go sideways or fall for one or two quarters in late 2008 and early 2009, so that the level of output would be below trend by spring 2009. Non-oil inflation will then be on a declining trend, while the effect of the increase in the oil price to mid-2008 will be dropping out of the index. (Indeed, oil prices may well fall over the next year or so.) If so, the Governor might – by, say, spring 2010 – have to write a letter explaining why inflation has fallen more than 1% below target! However, the short-term perspective is that inflation will rise sharply in the next few months.

Following that, the MPC should cut aggressively. He said that base rates (and hopefully inter-bank rates) should be at least 100 basis points (i.e., 1 percentage point) lower by spring 2009. While he had (correctly) been very pessimistic about macro outcomes in 2008 because of the excessive money growth of 2005-07, two unexpected shocks had made matters worse than he had envisaged. First, some banks had been taking undue risks in asset selection and, secondly, the price of oil had soared by far more than had seemed plausible in 2006 or early 2007. He voted to hold rates, with a bias to cut aggressively once the current hump in inflation had passed through.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: To cut

John Greenwood said that it was not right to cut at this point in time. The money numbers are starting to fall but he would not advocate waiting for inflation to peak. He said that a cut should come in the next three months. He voted to leave Bank Rate unchanged in August but with a bias to cut aggressively further out.

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Hold
Bias: to ease

Ruth Lea said that she agreed with the concerns of people such as Trevor Williams (see below). She said that it would not be right to cut now but that it was preferable to see how inflation develops and to re-evaluate in the autumn. She voted to hold immediately with a bias to ease.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: To Cut

Andrew Lilico said that he wished that there had not been a rate cut in 2007, but that we are where we are. Inflation is likely to rise above 4%. He said that interest rates should stay on hold until inflation measured by CPI has peaked. Two months after inflation has steadied or started falling. He said that a cut in December was appropriate. He voted to hold Bank Rate at its present 5% this month with a strong bias to cut for subsequent months.

He added that that the importance of preventing inflationary expectations leading to wage rises is not that this might lead to higher inflation (as if we believed in the cost-push theory of inflation), but, rather, that this would lead to higher unemployment as, for a given level of money stock not determined by salaries, the primary impact of higher salaries is upon the attractiveness of labour as a factor of production. It seemed to him that there was a great deal of confusion in the press on this point at the moment – as if we were back to the 1970s in terms of economic theory as well as many other things

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: Towards further easing

Kent Matthews said that there were two real interest rates and they were both strongly positive. The real interest rate faced by the financial institutions is the funding rate less the expected rate of asset price inflation, which is - and expected to be - negative. So the real rate of interest faced by the financial companies is massively positive. The other real rate of interest is faced by households. Mortgage and credit costs have been rising for those who can get credit but we are now in a classic situation of credit rationing.

In a rationed market there is a shadow price and this price is a very high real rate of interest. Credit market tightness is an endogenous response and has not been governed by policy. But conditions are bad and it is incumbent upon the Bank to take measured action by cutting rates in stages explaining the reason at each stage. He voted to cut Bank Rate to 4¾% in August and had a bias to further cuts.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: To ease

Patrick Minford said that he was concerned with world commodity price inflation but nothing could be done in the UK about it. There is a case for tightening of monetary policy in the global economy as a whole but the UK is already too tight. The Bank needs to loosen monetary policy. He said that the Bank of England had been pathetic in showing a total lack of leadership. He voted for a reduction of ¼% with a bias to further cuts.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Tightening

David B Smith said that he disagreed with Patrick that nothing could be done in the UK to avoid world commodity price inflation. The 11½% drop in the sterling index over the past year was a major independent source of inflationary pressure that indicated that Britain was pursuing relatively laxer monetary policies than other countries, at a time when global monetary conditions were excessively loose in any case.

More generally, he thought it was worth recalling why the MPC’s post-1997 mandate was framed in the way it was in the first place. That was because the consensus amongst economists was that there was no long-run trade off between output and inflation, and that high and volatile inflation was damaging, so that a central bank’s best contribution to activity and employment was to maintain low and moderate inflation, despite the possible output costs in the short-run.

He was concerned that the people advocating rate cuts at a time when inflation was accelerating to an as yet unknowable peak were implicitly saying let us junk the whole monetary framework – by reducing the inflation target to no more than a pious aspiration – and revert to neo-Keynesian monetary fine tuning. The history of previous inflation upturns suggests that central banks are often in denial about the extent to which they have let the inflation monster loose until it is too late for there to be any benign options left available.

With hindsight, he realised that his SMPC colleague Andrew Lilico had been correct in long arguing the case for price level rather than inflation targeting. This was because it would be easier to accept quite a long period of inflation overshoots over the next few quarters if it was known that there would be offsetting undershoots subsequently. As it was, private citizens would be quite rational in believing that inflation was being allowed to drift further and further away from its target, in part because of the political pressures ahead of the putative 2010 general election.

It had taken seven years of feckless fiscal policy and three years of lax monetary policy to create the present unpleasant economic situation. Symmetry suggested that there were now no quick or easy solutions available, especially as Britain (together with Poland) is running the second largest structural budget deficit in the Organisation for Economic Co-operation and Development area after the USA. He voted to hold Bank Rate for the time being but had a strong bias to tighten at the first opportunity, especially if real money-market interest rates were reduced any further by accelerating inflation.

However, he did want to include one caveat about the price of oil. In running the Beacon Economic Forecasting (BEF) macroeconomic forecasting model he had assumed that the oil price would stick at US$130 for a barrel of Brent Crude until the end of next year (Editorial Note: it was US$143.9 on 14th July but had eased to US$126.4 on 24th July). On this basis, he would expect annual CPI inflation to be not quite 4½% in the final quarter of this year, still 4% late next year, and 3½% in late 2010. However, an alternative scenario, in which the oil price fell by US$10 per quarter from 2008 Q4 onwards until it stabilised at US$90 in 2009 Q4, would give annual CPI inflation of 4¼% in 2008 Q4, 2¾% in the final quarter of next year, and 3¼% in late 2010. Unfortunately, it was surprisingly difficult to know what other people were assuming, often implicitly, about the future price of oil.

One example was that less than half the economic forecasting groups whose predictions appear in HM Treasury’s monthly forecast comparison publish their oil price assumptions. However, it was probable that much of the divergence of views about the economic outlook implicitly rested on different assumptions about the price of oil, rather than reflecting more profound disagreements. The MPC’s reputation would escape relatively unscathed if the oil price did fall to the widely touted US$80 during the next few quarters but the MPC no longer had any effective control over events.

Comment by Peter J Warburton
(Economic Perspectives Ltd)
Vote: Cut by ¼%
Bias: To ease

Peter Warburton said that past cuts in Bank Rate have not materially affected domestic credit conditions. Nor has the Bank of England’s Special Liquidity Scheme succeeded in unblocking the interbank market. In recent months, there had been a significant downshift in the perceptions and activity of households as a result of credit tightness and the implied real income squeeze from higher fuel and energy prices. There is every likelihood that real household consumption and real GDP will fall in 2009; monetary policy should be directed to mitigating these outcomes.

Plainly, the external factors driving the short-term evolution of the CPI lie beyond the influence of the MPC. To tighten policy – as one member voted to do in July – or even to refrain from easing until CPI inflation has peaked, would be to fight yesterday’s battle. Now that the credit crunch has disabled the wholesale finance and capital market credit mechanisms, it is unnecessary for monetary policy to reinforce these contractionary pressures. To the extent that UK economic activity is far more credit-dependent than at the outset of the last contraction, in 1990, the scope for a deeper and more painful correction requires that interest rates be cut immediately, with a bias to further easing.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: To tighten

Trevor Williams said that he advocated a hold for the same reasons advanced at this meeting. Rates cannot be cut when inflation is rising, especially as it is accelerating with no good idea of where, or when, the peak is going to be. The Bank has suffered a credibility loss which needs to be restored. The UK cannot be divorced from the global economy but cutting rates is not going to solve the problem of money growth that began in 1998. He said that he did not want the Bank to repeat the mistake of cutting rates in the past. Real interest rates had to stay positive and high for credibility to be restored. He said that there was no scope for cuts in rates at all. He voted to hold with a bias to raise.

Policy response

1. On a vote of six to three the committee voted to hold Bank Rate at its current position.
2. Three members voted to cut Bank Rate by ¼% with a bias to further cuts.
3. Of the six members who voted to hold Bank Rate at its present 5%, three had a bias to cut aggressively and another one had a simple bias to ease.
4. Two SMPC members had a bias to raise rates.

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group and Global Vision), and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

In its latest monthly E-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one to hold UK Bank Rate at 5% on Thursday 10th July. The one dissenting SMPC member favoured a ¼% reduction to 4¾%.

Looking further ahead, six of the SMPC holds had a bias to ease, two of the holders had a bias to tighten, and the sole rate-cutter had an easing bias thereafter. All the SMPC members concerned recognised that the Monetary Policy Committee (MPC) faced the most difficult situation that has arisen since the present British institutional arrangements were established eleven years ago.

In particular, the rise in consumer price inflation to 3.3%, when the problems in the market for credit had not been resolved, and the prospects for the global economy remained uncertain, left the authorities facing an acute dilemma. Some SMPC members were concerned by the rapidity with which the UK’s broad money supply and credit were decelerating. There was also some discussion as to how far previous errors by the MPC were responsible for the deterioration in Britain’s economic performance.

Comment by Roger Bootle
(Deloitte and Capital Economics Ltd.)
Vote: Hold
Bias: To Cut

These are the most difficult waters that the MPC has ever had to negotiate. There is a serious chance of it making a major policy mistake by not moving interest rates soon enough. The trouble is that it is not absolutely clear in which direction rates should be moved. My own view is that the direction needs to be down but I acknowledge the risks. With inflation still rising, and expectations having taken a worrying upward move, there is a real risk that unless interest rates are raised, inflation could take off and a rate well above the target could get embedded.

However, that is not the only risk. The real economy looks seriously weak and the outlook for the housing market looks dire. We could be facing a real economic crisis and a financial collapse. Meanwhile, I am impressed by the fact that core inflation has not moved much and neither has the rate of increase of average earnings. Although the parallels with the 1970s are superficially strong, the conditions in the economy are fundamentally different. The most likely outcome, I believe, is that although headline inflation moves well above 4%, the core rate moves very little and next year the headline rate comes crashing down, perhaps taking the rate below 1%, at which point the Governor would have to write another letter. This would be accompanied by very weak conditions in the real economy, perhaps amounting to a recession.

The MPC does not have the luxury of waiting until all is absolutely crystal clear. By that time the bird will have flown. So it has to be prepared to take some risks – without being reckless. It might be worth waiting a little longer to see what happens to core inflation and to wages. But I would stand ready to cut and, to make an impression on firms and individuals alike, I would be prepared to cut by ½% in one go.

Comment by Tim Congdon
(Financial Markets Group, London School of Economics)
Vote: Hold
Bias: To ease, but not immediately

A sharp slowdown in broad money growth is now under way. Over the last three years the annual rate of M4 broad money growth has typically been in the double digits. In the six months to May the annualised growth rate of M4 was 10% and in the four months to May it was 6%. Further, Chart 1.18 of the May Inflation Report suggests that much of the growth this year has been in deposits within financial groups, which – like inter-bank deposits – have little wider macroeconomic significance. If these deposits are taken out, the annualised rate of growth in M4 has probably been little better than positive at perhaps 3% to 5% in recent months. With inflation rising, real money growth is virtually nil. (In the year to April corporate money – i.e., money held by ‘private non-financial companies’ – was up by a mere 1.0%. In the last three months it has fallen by 1.9%.)

So the British economy has lurched over the last year from an annual rate of real money growth of about 10% to one of almost nothing. The results are everywhere, falling house prices, sharp rises in commercial property yields, the announcement of bankruptcies in the furniture retailing sector and so on. With other monetary economists in a letter to the Financial Times, I warned in mid-2006 about the possibility that this cycle could develop dangerous tendencies similar to those in previous boom-bust cycles. I have been surprised by how bad conditions have become – and also by how quickly they have changed. The leap in oil prices is part of the story, while the banks do seem to have been taking too many risks and need to retrench.

But, even when allowance is made for all the excuses, the Bank of England’s performance has been poor. The level of understanding of basic monetary economics within the institution remains lamentable. The section on ‘Monetary Aggregates’ in the May Inflation Report has been cut back to a mere two paragraphs. But even this meagre treatment contains an elementary blunder. According to the final paragraph on page 18, “Household deposits continued to grow strongly. That could reflect substitution away from risky assets such as equities…”. This is another example of what I have called “the individual experiment illusion”, i.e., the notion that when an individual sells equities to increase his or her deposits, the quantity of aggregate deposits (and so the “household deposits” in M4) thereby increases. In fact, the quantity of deposits in the aggregate is determined by the size of banks’ overall assets. If the seller of equities has an increased deposit, the buyer of equities has a correspondingly reduced deposit. A change in agents’ attitudes towards the assets in their portfolios does not affect the aggregate quantity of money. When will the Bank stop making this mistake?

With the quantity of money given by banks’ behaviour, the effect of an increase in agent’s liquidity preferences (i.e., what the Bank calls “substitution away from risky assets in equities”) is a fall in asset prices. Alternatively, if the quantity of money falls while liquidity preferences are given, the same effect follows, i.e., a fall in asset prices. A change in agents’ attitudes towards different assets has no effect on the aggregate quantity of money, which is set by a quite separate set of processes. Again, when will the Bank’s economists ever learn?

For the next three to six months, while the inflation news will be bad, I can see no real alternative to keeping base rates where they are. However, I expect domestic demand to be flat in the second half of 2008 so that a negative output gap will have emerged by, say, spring 2009. So my bias will be to ease in late 2008.

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Hold
Bias: Towards easing

The economic mood has darkened over the last month. The ongoing impact of the credit crunch and rising inflationary pressures create a toxic brew for the British economy.The credit crunch, with the three-month London Inter-Bank Offered Rate (LIBOR) rising in June to almost 100 basis points above the Bank Rate by the end of the month, is undoubtedly impacting on the real economy with the housing market arguably the most obviously affected area to date. Mortgage availability continues to tighten, housing market activity is now falling rapidly, with approvals well down, and prices are falling. The deterioration in the housing market is, if anything, accelerating and this is now having knock-on effects in the house-building sector.

The growth rate of the real economy is with very little doubt, continuing to slow. May’s 3.5% jump in retail sales was surely erratic. The weather was warm. The labour market, a lagging indicator of economic activity, is now slackening and unemployment rising. In the three months to April unemployment was 38,000 higher than in the previous three months. Job losses will continue to increase, particularly in construction and the retail and financial sectors. The chances of a quarter or two of flat – or even falling – overall economic activity are rising.

The inflation data continue to worsen, reflecting sharp rises in commodity prices. The latest Producer Price Index (PPI) and Consumer Price Index (CPI) data were worse than expected. It is now likely that CPI inflation will touch 4% in the second half of 2008 before, hopefully, falling back through 2009. The Bank’s key challenge now is to ensure that these largely external, commodity-driven increases in inflation do not translate into faster domestically-driven price increases. General inflationary perceptions and expectations are picking up. But so far, earnings inflation shows few signs of accelerating – a situation which is, on balance, likely to continue, given the weakening labour market.

There are, however, some ominous signs that average wage settlements could begin to tick up with the tanker drivers 14% settlement, albeit over two years, a dangerous precedent. The unions, empowered by their financial grip over the Labour party, are squaring up for tough and inflationary pay negotiations backed by industrial action. Even though I take the view that a price-wage-price spiral is still unlikely to develop, these industrial developments dictate monetary policy caution.

Given rising inflation rates, there is no scope for an imminent cut in interest rates. But, conversely, given the signs of a rapidly slowing economy and modest earnings inflation, there is currently no need for a rise. I vote for no change at the July meeting. But with a bias towards easing towards the end of 2008, providing domestically generated inflationary pressures do not build up.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: To cut

There is a great deal of confusion in financial markets about the basis and objectives of UK monetary policy. This is witnessed by the wild volatility in bonds markets, with rapid changes in the expected number and direction of interest rate movements – from cuts to three rises to one rise to who-knows-what, and all this with relatively little change in the underlying data. I believe that a key contributor to this volatility is the fact that inflation has gone above 3%, and the policy framework makes no clear statement about what happens next. As I have urged repeatedly, we need to know what happens now? How high is inflation permitted to go before policy-makers must act? It appears very likely that inflation will exceed 4%.

Must rates then be raised, virtually come-what-may in terms of growth? Some reputable forecasters are even suggesting that 5% might be reached soon. Would 5% be enough to force interest rate rises, come-what-may? Or is 5%, 6%, 10% fine in the medium term, provided only that on a graph somewhere we can see a line that goes down to 2% in three or so years’ time? We really urgently need some guidance from the Chancellor on this point. Until we get that guidance, bonds markets will still be largely in the dark about the likely path of interest rates.

Assuming for the moment that there is effectively no inflation target constraint for us at all at present, and that we act on discretion, in addition to the actual retail and cost price inflation data, I put weight on three other key factors:

1) Broad money growth has fallen rapidly, and now appears likely to fall to around 6% on the current policy stance, driven by sustained credit market problems. Since the Bank of England was unwilling, in 2006, to raise interest rates to control monetary growth, money markets have scheduled their own down-time. Over the next year or two, this will start to bear down considerably upon inflationary pressures, even without further interest rate rises.

2) House prices are in total free-fall. The dangers many of us warned about for many years appear to have come to fruition, and the results may yet turn out to be worse than any of us have felt able to be explicit in predicting. However, as I have argued many times before, house price rises were so excessive for so long that in the early phase of house price falls, the impact on consumption will be largely negligible. I believe that it will only be once prices have fallen more than 15% that a house-price-fall effect on consumption will start to be a factor – so this is an issue for next year, rather than this year.

3) Until recently, it has appeared that economic growth has not been suffering too badly, although the first concrete signs of a significant slowdown may at last be apparent. An economy that grew consistently rapidly for fourteen years has great momentum. When coupled with the hangover of the extremely high rates of broad money growth of recent years, this was always likely to mean that growth would slow only gradually. I continue to believe that 1% growth for each of the two years starting from 2008Q2 is possible, though I admit that this is now at the upper end of plausible predictions. Downside risks are considerable, and at least one two-quarter technical recession is now very likely.

Overall, then, we face an economy in which the monetary stance should soon be moving to interest rate cuts, despite high inflation. The collapse in monetary growth and an extended period of below-trend GDP growth is going to do the necessary work of bearing down on aggregate demand. If the UK still had an inflation target, I would probably be thinking of when we would want to raise interest rates. But without being able to take advantage of the benefits of a constrained discretion regime – and the superior long-term growth, inflation and economic stability performance that would imply versus the discretionary regime – I can see little point in considering interest rate rises. Pay pressures are not great. Oil prices cannot continue to rise much. So this inflationary episode will pass. It has largely destroyed the UK’s inflation target as it passed – because of the poor response to the situation of those that set the target. But we will pay the price for that in later years. For now, my vote is to hold, with a bias to cut.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: To ease

Things are not as straightforward as some economic commentators would have us believe. Certainly terms of trade shocks have pushed inflation above the target and it is likely to stay above target for some time. But despite the talk of inflation getting out of control, there is little sign of this in inflation expectations. Wage response has been muted and according to Income Relations Services annual pay awards are running at only 3.3%. True, inflation expectations as measured by the gap between long-term yields and indexed linked has edged up by 40-50 basis points in recent weeks. This is clearly a cause for concern but it is not catastrophic. The Bank of England has made noises to the effect that it no longer believes in the credibility of its own target. On the real side of the economy, the housing market has slumped, mortgage approvals have declined sharply, and growth has slowed to an almost standstill. Consumer spending has remained unaffected but no one believes that this is sustainable with real disposable income now showing negative growth.

There is nothing the Bank can do about the coming growth slowdown but the issue is whether the slowdown turns into a more serious downturn and if the costs from this are greater than the costs from a short-term rise in inflation. The weakness of sterling and the changing direction of interest rates in the Euro-zone mean that the Bank is unlikely to reduce interest rates in the near future. However, they should be cautious in going in the other direction. The growth slowdown the Bank wants to bring inflation under control is happening. The spread in inter-bank rates over base has remained much the same since March. Interest rates have effectively risen by 50 basis points. A rise in Bank Rate now would be overkill. I recommend putting base rate on hold and would be prepared to cut if the economy weakens seriously.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: To ease

This is a difficult period for the MPC, with two large shocks coinciding- the continuing credit crunch (a demand shock) and the world oil/commodity boom (a supply shock). The first requires a cut in interest rates, the second a rise. The question is what is the balance of forces? It would seem that the MPC's de facto judgment has been that the former more than offsets the latter, since three-month market interest rates are a bit higher than where they were in August last year when the banking crisis broke; if one looks at rates in the mortgage market (the main way in which households smooth their consumption) they are clearly substantially higher. Furthermore the Bank's large-scale assistance to banking liquidity has deliberately not aimed to reduce the three-month risk premium between market rates and base rate, since that very gap is charged as a fee to banks that take up the facility.

The bank is charged with maintaining inflation at 2% in the medium term. One must ask therefore how long the effect of the two shocks are going to last. It seems to me that the potential impact of the credit crisis is much larger - and of longer duration - than that of the world commodity boom.

On the last, it can only be a matter of time before the East Asian countries react to their own inflationary problems, which have become acute because of poor monetary policy (usually obsessed with buying dollars to hold their dollar exchange rates down). Just in the last few days India has raised interest rates for example. In terms of domestic reactions to this terms-of-trade shock we can see that wage growth is barely flickering. Hence the pass-through of the commodity price boom should be fairly quick.

On the first there are signs of a dangerous credit shortage in the housing market. Other indicators have remained so far surprisingly robust - for example the latest retail sales volumes, up 8% on a year ago. But the savings rate is very low and with real incomes falling and credit availability tight, the risks are that consumption will stall and even decline. Once that begins it takes a long time to reverse.

Thus my view would be that rates should be cut by a ¼% now, with a further bias to cut. This will still mean that monetary conditions in the marketplace will have been tightened since August last year - an excessive reaction to the twin shocks the economy is facing.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Tightening

Having opposed each of the three ¼% UK Bank Rate reductions carried out since last December - and having consistently warned that the depreciation of sterling indicated that Britain was pursuing relatively high inflation policies in what already looked like an excessively inflationary world – the issue that has to be confronted is whether there is anything other than a lack of moral fibre preventing one from advocating an immediate Bank Rate hike of, say, ½% or ¾%.

After all, if a 5¾% Bank Rate was considered appropriate when CPI inflation was running within 0.1 or 0.2 percentage points either side of 2% last autumn, why should a rate of 5% be appropriate now that CPI inflation has accelerated to 3.3% and is expected by the Bank of England to breach 4% during the next few months?

It is also worth noting that in terms of the three-equation Conventional Theoretical Macroeconomic model (CTMM), which underlies the current institutional structure of the Bank, its conceptual framework and its main forecasting model, one has to over-react to any deterioration in inflationary expectations if rising inflation is not to feed on itself.

Opinion polls carried out in the US, Euro-zone and Britain indicate that inflationary expectations are indeed increasing, although they are still generally running below the ‘headline’ inflation numbers. This may be because people ‘rationally’ believe that some of the recent upward pressure on the rate of price increase reflects transitory commodity price shocks. But it may also be because they form their expectations of the future rate of price increase using an ‘adaptive-learning’ approach.

It is well known that putting adaptive-learning into the CTMM can generate stagflation. I have long believed that the CTMM is a dangerously over-simplified model of reality, for the reasons set out in my April 2007 Economic Research Council paper Cracks in the Foundations? A Review of the Role and Functions of the Bank of England After Ten Years of Operational Independence (www.ercouncil.org). However, the US Federal Reserve and Britain’s MPC appear to set great store by the CTMM. This implies that they are playing with inflationary fire in terms of their own intellectual approach. The European Central Bank is more sensible and has realised that a strong currency and firm monetary discipline are the only ways in which the Euro-zone’s inflation prospects can be protected from the inflationary international background.

The main reason why Anglo-Saxon central bankers are not just behaving recklessly is to do with the balance of risks, particularly the unknown consequences of the global credit meltdown that commenced in August 2007. Credit rationing effects are not incorporated in any of the forecasting models employed by the leading central banks.

It is certainly conceivable that tighter credit standards could act as a major negative blow to output and employment in the major economies. However, monetary economists normally distinguish between the first round effects of a credit shock, which are considered to be transitory, and the sustained second round effects that follow once the banking sector’s liabilities and the broad money supply have adapted to the new situation on the assets side of the balance sheet. I would advocate aggressive rate reductions if there were indications that the global money supply was imploding, as happened in the Great Depression of the 1930s, for example. However, there is no evidence that this has happened. Aggregate OECD broad money has recently been rising by some 8¾% to 9% year on year, if high inflation countries are excluded. This figure was last observed in the late 1980s when ‘core’ OECD inflation was running around 4½%, compared with 3¾% in the year to May.

There does appear to be an observable deceleration in Britain’s M4 broad money stock. However, the 10% increase recorded over the past twelve months is still on the high side of what would be consistent with achieving the inflation target in the long run. A further modest monetary deceleration should be accepted – and, perhaps, even welcomed - provided that the pace of the slowdown is not so rapid that it leads to a recession

The Office for National Statistics (ONS) data published on 27th June revised the previous estimate of UK real GDP in 2008 Q1 down by 0.2 percentage points, although the balance of payments figures released simultaneously showed a reduction in the current account deficit from £12.2bn in 2007 Q4 to £8.4bn in the first quarter of this year.

Unfortunately, the improvement in the deficit on net exports was modest, from £14.6bn in 2007 Q4 to £13.5bn in 2008 Q1, and the overall improvement was due to temporary favourable ‘wobbles’ in net investment income and government transfers. Non-oil market sector gross value added, which excludes the government’s contribution to national output, rose by 2.7% in the year to the first quarter, while total GDP rose by 2.3%, both including and excluding North Sea oil.

Having incorporated the new figures into the Beacon Economic Forecasting (BEF) model, total UK GDP is now expected to rise by an average of not quite 2% this year, 2% next year, and 1¾% in both 2010 and 2011. The balance of payments deficit is expected to fluctuate between 5% and 6¼% of the basic-price measure of GDP throughout this period; it was 4.9% last year.

There must be reservations as to whether deficits of this scale and duration can be funded without posing a further threat to the external value of sterling. The pound has already fallen by 11.2% on a trade-weighted basis over the past year.

The most ‘scary’ aspect of the latest BEF projections, however, is the persistent high inflation expected over the next few years. This is partly to do with the price of oil. The BEF projections assume that it averages US$130 for a barrel of Brent crude in the second half of this year, giving an annual average of US$119.8 and sticks there throughout 2009, before rising by US$½ in each subsequent year.

In contrast, the current independent consensus oil price assumption reported by HM Treasury is US$112 for this year and US104.6 in 2009. An even more important factor, however, is the weakness of sterling at a time when international inflation is already running well above the rate consistent with a 2% domestic inflation target. This makes Britain a relatively high inflation country in an excessively inflationary world.

This more than offset the disinflationary benefits that arise from a widening of the domestic output gap in the BEF predictive framework, but not the official one. As it is, annual CPI inflation is expected to peak in the third quarter of this year, but still be around 4¼% in the fourth quarter, before easing to around 4% in the final quarter of next year, 3½% in late 2010, and just over 3% in late 2011. It would require a major reduction in the price of oil, not just a stabilisation therein, to bring UK inflation back within its target range over the MPC’s predictive horizon.

The issue that arises is what can be done to improve this rather unprepossessing medium-term economic outlook? The short answer is probably not very much, at least where the next eighteen months or so are concerned. One reason is that the UK’s economic openness means that the rather weak effects of the domestic policy instruments can be easily swamped by economic conditions overseas, and these international factors are unlikely to be helpful over the next few years.

Another reason is that it has taken approximately seven years of fiscal fecklessness and more than three years of money and credit indiscipline to create the present economic situation. Getting out of it could either require many years of tight monetary and fiscal discipline or the imposition of the sort of draconian policy package that has been associated with International Monetary Fund (IMF) bail outs of the British economy in the past. Finally, the political realities mean that the inconsistency between fiscal laxity and the monetary stance needed to bear down on inflation is likely to get worse as a demoralised government marks time until its likely nemesis in a 2010 general election.

Overall, it seems reasonable to keep UK borrowing costs on hold this month. However, I maintain a bias to tighten in the medium term, if higher rates are not forced on the authorities by a run on the pound. One justification for this ‘wimpish’ recommendation is that that the evidence suggests that small changes in Bank Rate do not have a significant impact on the economy. A necessary condition for improvement to Britain’s medium-term prospects is the implementation of a fiscal stabilisation package to improve the supply side. One can only hope that the Conservative opposition is swotting up on the subject of fiscal stabilisation. Somehow, one doubts it.

Comment by Peter J Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: To cut on confirmation of a sharp loss of economic momentum

The release of the full national accounts for the first quarter of 2008 has laid bare the constricting impact of the global credit crunch. Quarterly growth fell to 0.3% in Q1 from 0.9% in Q2 of 2007; the household saving ratio slumped to 1.1% from 3% in the previous quarter; and inventory accumulation of £5.3bn in the second half of 2007 was replaced by a small reduction in Q1. In fact, real domestic expenditure fell by 0.3% in Q1. On the output decomposition, four service sectors recorded falling activity in the first quarter: hotels and restaurants, real estate, renting and business activities, post and telecommunication and public administration.

In the nominal accounts, GDP at market prices rose at a 4.5% annualised rate in Q1, down from 6.0% in 2007, suggesting that the credit downturn is also having a contractionary impact. Once again, it is the domestic components of GDP where the constricting effects are most in evidence: a mere 3.2% annualised pace of growth in Q1 versus 6.2% in 2007. Hence, amidst the eruption of concern over measured CPI inflation, it is important to keep hold of the broader reality that domestic nominal activity has decelerated since the credit crisis began.

Meanwhile, the growth rates of bank credit and money holdings have declined steadily in the past few months. The annualised six-monthly pace of M4 lending has slipped from 13.7% in September 2007 to 10.5% in May. Annual growth rates for lending to private non-financial corporations and to households for loans secured on dwellings have fallen from 17% to 13% and 10.2% to 8.5%, respectively.

M2 money growth has been little changed over the past year, slowing from 7.0% last September to 6.6% in May, but wholesale deposit growth has dropped from 24.4% to 16.5% over the same period. Despite the re-absorption of conduits and attempts to accommodate “friends and family”, bank balance sheets are growing less rapidly than immediately before the crisis broke. This suggests that the internal pressures on the financial system are more than sufficient to achieve credit discipline in the months ahead.

Events of the past year have fired ‘Exocet’ missiles at the received wisdom about the UK economy and its policy framework. It is becoming apparent that:

1) The consistency and resilience of GDP performance over the past decade has been purchased at the price of profound balance sheet deterioration, principally through the assumption of colossal household, corporate and financial sector leverage, and the escalation of public sector off-balance sheet and contingent liabilities.

2) Credit and capital market innovations and structures have defended the UK economy from the inflationary implications of excessive domestic credit growth. The closing of these credit channels has necessitated a re-intermediation of credit through the banking system where its inflationary impacts are likely to be greater.

3) While the inflation target has served an important purpose in helping to anchor domestic inflationary expectations, the framework of inflation targets offers no defence against a material shift in the relative price of imported fuel and food – itself a symptom of global credit excess.

The powerful headlines created by successive CPI releases, showing a jump from 2.5% in March to 3.0% in April and 3.3% in May, cry out for a policy response but there is no rational response available. The argument for interest rate reductions can still be made on the basis of a forward-looking assessment of nominal activity in 2009-10, but there is an obvious danger that, in present circumstances, such a move would be interpreted as a neglect of duty on the part of the MPC.

If, as seems likely, the abrupt loss of economic momentum will be confirmed by incoming data for Q2, and will follow through in the second half of the year, then the opportunity to implement a rate-cutting agenda will return. My sense is that we are nowhere near the darkest hour in this crisis, as the UK banking sector remains complacent about its exposures to doubtful debts and balance sheet risks. Only when the consensus economic forecasts for 2009 come crashing into negative territory – as ours has been for some time – will this inflation panic subside.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: To tighten

This is not a time to raise interest rates but inflation remains the biggest risk to medium term prospects of price stability. The economy is slowing, though I think it could bounce back modestly somewhat in Q2 from the revised lower 0.3% rise in Q1. Retail sales are resilient, as consumers refuse to buckle under the pressure of higher borrowing costs, a falling housing market, lower confidence and a reduced availability of credit.

This would seem to support my perception that the credit crisis, by itself, would not be enough to derail the economy, although it would hit financial markets and wreak havoc on commercial banks’ balance sheets and business models. But with the credit crisis still unfolding, the Bank still has to wait to see if its effects are spreading into the wider economy before being sure that a rate rise will not plunge the banks back into difficulty and threaten recession.

Consumer spending will slow eventually, under the weight of reduced real income from higher inflation and the rise in energy costs, but the MPC has to wait until that happens to assess its economic impact and then to judge whether it is enough to lead to a reduction in inflation so that it has a realistic chance of hitting the 2% target in two years time, i.e. 2010. The prospects are good that the slowdown will be enough to help ease inflation pressure so that only a modest rate rise is necessary.

The slowdown in M4 is a good sign also that the income effects of higher oil prices and of tighter credit and higher cost of borrowing are impacting money growth. And most of the effects of this adjustment may already be evident in the slower pace of financial markets activity in the UK in the last month. Moreover, the Purchasing Managers (PMI) surveys for services and manufacturing are confirming that the pace of economic growth has eased.

Hence, there has been some slowdown in the rate of M4 borrowing by companies and, more modestly overall, by individuals. This is signalling slower economic growth ahead. But the fall in the sterling exchange rate and the rise in inflation expectations do mean the MPC cannot yet rule out a rate rise. To do so would send a message to wage bargainers that the inflation target has been abandoned, which could cause just the wage-price spiral the authorities want to avoid.

In addition, the risks remain that the pound could slip further against the dollar and deliver another inflation shock to the economy. This is why I believe that, even if the economy weakens as expected, the eventual fall in inflation will not be sufficient to justify a cut in Bank Rate. The world backdrop is much more inflationary than at any time since the early 1990s and, without a strong exchange rate, the UK’s domestic interest rate simply cannot be sustained below 5% without continuing sub-trend economic growth.

What is the MPC?

The SMPC is a group of independent economists who assemble once a quarter at the Institute of Economic Affairs (IEA) in Westminster. The inaugural SMPC meeting was held in July 1997 and the Committee has met regularly since then. That it is the first such body in the UK, and meets regularly to discuss the deeper issues involved, distinguishes the IEA’s SMPC from the similar exercises now carried out by several publications.

In its latest monthly E-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one to maintain UK Bank Rate at the 5% rate originally announced in April on Thursday 5th June.

The one dissenting SMPC member favoured a ¼% reduction to 4¾%. Looking further ahead, four of the SMPC holds had a bias to ease, two of the holders had a bias to tighten, and two holders and the sole rate-cutter had a neutral bias thereafter. All the SMPC members recognised that the UK monetary authorities faced a worsening dilemma, following the rise in consumer price inflation to 3%, when the problems in the market for credit had not been resolved, and the prospects for the global economy remained uncertain.

Several SMPC members discussed the extent to which previous errors by the Monetary Policy Committee (MPC) were responsible for the deterioration in Britain’s economic performance, as opposed to external factors and the profligate UK fiscal background, over which the MPC had no control.

Comment by Tim Congdon
(Financial Markets Group, London School of Economics)
Vote: Hold
Bias: To ease

For me the two most important pieces of news in the last few weeks have been the surge in oil prices and the Bank of England’s analysis of money supply developments in the last few years in its latest Inflation Report. I have been warning that the world faces a chronic shortage of oil for some time, but this year’s oil price move – to the highest-ever levels in real terms – has come as a surprise. Essentially, the price has increased from just over $90 a barrel to $130 a barrel since the end of 2007. This is a huge shock to the world economy, a transfer from oil consumers to oil producers equal to about $1¼ trillion or over 2% of world output. The transfer will be effected partly by a rise in prices, implying an impact effect on UK prices of at least 1%. Moreover, the pound is about 10% down on a year ago (in trade-weighted terms). If the price of oil stays up, the damage to UK inflation in, say, the two years from end-2007 can be quantified as perhaps ‘3% to 4% more (i.e., 1½% to 2% each year) than would otherwise have been the case’.

Wage increases have been surprisingly, and impressively, stable. It is difficult to believe that UK output is much above trend or that unemployment is significantly beneath the natural rate. Although domestically generated inflation is under control, I am against early interest rate cuts. Late 2008 will be tough for the UK housing market and parts of consumer spending.

The Bank of England’s chart on M4 growth on page 18 of the Inflation Report shows that – when the effect of intra-financial sector credit is removed – M4 growth surged in 2005 to 2007 to the 12% to 14% annual growth rate area, but is now plunging. The asset price fluctuations in this cycle look increasingly explicable. I feel fully vindicated in my concern – first expressed in mid-2006 – that excess money growth would again lead to a rise in inflation and an unnecessary cycle. Anyhow that is history. The implication of the current plunge in M4 growth is that corporate balance sheets will be squeezed for at least six to nine months and the UK economy may suffer one or two quarters of falling output. That is not really necessary. For 2009 I expect oil prices to be lower than now, with favourable effects on the main price indices. So by late 2009 inflation will benefit from both oil price movements and the impact of the mini-recession on the output gap (which may go negative). I am in favour of keeping rates at 5% for the time being, but expect to support rate cuts before the end of the year.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: To ease

Over the next few months the Consumer Price Index (CPI) inflation rate may well exceed 4% year-on-year for several months in succession. This is because the month-to-month increases in the middle of 2007 were very low, averaging only +0.06% per month over the period May-September.

Consequently the month-to-month changes will need to fall below the comparable figures of last year in order for the year-to-year rates to see any decline from the April figure of 3.0%. Even if inflation averages only 0.2% per month from May until the year end, the average inflation rate for the year as a whole will be 3.0%, well above the targeted 2.0%. But this is essentially history. It is now too late to do anything about any target overshoots in 2008.

The government, from Gordon Brown downwards, is busy blaming the global economic situation (the subprime or credit crisis, energy prices, and food prices) for the country's economic woes. When Mervyn King writes his next letter to the Chancellor he also will no doubt blame food and energy prices, and probably he will add the fall in sterling. But these are at best only superficial or “accounting” explanations for inflation. The deeper explanation is that within the UK the momentum of aggregate demand or spending was allowed to build up over a period of two or three years to the point where overall prices have been pushed up beyond the inflation target.

What caused overall spending in the UK to achieve this momentum? After all, domestic spending and inflation in Japan have been much more subdued, even though Japan has had substantially lower interest rates. One set of proximate causes is the extended rise in UK asset prices - especially equity prices and housing prices - between 2003 and mid-2007. Wealth effects have powered the spending that has caused the CPI inflation target to be exceeded. But what in turn pushed up asset prices?

Since the outbreak of the credit crisis it has become plain that the excessive leveraging up of both household and financial sector balance sheets over the past several years and the associated surge in property and security prices were a direct result of allowing the monetary aggregates (M4) and non-bank credit to grow too rapidly over a long period. Unless the excess funds are removed from the economy (e.g. by rapid de-leveraging), it is unavoidable that there will be a period of above-target inflation.

But, if the excess funds are abruptly removed from the economy, then the economic downturn will be exacerbated - as a sharp monetary slowdown would coincide with a period of higher inflation. Currently the data suggest that money growth is slowing, but not too drastically. This justifies keeping rates on hold. But if, as seems likely, money growth slows further, then interest rates may need to be cut.

For too long the official view has been that rapid monetary growth was confined mainly to non-bank financial companies’ holdings of M4, and that these would not impact on developments in the rest of the economy. Similarly the official emphasis has been almost exclusively on interest rates, not on quantitative measures of monetary growth. In future the MPC will need to find a framework which takes account of both the quantity of money (broadly defined) as well as interest rates in setting monetary policy.

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Hold
Bias: Towards easing

There are increasing and consistent signs of a weakening real economy. Though caution should always be exercised with monthly data, retail sales have slipped back in March and April (admittedly after a sharp growth in the first two months of the year) and the latest unemployment data ticked up. The credit crunch, with the three month London Inter-Bank Offered (LIBOR) rate staying well above Bank Rate, is undoubtedly impacting on the economy with the housing market arguably the most obviously affected area to date.

But the startling economic news in the last month has been the deteriorating inflationary picture with large jumps in producer price and CPI inflation rates, reflecting sharp rises in commodity prices. The Bank of England’s May Inflation Report was notable by its significantly more pessimistic forecasts of higher inflation (as well as weaker GDP) which led to newspaper banner headlines along the lines of “no more interest rate cuts until 2010”. Granted the inflation data are poor and the Governor’s letter writing skills will be well employed in letters to the Chancellor over the next year or so. Granted, too, that general inflationary perceptions and expectations are picking up. But so far, earnings inflation shows few signs of accelerating – a situation which is likely to continue, given the weakening labour market. Under these circumstances a price-wage-price spiral is unlikely to develop and there is still room for further cautious easing by the end of the year.

However, with rapidly rising inflation rates (CPI inflation is heading for 3¾% to 4% in the second half of the year), imminent cuts in interest rates can, and should, be ruled out. I vote for no change at the June meeting. But with a bias towards further easing.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral

The current objective of monetary policy is unclear. Consider three kinds of inflation target. One is a band (e.g. 1% to 4%); a second is a point target without any restriction on how far from the point target inflation is permitted to go in the short-term; the third is a point target with a permitted band around it, outside which inflation is not permitted to go even in the short term. I (and everyone else) had thought the UK target a target of the third kind until early 2007. It now appears that the target is actually of (or has now changed to be of) the second type meaning the UK inflation target is a point target with no restriction on how high inflation is to be permitted to go in the short term, provided only that inflation return to the point target at some point in the future. Such a target seems to me to differ from pure discretion only insofar as there is communication concerning the intention of policy over the medium-term. Unlike the third kind of regime above, the UK's inflation target is no longer really one of constrained discretion (in any material sense of "constrained"). Instead, the UK operates under discretion-with-formalised-communication.

Discretion is by no means a stupid monetary policy regime. However, I believe that we can do better than relying on discretion and that at times such as the present it would be particularly useful to do so. Hence, my strong recommendation is that the government add to the point target for inflation a band of discretion around that point target outside which inflation is not to be permitted to go even in the short term. This would allow the market to understand policy much better. Perhaps the band of discretion should be 2% or even more either side of the target (instead of the 1% I thought - wrongly it seems - was the band of discretion before 2007).

The other issue that arises is what the 2008 and 2009 inflation targets should be. Given where we are, I see little merit (and much demerit) in having a 2% target for 2008 or 2009. I suspect that a 3.5% target for 2008 is now appropriate, and the 2009 target should be 2.5%. I have heard it argued that the target cannot be changed. I find this argument difficult to comprehend, given that the inflation target was changed as recently as 2003. If it was reasonable to change the target in 2003, why is it improper to consider changing the target for 2008 and 2009? When inflation targets were first conceived, it was to deal with situations precisely such as this, so that there would be a commitment to a series of (falling) inflation targets for some years ahead, specifying a rectification programme. That is what we now need in the UK - a clear set of targets specifying the UK's rectification path for inflation. Another thought is that increasing the inflation target would reduce credibility and raise inflationary expectations. I do not understand this claim. How can it be less credible to set a target that we expect policy to meet than for us to set a target that policymakers have no intention of trying to meet and that no-one believes there is any intention to meet? Isn't that almost the definition of lacking credibility? I also point out that the inflation expectations data has risen dramatically.

What ought to be happening now is that rates should have been raised much more aggressively in 2006 (as urged by this Committee) and should certainly not have been cut during 2007, so that we should now be able to cut rates. Instead, we face a situation in which it will seem very difficult to cut until inflation has peaked, unless the inflation target is raised. I find it very difficult to anticipate the appropriate policy in the current uncertain environment. I would like to be voting for cuts; yet at the same time it seems plain to me that the target we have actually been set calls for us to be raising rates (absurdly) at this stage. I am very disturbed that the warnings I and others offered for many months have not been heeded, and that the current dangerous situation has been brought about.

All I can see to do now is to wait until inflation peaks. Once that occurs, I will be voting for cuts. The slowdown in growth will be considerable, house prices falls will be considerable, and this pair will probably solve our current inflation problem for us. I find it very disappointing that we are now relying on technical recession or near-recession in order to meet our inflation target. I would have thought that a key purpose of the framework was that we avoided the need for such. However, we are where we are, and I see little option but to hold. Can the Chancellor please amend the inflation target, either specifying the band of discretion outside which inflation is not to go so that we have some guidance on whether and when our thoughts should eventually turn back to rate rises, or (perhaps better, now) set us new and appropriate inflation targets for 2008 and 2009?

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: Neutral

There are currently two strongly-held views about the British economy. One is that inflation is serious and about to take off. The other is that the economy is plunging into deep recession because of the credit crisis. Views combining these two positions are rare but can be found too. In fact the inflation we are observing, which is clearly serious, is essentially due to a terms-of-trade shift against the UK. Commodity price inflation is being driven by loose monetary policy in several major emerging markets, China the worst, as well as by rapid growth for supply-side reasons. The fall in the exchange rate I interpret as a decline in the relative position of financial services in the world economy with the great credit unravelling.

What is most interesting and, I believe, predictable is the absence of response to this terms-of-trade shock by UK wages. Their growth has in fact declined since a year ago to 3.7%. The reason for the lack of response is that: a) the UK labour market is highly competitive these days, with high cross-border mobility, so the equilibrium real wage is unresponsive to largely shared terms of trade shocks (largely the same in Poland as here); and b) monetary policy is tied down by the medium term inflation target so that forward-looking workers and firms do not expect higher future inflation.

This implies that inflation is not about to take off (unlike say in the 1970s). In turn this conditions the outlook for the real economy. In spite of all the press comment it is still hard to find actual economy numbers that are particularly weak - in contrast to panicky surveys which are essentially just reacting to this comment. The economy is fully employed, profits are fairly strong, capacity utilisation is fairly high, and investment seems to be holding up. Even the housing market is not living up to its billing - the actual falls in prices are quite modest and the pressure is showing in volumes as people are taking their houses off the market in the expectation of firmer prices later.

Monetary policy here has been dominated by two mutually cancelling events. First there has been the sharp rise in the term premium due to the credit crisis; that has now fallen back a bit from its heights of around 100 basis points last autumn. Interestingly, the efforts of the major central banks to bring this premium down by a variety of direct liquidity injections have been in vain. The latest by the Bank of England, expected to reach £150bn with long maturities, explicitly keeps the term premium as a fee on the service and so exerts no direct downward pressure on it. Second the MPC has cut Bank Rate by 75 basis points. The net result of these two things has been to leave interest rates roughly unchanged from last July.

My view on the next Bank interest rate move is that it should be down. The downside risks to the economy still appear to be strong. The risk to inflation seems minimal. However, in these circumstances it is also important that the Bank preserves the credibility of the inflation target. Unfortunately this has been undermined by the shift to the CPI; the upward drift of the gap between index-linked and nominal gilts reflects the detachment of the RPI from the CPI. This should improve as house prices ease. The RPI was always a better index because it cannot be so easily manipulated by politicians; there is a powerful RPI committee with wide representation. The combination of the RPI gap from CPI and the idle chatter about how Darling and the Bank would like to sideline the inflation target could be dangerous. This is reinforced by the widespread failure to understand that the 1% to 3% range at which a letter is written has no status, as there is actually no technical range within which inflation has to be kept, only a commitment to bring it back over time to the target. So I would recommend only a small downward move of rates of ¼%, with no bias to ease until the inflation numbers improve.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Probably hold next month too

The seeds of inflation are sown about two years before the inflation becomes apparent. It is too late to stop the current rise. The cure is always painful. Policy should be aimed at minimising the pain and not prolonging it. However, the credit crunch will provide the remedy. The authorities need not tighten policy further. Indeed, my guess is that the credit crunch will be over-kill. Over-kill suggests that interest rates can be lowered to reduce the pain. This would not be wise at the moment. The trade unions are almost bound to be militant in a vain attempt to keep their members’ after-tax income rising in line with inflation. Reducing interest rates would encourage militancy, which would prolong the pain. The best course of action is to leave interest rates unchanged for the time being and for the monetary authorities to stand ready to act decisively when the time comes to reduce them.

Reducing short-term interest rates is not the only weapon at their disposal. The Bank of England has already deployed a weapon that it does not normally use. On two occasions recently it has supplied more reserves than the banks wanted. But will they use them? You can lead a horse to a trough but you cannot make it drink. The Bank of England pays interest on the balances that banks keep with it, that is, on their reserves, which encourages them to sit on reserves. Banks would be encouraged to drink if the interest rate was reduced. The weapon of last resort is for the authorities to make quite sure that the money supply (M4) grows at an adequate rate by under-funding, that is, by selling less gilt-edged stock than is needed to finance the budget deficit. If necessary the authorities can purchase gilt-edged stock previously issued, corporate bonds or even equities. This is the cure for debt-deflation that Irving Fisher proposed in the early 1930s. It will become extremely important if all else fails.

Postscript: The Debt Management Office

When the Labour Government came to power the previous functions of the Bank of England were split into three. The MPC was given the task of setting interest rates. The supervision of banks was passed to the Financial Services Authority (FSA). Managing the gilt-edged market was passed to the Debt Management Office (DMO). It is generally acknowledged that a lack of precision about the roles of the Bank of England and the FSA contributed to the Northern Rock crisis. There is a danger that a similar muddle could occur between the Bank of England and the DMO. The roles of the Bank of England and the DMO certainly need clarifying.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Tightening

One advantage of having an in-house econometric model is that it gives one the courage to go out on a limb. Once an oil price assumption of over US$110 per barrel of Brent Crude was fed into the Beacon Economic Forecasting (BEF) model of the international and global economies it was clear that the UK inflation target was a dead duck, not just this year but in 2009 and, probably, 2010 also. One reason many people seem to have been caught by surprise by the acceleration in CPI inflation in April, was that the oil price assumption incorporated in the consensus forecast was too low. This may, in part, reflect publication delays when the oil price has been rising rapidly. Rather surprisingly, only twenty out of the forty-four forecasting groups whose predictions appear in the monthly comparison of independent forecasts compiled by HM Treasury reveal their oil price assumptions. This makes it impossible to work out the assumed oil price that underlies the consensus inflation prediction. However, the May 2008 HM Treasury consensus forecast reveals that the average oil price assumption made by the twenty forecasters who submitted this information was US$101.5 for this year, followed by US$93.1 in 2009. These figures compare with the US$128.3 recorded on 27th May. There may be an element of speculative overshooting in the current price of oil, although the 21st May MPC minutes argued that this was not a major factor. However, the mean assumption that the oil price will be US$35¼ lower next year may explain why more alarm bells have not been ringing on the inflation front. Plugging a ‘compromise’ US$115 assumption into the BEF model gives a CPI inflation projection of 3¼% in the final quarter of this year, 3¾% in 2009 Q4 when the lagged effects of this year’s fall in sterling will be most potent, and 3½% in the closing three months of 2010.

In theory, oil price shocks represent relative price changes, not absolute ones. Oil price hikes do not help matters in the short run, and may worsen the inflation/output trade off for a couple of years. Even so, their impact on output should eventually prove transitory, provided that the supply side is not harmed by harmful political responses and protectionist forces are kept at bay. Nevertheless, a transitory inflation shock can induce a permanent rise in the international price level, and possibly its rate of change, if the global money supply rises to accommodate it. Because money is endogenous in the BEF forecasting model, for example, inflation shocks get built in unless the monetary authorities raise real interest rates to offset this tendency. In practice, central banks have been cutting rates and the current real three-month rate of interest in the world as a whole appears to be zero. This explains why the annual growth of the OECD broad money supply accelerated to 8¾% in 2008 Q1, representing the fastest increase since 1990, when OECD inflation averaged 4.9%. The low cost of carry associated with zero real interest rates is also a reason why there has been so much speculative activity in all commodity markets, not just that for oil. Financial speculators need – and aggressively lobby for - cheap money the way airlines need cheap aviation fuel. It is not necessarily in the interests of society as a whole that central banks supply it.

The UK national accounts data, released on 23rd May, confirmed that real GDP rose by 0.4% in the first quarter, and was 2.5% higher on the year. However, this measure still seems to be understating the strength of the private sector component of activity on which monetary policy operates. This is because of weak oil production and a sluggish expansion of measured government output. Non-oil GDP rose by 0.5% on the quarter and 2.6% on the year in 2008 Q1, while non-oil market sector gross value added increased by 0.5% to a level 3.0% up on the first quarter of 2007. One would have to be sanguine about the growth of UK productive potential not to regard this as being on the high side of trend, especially now that Poles are returning home because of the pound’s collapse against the Zloty.

Sterling remains weak, there is a growing policy inconsistency between the irresponsibly lax UK fiscal stance and the monetary regime needed to bear down on inflation, and the trade figures remain dire. In addition, the CPI is running some 0.4 percentage points below the rate that one would expect from the ‘double-core’ retail price index excluding mortgage rates and house prices - which rose by 3.9% in the year to April - suggesting that there could be an adverse catching up at some point. RPIX inflation, at 4%, was above its old target range for the third consecutive month in April, when the ‘headline’ RPI inflation rate was 4.2%. Overall, there is little concrete evidence that the UK economy is heading for a hard landing, let alone a crash. Furthermore, some slowdown from the heady pace of recent years was both inevitable and desirable. Things have not yet reached the point where higher interest rates are immediately desirable and there remain serious downside risks. However, I maintain a strong bias to tighten in the medium term, if higher rates are not forced on the authorities by speculative shorting of the pound. This looks like an increasingly probable scenario, as the credibility of the British political authorities and their sense of fiscal responsibility sink ever lower.

Comment by Peter J Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: Cut sharply on evidence of a material loss of economic momentum

The release of a 3% headline inflation rate for the April CPI has sparked some wildly differing reactions. For some, it is an understandable reflection of the acute pressures on prices of internationally traded energy and commodities, aggravated by the abrupt relaxation of the US monetary stance. As such, it prompts no particular change of direction. For others, it is an affront to the UK policy framework and must be countered by an immediate interest rate increase. This latter reaction may appear logical, yet it neglects the broader context of: (a) the legacy of many years of excessive M2 money stock and household credit growth in the UK, which by implication contradicted the supposed commitment to low inflation; (b) the potential for the global economy to slow dramatically as a result of the credit crunch; and (c) the likelihood that the UK economy will suffer disproportionately as a result of its openness, the strong representation of the financial sector in its economy and the severe exposure to the decimation of structured credit .

To those who dismiss all three of these concerns, the way is clear to remove the easing bias and even to withdraw the 75 basis points of easing that has occurred since last December. But for those of us who place significant weight on all three considerations, there remains an expectation that UK Bank Rate should fall in order to moderate the overly-restrictive credit conditions facing the UK private sector. Specifically, the real rate of interest with respect to private sector inflation (ex-energy) is still well above 3%. Even more important than the price of credit is its availability which remains tightly rationed. On a strong view of the Special Liquidity Scheme, announced in April, there should be no further need for Bank Rate reductions on the grounds of unintended tightness, but it is an empirical issue whether the Scheme will be successful in eliminating the excess LIBOR-Overnight Index Swap spread.

The key issue is whether the UK is about to suffer a sudden loss of momentum, such that GDP will soon show quarter-to-quarter falls and next year, a negative annual growth rate. This is my central expectation, based on the lagged effects of the constriction of credit on transaction activity, the real income squeeze exerted by soaring food and energy prices and the lack of scope for fiscal relaxation. If there were to be “no rate cuts until 2010” as the Financial Times interpreted the latest Inflation Report, then this would reinforce my downbeat expectations.

However, it is quite conceivable that this contraction of economic activity will have little impact on the profile of CPI inflation outturns over the coming year. It is a fallacy to believe that the UK operates as a giant factory at varying levels of capacity utilisation. It is highly probable that CPI inflation will exceed the 3% upper bound frequently in the coming year. There may be no level of UK Bank Rate that will prevent it happening. The deeper reality is that inflation targets operate as an expectations reinforcement mechanism. Interest rates are a signalling tool, not a deterministic control.

Given that the Bank of England has a clear interest in defending its inflation target, even if failure is inevitable in the near-term, it would be very difficult to justify a rate cut in present circumstances. The time to cut Bank Rate aggressively was in the interval from September 2007 to March 2008 and indeed this was my preferred course of action. The landscape has altered materially as a consequence of the sharp ascent of oil prices and energy utility prices. These have accentuated the downside risks for the economy. As and when this scenario of sequentially negative GDP materialises, another opportunity will arise for cuts in the Bank Rate.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Strong bias to raise
I am amazed at how complacent everyone has been about inflation in the developed world and about oil prices, in particular. Current international inflation figures are a clear sign that monetary policies in the UK, in the Euro-zone and in the US were too lax two to three years ago. Central banks did not take appropriately tough decisions then and they are not taking them now. The cut to a 4½% Bank Rate in the UK was mistake and keeping it there for a whole year thereafter was an even bigger one. The fast growth in M4 was a warning as many of us pointed out. The widening trade deficit was another one. The strength of the pound was illusory, and led to pent up inflation that was waiting to burst free. Now that it has, we have another inflation impulse to take account of going forward. But even now, you get calls for rate cuts. What madness. As has been said many times by some SMPC members, the credit crisis is a red herring; the real risk is inflation, even with the credit crisis interest rates should not be cut much. Losses amongst financial firms are not reasons for loosening monetary policy rates. Illiquidity should be dealt with by employing appropriate non interest rate tools.

As far as the June rate decision is concerned, I have a strong bias to raise rates, but wish to hold for the time being. The reason is that UK rates are close to neutral and the measures to deal with the credit crisis are not yet fully in place. The bank should announce a £150bn facility and accept ABS as collateral. Once that happens and LIBOR rates are at a more normal margin above Bank Rate, the MPC should concentrate on getting inflation back to target.

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group and Global Vision) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that a full set of nine votes is always cast

Following its latest quarterly meeting (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) narrowly voted to leave Bank Rate unchanged on Thursday 8th May. In particular, five members of the shadow committee voted for rates to remain on hold, while four members voted to cut the official interest rate.

The advocates of a rate cut were divided, with two wanting a ¼% reduction and two a cut of ½%. The SMPC gathering was held on Tuesday 15th April. However, the vote was re-opened following the announcement of the Bank of England’s Special Liquidity Scheme on 21st April. One member changed his vote from a ¼ % reduction to a hold in response.

Members of the SMPC remained concerned by the problems that had arisen with sub-prime lending. However, whilst some members wanted a reduction in interest rates, others expressed the view that interest rates were not an effective tool for dealing with the serious problems in the UK banking sector. Furthermore, a number of members felt that loosening monetary policy could damage the Bank of England’s credibility given the serious inflationary pressures in the economy.

Members also stressed the importance of non-interest-rate measures in the current circumstances. There was general agreement that the Bank of England should provide liquidity to the markets. However, members stressed the crucial importance of mopping up liquidity after the crisis was over, in order to avoid the severe inflationary problems that have appeared after some previous financial markets shocks.

David B Smith invited Trevor Williams to give his assessment of monetary conditions.

The Monetary Situation – world credit market conditions remained intense.

Trevor Williams referred the other SMPC members to the briefing charts he had presented to the committee. He began by stating that credit market conditions and financial volatility remain intense. Bond yields are reflecting a flight to quality. Banks are still worried about counterparty risk. However, OECD money supply has not collapsed and individual country money supply growth remains strong. Inflation is increasing everywhere, even in Japan. The reason is the rise in producer prices. Dollar commodity prices are rising sharply. But wage growth across the OECD, although accelerating, remains low. Output gaps of the major economies are slightly positive or close to zero. However, the latest International Monetary Fund (IMF) forecast is for a generalised growth slowdown even in the fast growing far-East.

Global house price gaps (the extent to which house prices cannot be explained by fundamentals) have increased sharply indicating the vulnerability of major economies. Yet there is little sign that the credit crisis has affected economic activity. Industrial production continues to grow at a solid pace and GDP growth globally has not shown a significant downturn. Labour market conditions remain favourable and the unemployment outlook is benign. In general the major economies are rebalancing the structure of growth from domestic demand to exports.

David B Smith thanked Trevor Williams for his presentation and opened the meeting up for discussion.

Discussion

Gordon Pepper commenced the discussion by suggesting that adjusting the broad money figures for securitizations may indicate tighter conditions than shown by the raw numbers. Roger Bootle said that the continuing growth in money supply represents a substitution from capital market borrowing to bank-borrowing and agreed with Gordon Pepper that the numbers had to be treated with care. Andrew Lilico said that the weakness of the inflation targeting approach - rather than a trend price-level targeting approach - is that there was no pressure to deal with a build up of liquidity, despite the threat that this could pose to inflation discipline in the long run. In reply, Roger Bootle said that we are starting from where we are now, not where we would like to be. Raising rates would compound the policy mistakes of the past. Gordon Pepper added that banks have to recapitalise. The role of the Bank of England is to provide liquidity and then mop up the excess liquidity after the crisis has abated.

Anne Sibert said that the crisis was the outcome of a market failure. Bad corporate governance has led to counter party risk. The Bank of England should respond by allowing the commercial banks to borrow using less than the very best AAA rated collateral as security. Trevor Williams said that this was what the Federal Reserve was doing in the USA but the problem is whether the excess liquidity would be withdrawn after the crisis. Roger Bootle said that the arguments for tackling the fundamentals that caused the crisis are good ones. However, the scale of the risks are so great and the potential outcome too serious to avoid anything but immediate action to stop the financial system from collapsing. Andrew Lilico said that we should do more about addressing the fundamentals and the problems of moral hazard.

There followed a general discussion about the merits and de-merits of deposit insurance. Andrew Lilico was critical of the deposit insurance system as creating excessive and costly regulation. Kent Matthews said that while it would be useful to provide a statement of what should be done in the SMPC Minutes we have to make a recommendation on interest rates. David B Smith said that one of the strengths of the SMPC was that it did not have the same restricted mandate as the actual Monetary Policy Committee (MPC), which was to achieve the inflation target using just the one policy instrument of the short-term rate of interest. This meant that the SMPC had – and should employ - the freedom to look at the wider institutional framework, as he had tried to do in his April 2007 publication for the Economic Research Council Cracks in the Foundations? A Review of the Role and Functions of the Bank of England After Ten Years of Operational Independence (www.ercouncil.org), which had forewarned of the difficulties that would arise if the Bank of England ever found itself in a lender of last resort situation.

In particular, David B Smith thought that there was now a case for the re-imposition of mandatory reserve asset ratio requirements on banks whose deposits were insured by the tax payer – this was partly because Basle agreement style capital controls had been tried and seemed to have failed – and also for introducing a second monetary pillar into the UK approach as a check against boom/bust credit cycles. This would be in addition to the traditional role of money and credit monitoring as a longer leading indicator of inflation pressures beyond the conventional macroeconomic forecasting horizon. David B Smith wondered whether the UK financial system would be facing such extensive problems if the Bank had used variable liquidity ratios as an additional tool to limit the growth of broad money and credit over the past three years to significantly below 10%.

Votes

David B Smith then asked the members of the committee to vote on a rate recommendation. In one case, a member (Gordon Pepper) changed his vote subsequent to the 15th gathering from a ¼% reduction to a hold following the announcement of the 21st April Special Liquidity Scheme.

Comment by Philip Booth
(Cass Business School and Institute of Economic Affairs)
Vote: Cut by ¼%
Bias: Neutral

Philip Booth said that he could see the dangers to the macro-economy from not cutting interest rates but the fact is that there is insufficient information within the banking system about the location of bad loans for the interbank market to start functioning again. This is not a problem that will be resolved by reducing interest rates. The risks are that policy is too slack to maintain inflation discipline in the long run. On balance he voted for a reduction of ¼% in Bank Rate on 8th May with a neutral bias thereafter.

Comment by Roger Bootle
(Deloitte and Capital Economics Ltd.)
Vote: Cut by ½%
Bias: To cut

Roger Bootle said that the situation was extremely dangerous. The general lack of confidence and trust across the banking system compounded by weakness in the housing market poses strong dangers for the macro economy. He said that the danger to the macro economy warranted a reduction of ½% in Bank Rate in May alongside a widening of the collateral requirements for lending by the Bank of England. A strong signal had to be sent to the markets that the Bank was prepared to act.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral

Andrew Lilico said that the situation could become very serious but this is not a crisis of capitalism. He said that interest rate cuts are likely to be ineffective anyway. The worst danger at this point is that the central bank acts ineffectively, costing it credibility and the ability to be effective later in the crisis in providing support and preventing matters slipping into recession. He voted to hold with a neutral bias.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: Neutral

Kent Matthews said that he supported the Bank’s moves to inject liquidity into the inter-bank market by accepting less than AAA paper as collateral. There was also a purpose in cutting rates even if the full cut is not passed on to consumers. The commercial banks have to rebuild their capital and widening spreads is one of the ways in which they can do this. A cut in Bank Rate will be passed down to consumers on a less than 100% basis but the effect on confidence cannot be discounted. Consumer spending has not collapsed and the economy has not taken a serious downturn. Inflation risks remain and so the cautious approach adopted by the Bank is the correct strategy. Cuts have to be measured and the Bank has to show that it is in control of financial events. He voted for a cut of ¼% in May with a neutral bias subsequently.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Great uncertainty - wait and see how things develop

Gordon Pepper stated in his revised submission that, in normal times, steering the UK economy has been described to be like driving a car looking out of the back window. Analysis of the latest trends in economic data is of little use at present because the credit crunch could be overwhelming. The forward-looking monetary indicators are also currently jammed. What matters is whether the supply of money is greater or less than the demand for it. The published data for M4 suggest that supply is still excessive but this is most likely wrong. First, an unknown adjustment should be made for asset-backed commercial paper. If the same adjustment had been made in the UK as in the US, the growth of the money supply prior to last August would have been increased; since then it would have reduced. Further, the demand for liquid assets in general has risen because credit is no longer freely available and the demand for bank deposits in particular has risen because the market in competing liquid assets has dried up.

Back to the credit crunch - a week ago the outlook was grim. The head of the IMF had described it to be the worst crisis since the 1930s. The prime minister was so concerned that he flew to New York for discussions, surely aware that his visit would be over-shadowed by that of the Pope and would attract poor publicity. A few days later it appears that the problem may be on its way to being solved.

The danger lights were flashing because quite a few banks were deliberately attempting to cut back on their lending. They were raising rates to avoid doing business. They did so for two reasons. The first was that they are afraid of being caught with insufficient liquidity, as per Northern Rock, with the inter-bank market not functioning properly. The second was that they have insufficient capital to support their businesses.

The Special Liquidity Scheme announced by the Bank of England on 21st April should go a long way to solving the liquidity problem but not the capital one. Huge quantities of illiquid assets can now by swapped for gilt-edged stock but only if a bank has the necessary capital to put up substantial margin, for example, 12% for residential mortgaged-backed securities and credit card asset-backed securities that are either floating rate or fixed interest with under three years to maturity. The margin rises to 22% for fixed-rate ones with between ten and thirty years to maturity. In addition, an extra 5% has to be put up for own-named securities. Swapping such assets uses up capital at a time when it has been depleted by large losses. The Bank’s measures by themselves would not alleviate the crisis.

Royal Bank of Scotland’s huge rights issue, if it is a success and other banks follow suit, is the other half of the solution. It will provide the capital to put up margin. A danger now is that a huge volume of new issues, in combination with a decline in surplus savings from China, will produce a fall in the stock market. This could trigger another round of bad debts, and so on. It would not be the first time stabilising one market has destabilised another.

Comment by Anne Sibert
(Birkbeck College)
Vote: Hold
Bias: Neutral

Anne Sibert said that the inflation outlook for the UK was uncomfortable. It won’t be long before the Governor will have to write another letter explaining the overshoot of the target. If not for the financial crisis, we would be talking about raising rates. Without concrete evidence of a slowdown in the economy she voted to keep rates on hold and to ease liquidity in the market with a neutral bias.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Tightening

David B Smith commented that it was always uncomfortable pushing against a crowd going in the opposite direction, particularly if some elements of the crowd were seized by panic, and others were whipping up the sense of fear for their own financial motives. He also accepted that it was legitimate for market traders to concentrate on the very short run. His contacts in hedge funds for example were now concentrating on forecasting intra-day volatility, because the markets were so efficient that any non-random element in inter-day movements had been largely ironed out. Central banks are in a different position, however, because it can take five to ten years for the consequences of today’s policy actions to fully work their way through to the price level. While the output gap seems to be the main influence on changes in the rate of inflation over horizons of up to eighteen months or so, movements in the price level beyond that period appear to be dominated by the behaviour of broad money in a largely closed economy, such as the Euro-zone, and international prices and the exchange rate in an open economy, such as Britain’s. Movements in the exchange rate are themselves reflections of the relative tightness of domestic monetary policy compared to that being pursued overseas. However, other factors also matter, and currencies often exhibit speculative over- or under-shooting in the short run.

Britain has a more open economy than the US or the Euro-zone. This means that any downwards movement in the external value of the pound poses more of an immediate inflation threat than would be the case with the US$, Euro or Yen. In the long run, a 1% depreciation of sterling appears to be reflected in a 1% hike in the UK price level, although this long-run appears to be around ten years or so. Even so, the 10½% decline in the sterling index over the past year represents a substantial depreciation by any standards. Indeed, it is not far short of the devaluation of 1967 and the depreciation of sterling in 1992, which followed Britain’s expulsion from the Exchange Rate Mechanism. Incidentally, the government of the day lost office after both depreciations. However, the pound was strong a year ago and the annual average depreciation since the new sterling index was introduced in January 2005 has averaged a more modest 2% per annum.

The MPC is not too concerned about the weak pound because its model of inflation is a closed economy one, which emphasises the importance of the deviations of demand about the economy’s long-run supply potential. From the MPC’s perspective, the depreciation of sterling allows for a re-balancing of the British economy from consumption to net exports and will not lead to high inflation as long as the economy is running below its full potential. The MPC also appears to believe that the balance of probabilities facing the world economy contains a serious risk of a 1930s style meltdown of the financial sector, negative money and credit growth, and the emergence of serious deflationary pressures.

The problem with this scenario is that there is no sign of it in the data. Outside the US, global activity remains satisfactory, the growth in the international broad money supply has been accelerating, the ‘headline’ consumer price measures that best reflect the experience of ordinary people have been running at high rates, and the prices of oil, gold and non-oil commodities have all risen sharply, in a manner that is more reminiscent of the build up of global inflationary pressures in the early 1970s than it is to the experience of the 1930s.

As far as Britain is specifically concerned, it is worth stopping to ask what a 2% CPI inflation target implies in a long-run steady state for other elements of the economy – on the assumptions that annual CPI inflation is downwards biased by around ½% compared to other inflation measures, and that the long-run increase in productive potential is around 2½%. Under these circumstances, one would want ‘double-core’ retail price inflation excluding house price depreciation and mortgage rates to be running at around 2½% - compared with 3.4% in March - annual house price inflation of around 5% (the Department of Communities and Local Government index was up 6.7% in the year to February), M4 broad money growth of no more than 9.0% (it was 12.0% in March); and a rough balance on the current account of the balance of payments, not the deficit of 4¼% of national output recorded in 2007. One would also want international inflation to be no higher than 2½% - the latest OECD figure is 3.4% - or sterling appreciating to offset the excess.

The conclusion was that the British economy, had still not entered the neutral zone consistent with hitting the inflation target in the long run, but was still in the overheating zone, a view that was supported by the 3.4% increase in non-oil private-sector Gross Value Added in the year to 2007 Q4. David B Smith did not believe that Bank Rate had a powerful impact on the economy, and was not too perturbed by the relatively modest reductions so far. However, he could see no case for further cuts in the absence of firm evidence of a slowdown, and thought that policy would need to be tightened – perhaps, abruptly and in the context of a run on sterling – at some stage over the next eighteen months or so.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Neutral

Trevor Williams said that he voted for a hold with a neutral bias. What to do next will depend on the data and how the economy develops in the coming months. The Bank should use non-interest methods of increasing liquidity, accepting longer maturity paper as collateral and considering under funding. The negative feedback from the financial crisis to the real economy depends on the ineffectiveness of central bank policy. Furthermore it was not just a matter of a lack of liquidity but liquidity not being in the right place.

Votes in Absentia

The SMPC allows a small number of votes to be cast in absentia and adds their written submissions to the record of the meeting, to ensure that exactly nine votes are cast. On this occasion one such vote was required since eight SMPC members were present at the physical meeting.

Comment by Patrick Minford
(Cardiff Business School and Cardiff University)
Vote: Cut by ½%
Bias: To ease

Patrick Minford said that the economy will slow to below 2% growth this year but that the downside risks are severe as long as the excessive tightness in the three-month money market continues. The housing and mortgage markets were clearly fragile. The risk of the UK having the same problems as the US was clearly present if current tightness continues. For the inflation outlook he distinguished between terms of trade shocks via the commodity prices boom and a domestic inflationary process. So far wages growth, the main element determining domestic inflation, had been consistent with the inflation target. With the current problems in the mortgage and housing markets and the effect of these on consumer confidence, the Bank does not have to worry that its credibility will be undermined by an easing. He voted to reduce Bank Rate by ½% in May with a bias to ease even further in subsequent months. Additionally he supported the Bank’s policy of attempting to unblock the inter-bank lending market in order to bring down the high risk premium, defined as the three-month London inter-bank offered rate (LIBOR) minus Bank Rate. The market rate represented by LIBOR should be brought down to 4.5%.

Policy response

1. By a narrow margin of five to four, and following a change of view by one member, the committee voted to hold Bank Rate at the 5% announced on 10th April in May.

2. Two SMPC members voted to cut Bank Rate by ½% on 8th May and two members voted for a cut of ¼%.

3. Of the five who voted for leaving the official discount rate unchanged in May three had a neutral bias, one had a bias to tighten, and one thought that ‘wait and see’ was the best policy.

4. Among the four SMPC members who voted to reduce Bank Rate on 8th May, the two ¼% rate cutters had a neutral bias, while the two advocates of a ½ % reduction had a bias towards further easing.

5. There was strong support at the 15th April SMPC meeting for non-interest policy to increase the injection of liquidity into the money markets. This was before the announcement the Bank of England’s Special Liquidity Scheme on 21st April, which SMPC members were not aware of at the time.

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group and Global Vision) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that a full set of nine votes is always cast.

In its latest monthly E-mail poll (carried out in conjunction with the Sunday Times) the Shadow Monetary Policy Committee (SMPC) voted by seven votes to two to leave UK Bank Rate unchanged at its current 5¼% on Thursday 6th March.

The two dissenters from the majority vote both wanted to cut the official discount rate by ¼% (to 5%) on this occasion. Looking further ahead, both the SMPC rate cutters had a bias towards further rate reductions, while three of the holders had a neutral bias thereafter, two had a bias to cut, one was prepared to cut - but only if the credit crunch worsened - and one ‘hold’ had a bias to tighten.

Virtually all the SMPC members involved expressed concern about the problems that had arisen in the global market for credit, but a number also pointed out that the putative UK recession appeared to be everywhere, apart from in many of the official statistics for the domestic economy. There was also a substantial minority who felt that earlier policy mistakes, which had meant that UK monetary policy had been too lax for too long, meant that a further reduction in Bank Rate was not appropriate.

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Hold
Bias: Towards cuts

Even though there are undoubted signs of weakness in the housing market and the real economy, the indicators recently released remain remarkably, arguably deceptively, robust. In particular, January’s retail sales were firmer than expected, buoyed by price cutting, with the Office of National Statistics’ (ONS’s) ‘main message’ being a ‘steady underlying growth in retail sales’.

But my expectation is still for a sharp slowdown in consumer spending in 2008. Furthermore, the housing market continues to look vulnerable, given the continuing tight credit market conditions. This year’s ‘reset shock’, in which, on some calculations, at least 1.4 million homeowners face a sharp jump in loan repayments as their fixed interest mortgages expire, can only exacerbate the situation. But, provided unemployment does not rise rapidly, a replay of the early 1990s housing crash looks most unlikely. And, if it does, the Bank is in a good position to respond by cutting rates sharply.

Inflationary pressures are rising and Consumer Price Index (CPI) inflation is expected to pick up to around 3% in the first half of the year, despite the weakness of the prices of retail goods, partly driven by higher utility bills. Unless the housing market does deteriorate rapidly, aggressive cuts in interest rates are quite inappropriate. My bias is, nevertheless, for further cuts. But there is no urgency and, after February’s widely anticipated ¼% cut to 5¼%, the Bank Rate should be left on hold in March.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral

The two key variables towards which monetary policy is directed are inflation and growth. At present the future outlook for the one is fairly clear - inflation is going to rise, and will very probably exceed 3% again this year, after which it may drop back a little, but is likely (based on the current policy stance) to be above target for most of the time over the next few years. The outlook for the other is far from clear - growth will surely decelerate, but it is difficult to say by how much. Data is very mixed. Retail sales, which some evidence suggested was slowing rapidly in December, picked up again in January. Gross Domestic Product (GDP) data remains robust. Input price rises are disturbingly rapid, but wage growth is still moderate. House prices fell for a brief period, but may have stabilised. It remains possible that the growth slowdown will be very mild indeed - perhaps only down to a little below 2% growth - but equally there remains the possibility of a much sharper slowdown - to perhaps only 1% growth.

At present, my key point of difference with the Monetary Policy Committee (MPC) relates not to the interpretation of events but, rather, to the interpretation of the MPC's role within them. In early 2007 inflation rose above 3% - an event that the MPC had assigned a non-trivial probability to in August 2006, but made no material effort to prevent. The MPC is now predicting, as its mainstream scenario, that inflation will exceed 3% in 2008, and yet has been cutting rather than raising rates.

It is asserted that the MPC's target is always 2%, and that the only material difference between inflation of 3.0% and 3.1% is that in the latter case the Governor is required to explain to the Chancellor why this is so. As I have done on previous occasions, I again now dispute that this is the correct way to understand the UK's inflation target. In my view, the correct way to understand matters is that there is a target of 2%, a tolerance band of 1% either side within which the MPC has discretion to allow inflation to fluctuate away from target for fairly brief periods (employing its two-year-ahead horizon), and inflation should not be permitted to go below 1% or above 3% except as a consequence of significant surprises or force majeure. The MPC disagrees with this interpretation, but it is not a matter for the MPC to interpret its own target. That is a matter for the Chancellor. What we lack (as we lacked last year) is any comment from the Chancellor clarifying his interpretation of the target. Last year, that was perhaps excusable (it may not have been necessary to provide such a clarification for just a one-off one-month event). But now we need such a clarification, and I hope that the Chancellor can provide it soon. Indeed, more than that. It seems to me that the MPC believes that an appropriate target for inflation in 2008 is 3%. Maybe it is correct. If so, it is for the Chancellor (not the MPC) to set the Bank of England a 3% target for 2008 inflation (after all, an inflation target is always for just the next year's inflation).

As things stand, the UK's inflation targeting regime runs the risk of gradually dissolving into un-clarity. For if the target is always 2% and there are no consequences to its being 3.1% rather than 3%, are there consequences to its being: 3.2% rather than 3.1%?; 3.5% rather than 3.2%?; or 4% rather than 3.5%? It will seem that policymakers have decided, as they have done so many times in the past, that it is better to have a little more inflation today - perhaps 3.5%, this time - than a little less growth. And if growth does not pick up as swiftly in 2009 as expected? Or if it seems as if it might fall further? Will we say that it is better to have inflation rise a little further (perhaps 4%, by then) rather than growth slow further? Once we lose the discipline of an upper limit to inflation - once the aspiration becomes a vague ‘We'll get inflation down to target sometime in the future’ then monetary credibility will suffer, economic agents will respond (as they are now responding) to lower interest rates by raising their inflation expectations, and monetary policy will lose its bite over growth. Then we will have the counterproductive consequence that being too greedy for growth will mean that we are less able to control growth at all.

Inflation targeting is an excellent monetary policy regime that allows policy-makers to communicate with the public their views about the future path of the economy, and thereby to manage growth subject to the achievement of the inflation target. But it should be regarded as a policy of constrained discretion - and the nature of the constraints needs to be clear. At the moment, who knows what upper limit to inflation the MPC would consider acceptable in order to avoid an ‘excessive’ slowdown in growth? And that is not the MPC's fault. That is something that the Chancellor must tell us.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral

Despite the recent cut in rates, monetary conditions remain tight. Signs of a cooling housing market, and slowing consumer spending, will add to the pressure to cut rates further. However, the effect of rate cuts are more psychological than real. Commercial banks will want to rebuild their degraded balance sheets and will not necessarily be passing the full extent of the cuts through to the consumer. There are short-term inflationary pressures but these have not fed into long-term inflation expectations, as yet. The Bank of England has not lost credibility and the markets still expect it to do the right thing on the first sign of a resurgence in inflation. It is all the more important that the Bank should not be impetuous in its action. There is sufficient uncertainty in financial markets to warrant a cautious reaction. Interest rates may have to fall but this should be done in a measured way. This implies that Bank Rate should be held in March, but with a bias to cut thereafter.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: To ease

The current situation is one of considerable uncertainty about real activity, with problems surfacing almost daily in the financial markets, as major institutions continue to write off massive losses in the sub-prime market. This uncertainty centres on future growth more than on future inflation. It is true that commodity and food prices have been very strong recently and also that there is serious inflation in China. China needs to tighten monetary policy and allow its currency to float upwards as part of that - it is awash with dollars procured in large scale foreign currency intervention. However external inflation does not cause internal inflation in an economy with a floating exchange rate like the UK. At most, it causes temporary inflation and it may be part of an unfavourable movement in the terms of trade to which households need to adjust. If one examines the degree of UK monetary tightness through the lens of real interest rates, it appears somewhat excessive, with activity weakening. The risk premium between bank rate and the money markets, while down from its peaks, has recently risen again to 0.4%. Indicators of domestic inflation are consistent with the inflation target being met in two years' time; the major one, wages, is consistent with 2% inflation in the longer term. In these circumstances I would support a further ¼% cut, with a bias to some further easing.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: It is still possible that interest rates may have to be reduced aggressively

The main criticism of the Bank of England is not that it supplied insufficient liquidity when the credit crunch broke but that the MPC allowed inflationary momentum to develop, there having been yet another example of rises in interest rates that were too little, too late. The MPC has actually been lucky. It has not had to take the unpopular action of raising rates further. The credit crunch has done the dirty work for it.

People and companies borrow from a bank to raise money to finance expenditure on goods and services and on assets. If banks will not lend, the expenditure will not be incurred. Most people realise the way in which a fall in bank lending would curtail economic growth. But this is not the main effect. A bank loan creates a bank deposit. A deposit is not destroyed when someone spends the money. It is merely passed to the provider of the goods and services or the seller of the asset. Money is like the ‘hot potato’ of the childrens’ game. One child can pass it to another but the group as a whole cannot get rid of it. If money and the economy are out of adjustment it is mainly the economy that does the adjusting. This continuing effect, which is most important, is not widely appreciated. When the credit crunch broke in August 2007 I wrote that the main threat was that there would be a fall in bank lending leading to insufficient monetary growth. If this had happened, I had thought that I would quite likely be arguing that the MPC was reducing interest rates by too little, too late!

In the event, bank lending has continued to grow, albeit at a slightly reduced rate, and monetary growth has only declined a little. The provisional estimates for growth in January were published on 20th February. The year on year growth of M4 has fallen only slightly, from a peak of 13.9% in May to 12.9%, whereas that of M4 lending has fallen from 14.6% in January 2007 to 12.4%. It must be admitted that the data for the explanation of M4’s behaviour are very difficult to interpret. There is, for example, doubt about the effect of securitisation of loans and its unwinding. Nevertheless the main reason for the decline in the growth of M4 appears to be not domestic factors but the extraordinary behaviour of non-resident and foreign currency deposits and of non-deposits liabilities. The gale appears so far to be international and not domestic. Further, the large UK banks appear to have avoided the huge depletion of capital experienced by some banks. Put simply, the alarm bells for the UK economy are not sounding, at least not yet. It follows that UK interest rates should not at the moment be reduced further.

Some may even argue that the MPC has already relaxed too much. I disagree. People’s demand for money rises when they fear that credit will not be easy to obtain and when the markets in liquidity assets dry up. Such a rise in demand mops up supply and a rise in interest rates is not needed. My conclusion is that interest rates should be left unchanged.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: To ease

Monetary and credit market conditions remain very tight. The end-year crisis in the money markets has passed, but three month inter-bank rates are still 40 basis points above bank rate, reflecting the shortage of bank capital. The bank reporting season should help to ease the problem of counterparty risk in the banking system, but will do little to resolve the problem in the hedge fund and Structured Investment Vehicle (SIV) sectors, which remain completely opaque. It will do nothing to ease the pressure on regulatory capital.

Mortgage lenders are very short of funds and have been tightening their loan criteria and pushing up their lending rates, despite the recent reductions in Bank Rate. This situation could have serious consequences for the housing market unless it is resolved quickly. The housing market and the high street have held up remarkably well in the face of these pressures, but Bank Rate may have to be cut sharply if the situation deteriorates.

To set against this, world food and energy prices are pushing up the CPI and the pound has fallen back against other currencies. Public perceptions of inflation appear to be on the increase. In view of this, I would keep Bank Rate on hold in March. However, the weakness of the domestic market should make it difficult for importers to pass their higher costs on to the consumer, allowing rates to be cut at a measured pace over the next few months. Retailers’ prices are already under strong downward pressure.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Tightening

The sterling index is currently some 8¾% lower than it was a year ago, while the pound has fallen by 11¼% against its main trading partner, the Euro, although it has risen by not quite ½% against the weak US$. The extent to which one is concerned by this development depends on ones’s fundamental model of inflation. Where the MPC is concerned, the prime determinant of inflation appears to be the domestic output gap, which can be influenced by its interest rate policies, so the main effect of the weaker pound is to allow a much needed re-balancing of the UK economy from domestic consumption towards net exports. In an alternative ‘international–monetarist’ model of the inflation process, however, one would expect that the logarithm of the domestic price level would eventually equal the logarithm of the overseas price level less the logarithm of the exchange rate plus a constant term. The empirical evidence suggests that the latter model provides at least as good an explanation of the movements in the UK price level over the past four decades as the output gap. However, the two approaches can be combined, with the output gap being used to explain short-term accelerations and decelerations in the rate of inflation, while overseas prices and the exchange rate are used to explain the long-term low frequency trends in the price level. The main reason for not panicking at this point is that it seems to take a long time for movements in the external value of sterling to be completely reflected in the domestic price level, although the effect of overseas price level trends appears to be far more rapid. Indeed, there is evidence that inflation trends are increasingly being generated at the global level and that the external world output gap is an increasingly important influence on inflation in individual countries.

If one regards the depreciation of sterling over the past year as being the equivalent of a ‘half devaluation’ under the old fixed-exchange rate system, then it is clear that none of the measures required to make a devaluation work, without risking a serious feed through into domestic inflation, have been implemented. In particular, fiscal policy has been loosened, not tightened, interest rates have been cut not raised, money and credit growth have not been reined in, and the labour market has not been rendered more flexible by de-regulation and other supply side reforms. The massive expansion in the size of government employment over the past decade - and the sharp reduction in the numbers employed in important net-export producing sectors, such as manufacturing - also imply that the British economy no longer has sufficient supply side flexibility to make a devaluation work. In particular, the price elasticity of demand for UK imports appears to be approaching zero these days, while the overseas price elasticity of demand for UK exports appears to be too low to offset this and ensure that the volume gains from a de facto devaluation of sterling offset the adverse effects on the terms of trade.

All of this suggests that the UK economy could be on the brink of something extremely nasty, particularly now that the entire political class appears to have lost its authority, and the credibility of the Bank of England has been damaged by the Northern Rock debacle, albeit unfairly so. The risk of a sudden rupture in the foreign exchange market’s confidence in sterling, or simply an inability to continue funding the current account deficit at anything like the present level of sterling and/or real interest rates, suggests that the MPC is now treading on egg shells to some extent. A minor mystery with the January CPI figure was why it was only 2.2% up on the year when the ‘double-core’ retail price index (which excludes both mortgage rates and house price depreciation) rose by 3.1%. The normal gap between the two series is 0.5 percentage points and not 0.9 percentage points. There may well be an explanation for this – it is definitely not being suggested that the figures were fiddled - but it may also be that CPI inflation was fortuitously low in January, and might blip the other way in subsequent months. The March MPC decision will be announced six days before the 12 March Budget. It must be presumed that the MPC will be given some indication of the main fiscal balances likely to be involved, as has been the practice in previous years. There seems little reason to expect that Bank Rate will be altered in March, and there is certainly almost no justification for a further cut. Longer-term, I maintain my bias to tighten.

Comment by Peter J Warburton
(Economic Perspectives Ltd)
Vote: Cut by ¼%
Bias: To cut

Last month’s Bank Rate reduction, to 5¼%, leaves the overall posture of UK macroeconomic policy much too restrictive. The 12 March Budget will confirm a more stringent fiscal policy stance, making an even stronger argument for the easing of monetary policy.

Purchasing manager survey responses for January may not have plummeted in the UK, as elsewhere, but there is ample evidence of a material loss of economic momentum dating back to last August. Comprehensive data for the UK private service sectors are available only to November but it will be very surprising if the outcome is not a more decisive confirmation of the downturn when the December and January readings arrive. Business services and finance have slipped to barely a 2% annual growth pace, from 7% recently, and a composite of post, telecom, hotels, restaurants and motor trades have shifted below the zero line, from having 9% growth momentum in the early part of last year. This leaves only distribution and transport to carry the growth flag. The message from the retailers after their busy season suggests that their trade has also suffered. The January GfK consumer confidence reading, at minus 13, was the weakest for any year since 1993.

In the industrial sectors, the level of output has edged lower since last summer. Government and other services continue to contribute modestly to GDP, but even this stimulus is in doubt as fiscal policy is forced into pro-cyclical mode: tightening into a private sector contraction. The Institute for Fiscal Studies estimates that an extra £8bn per annum in taxation would be required to restore credibility to the Treasury’s fiscal arithmetic over the coming year. While such stringency is unlikely in March, this is the probable direction of adjustment. Bearing in mind that the private sector’s CPI inflation annual rate has fallen to 1.5% (ex-heating and lighting), a real interest rate of 3% should be more than sufficient to contain inflation expectations. An easing of monetary policy is not only desirable for its own sake, but as a necessary foil to the inadvertent tightening of the fiscal noose.

Moreover, the risk of fuelling inflationary pressures should not be considered a serious obstacle to a further 75 to 100 basis points of easing in the context of the non-linear threat to domestic economic activity, particularly in the sectors strongly connected to asset market turnover. The prevailing loss of potential for securitising loans is roughly equivalent to a 25% to 30% cut in lending capacity in the residential property market: this is already bearing fruit as a sharp decrease in mortgage approvals and will soon affect housing transaction volumes. Alliance & Leicester went further, indicating that they planned to shrink their mortgage book over the next twelve months. Commercial property is likewise.Finally, it should be noted that little if any of the decrease in short-term market interest rates between August and December has been reflected in the interest rates faced by households. The February Inflation Report (Table 1A, page 14) reports that interest rates for new loans and mortgages averaged 14 basis points higher in the period and for the outstanding stock of loans, 4 basis points higher despite a 25 basis point Bank Rate cut and a 77 basis point reduction in 2-year swap rate. If the purpose of Bank Rate cuts is to alleviate pressure on marginal borrowers, then it will require deeper cuts to achieve this. My vote is for a ¼% cut at the March meeting, notwithstanding the imminent impact of higher utility prices on the consumer price index.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Neutral

The UK economy is not slowing down as fast as many seem to have been warning about and expecting. Data in the past month has been strong overall; from the labour market data - the Labour Force Survey (LFS) jobless rate fell to 5.2% from 5.4% and employment rose 175,000 in the three months to December; to money supply, which accelerated to 12.9% year on year in January and to retail sales volume, which accelerated to 5.6% year on year in January. None of these, it seems to me, suggests an economy on the verge of recession, albeit slowing. With pipeline inflation pressure still high – there were surges in the producer input and output price inflation data for January and surveys suggesting that companies are trying to pass on more of their higher prices – this is not a time to be cutting rates any more than seen so far. Indeed, there would be no case for a rate cut from the earlier 5¾% at all, if not for the ongoing credit crisis and the weakness in the US. Actual annual retail price inflation rose to 2.2% in January, with an even bigger rise likely in February when the data are released in March.

You do not have to be a monetarist to worry why, with so much liquidity in the system, should there be a negative economic impact from the banking and credit crisis at all? In fact, the opposite may be true, and a policy mistake is being made with too much monetary loosening and liquidity being added that - if not drained off at the right time - will lead to an even bigger inflation and asset price problem in future. With this backdrop, it is no wonder that inflation expectations remain high in the UK. Without the benefit of benign labour markets, the UK Bank Rate profile would not justify even the easing of the monetary stance seen so far. I therefore vote for rates to remain on hold in March and have a neutral bias thereafter.

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group and Global Vision) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that a full set of nine votes is always cast.

At its latest meeting, the IEA’s Shadow Monetary Policy Committee (SMPC), a group of leading monetary economists that monitors developments in UK monetary policy, voted narrowly to cut the UK Bank Rate by ¼%, rather than hold it at its current level.

All members of the SMPC were concerned by the problems that had arisen with sub-prime lending, the consequent impact on the property market, and the softening of economic activity. However, a substantial minority felt that earlier policy mistakes, which had led to British interest rates being kept too low for too long, meant that a reduction in rates should not take place now.

Those wishing to hold rates were concerned about a number of trends in the UK economy including: strong broad money growth; the large balance of payments deficit; the depreciation of sterling; the lax fiscal background; and output appearing to be above trend. The holders consequently felt that the Monetary Policy Committee (MPC) had to stay focused on its core inflation objective.

This view was summed up by David B. Smith, Chairman of the Shadow Committee who said, ‘The December rate cut was an error because it risked de-stabilising sterling…Furthermore, inflation expectations had been rising, both in Britain and overseas…There is a real danger of global “stagflation”’.

However, the majority view, which was held by the five SMPC members who wished to cut rates, was that the deteriorating credit market conditions would lead to a serious slowdown in the economy. John Greenwood, Chief Economist at Invesco summed up the views of those wishing to cut rates commenting: ‘Events in the market for credit are sufficiently severe to create a significant downturn in economic activity.’

The SMPC meeting was held on 15 January. However, all committee members were given the chance to re-consider their vote following the 22nd January US rate cut. One switched from a ‘hold’ to ‘down ¼%’ as a result.

The minutes of the meeting are attached below. Minutes of all recent SMPC meetings are available from the SMPC section of the IEA website at www.iea.org.uk. The SMPC, which has shadowed the MPC since its creation, meets quarterly but also conducts a regular e-mail poll in intervening months.

It normally publishes this, together with a poll on the Committee’s view on interest rates, on the Sunday before the Thursday Bank Rate announcement.
The results of the latest Shadow Monetary Policy Committee (SMPC) quarterly gathering (carried out in conjunction with the Sunday Times) are set out below. The rate recommendations are with respect to the UK Bank Rate decision to be announced on Thursday 7th February.

Minutes of the Meeting of 15 January 2008

Attendance: Philip Booth (IEA observer), Tim Congdon, John Greenwood, Ruth Lea, Andrew Lilico, Kent Matthews (Secretary), David Brian Smith (Chair), Peter Warburton, Trevor Williams, Melanie Powell (Derby University observer), Eugen Mihaita (Derby University observer).

Apologies: Patrick Minford, Gordon Pepper, David Henry Smith (Sunday Times observer), Alistair Heath (The Business observer).

Chairman’s Comments

David B Smith welcomed Melanie Powell and Eugen Mihaita from the University of Derby as observers to the meeting and reminded members to complete the mini-biographies for the media contacts list.

David B Smith invited Peter Warburton to give his assessment of the world and domestic economy.

The Economic Situation

The International Economy – increased risk environment and softening of economic activity.

Peter Warburton referred the committee to the briefing charts and began by stating that world economic activity in the third quarter of last year, when much of the published data expires, was not a good guide to what is to follow. The third quarter figures confirmed that growth of world economic activity was solid. However, a composite leading indicator is signalling a sharp downturn in the seven largest developed economies. Another indicator of world trade was the Baltic Freight index which was showing a severe downturn, even after allowing for seasonal effects. Similarly, exports from the three major far Eastern exporters - China, Korea and Taiwan - were also showing a growth slowdown.

Peter Warburton added that US consumer spending in the third quarter was still strong but unemployment had edged up with layoffs in the financial sector showing the largest rise. Non-financial corporate profits growth has turned negative.

Even so, a weighted measure of broad money supply for fifty of the largest nations had accelerated in October. One interpretation was the repatriation of credit market debt back onto bank’s balance sheets. But global core and headline inflation has risen in recent months. Indicators of US inflationary pressure picked up in November but worsening inflation indicators have not prevented ten-year yields in US Treasury bonds from declining. The riskier environment is reflected in corporate bond spreads which have widened and credit default spreads which have increased markedly. Fed funds futures indicate that further cuts in interest rates. The market is currently expecting a further 60 basis points (0.6 percentage points) reduction by the end of January.

The Domestic Economy – A softening outlook

Peter Warburton began his discussion of the economic outlook for Britain by stating that: indicators of consumer confidence had shown a sharp decline, despite the fact that the spread of the London Inter-Bank Offer Rate (LIBOR) over the official Bank Rate had settled down to a more familiar level; mortgage lending was running at a slower pace than in the previous year and growth in retail sales had softened in recent months; and overall house price inflation had softened with commercial property values showing a sharp decline.

M4 growth slowed sharply in October and November, although the latter figure was subsequently revised upwards. The year-on-year growth of M4 broad money was reported as 11.7% for November and the rate of growth of M4 lending remained steady at recent levels. A significant portion of bank assets are unaffected by interest rate cuts because of securitization. Cuts in rates are not being fully passed on to customers as financial intermediaries seek to restore margins. Sterling has depreciated suddenly in response to market expectations of future interest rate cuts.

The recent national accounts figures confirmed that the British economy suffered from serious imbalances. The third-quarter current account deficit, at 5.7% of Gross Domestic Product (GDP), was one of the worst on record. Credit tightening will weaken activity in the private business and financial service sectors, which together generate 60% of GDP growth. Consumer Price Index (CPI) inflation is at 2.1%, close to the 2% reference rate, and core CPI inflation at 1.4%. Headline Retail Price Index (RPI) inflation is 4% and RPI excluding mortgage interest (RPIX) runs at 3.1%, showing no change over the last three months. The decomposition of RPI shows that it has been externally-determined and administered prices that have been growing sharply in recent times while the rate of private sector generated price inflation has been falling.

David B Smith thanked Peter Warburton for his presentation and opened the meeting up for discussion.

Discussion and Policy Response

Discussion
Growth slowdown in 2008

Trevor Williams started the discussion by asking for clarification on the US broad money supply figures. In replying, Peter Warburton said that financial innovation has created synthetic demands for short term assets that have created shifts in both the demand and supply of money. The potential for this type of money to migrate to consumer spending is low. Tim Congdon agreed that, in the case of US broad money, there had been some artificial inflation of bank balance sheets but China and India has strong money growth as indicated in the world broad money figures. He said that he expected world economic growth to slow to 3% against a traditional 4%.

David B Smith said that to him the current economic situation felt more like the period in the late 1960s and early 1970s, after Richard Nixon had broken the US$’s link to gold and world inflation was taking off, than it did to a re-run of the Great Depression. People who wanted to cut rates aggressively in the UK were doing so on the basis of the, as yet untestable, hypothesis that the global credit crunch was going to drive down UK growth very sharply indeed. He did not deny that this could happen. However, there was no evidence in the data that it was happening so far, or that money and credit growth were turning sharply negative. David B Smith added that, if one was discussing the 1930s slump, it was worth bearing in mind that not one bank in the then British Empire had gone bust during this period, whereas several thousand had gone under in the US, and that the severity of the inter-war recession in Britain was only approximately half that recorded in the US and Germany. He did not deny that the US may be heading into recession, but he thought that the UK was already so far into the overheating zone that it should not simply follow US monetary initiatives. He reminded the committee that the size of the balance of payments deficit in relation to GDP was a prima facie indicator of the excess of domestic demand over home supply in a small open economy, such as Britain’s.

Andrew Lilico asked to what extent are the downside risks interdependent and to what extent are the inflation risks interdependent? Peter Warburton said that, if the tightness of credit continues, he believed that things will go badly wrong for the economy. The UK is more highly geared than the USA so if credit gets re-priced the impact is stronger in the UK. He also added that while the spread between LIBOR and Bank Rate has fallen back to normal levels this could widen again in the future. He said that the increased risk would be priced into spreads as hidden losses emerge. Ruth Lea said that central banks might now respond faster - if that were to happen - and make liquidity available, while Tim Congdon said that banks use write-offs strategically. He added that the extent of write-offs may be overdone and that write-backs may occur. Trevor Williams suggested that spreads are like speculative bubbles which eventually burst.

John Greenwood stated that there are huge amounts of liquidity outside the banking system. When the Japanese bubble collapsed, non-bank finance imploded which resulted in strong effects on the real economy. The avoidance of Basle regulations had led to the fast development of non-bank credit. Peter Warburton agreed that the proliferation of credit channels has confused the operation of monetary policy. Philip Booth said that he was sanguine about the cycle. Low rates of interest, strong credit growth, and fast house price inflation that had not as yet fed into goods price inflation had to be slowed and that is what is happening.

David B Smith stated that this was one of the most interesting SMPC meetings that he could recall – in large part because of the genuine uncertainties involved and the fact that the standard macroeconomists toolkit had little to say on issues such as credit rationing – but that time was now running out, unfortunately.

Individual Votes

David B Smith then asked the members of the committee to vote on a rate recommendation.

Comment by Philip Booth
(Cass Business School and Institute of Economic Affairs)
Vote: Cut by ¼%
Bias: Neutral

Philip Booth said that previous unduly low UK rates of interest, strong credit growth, and fast house price inflation had arisen partly because the Bank of England had been asked to target a price index – the CPI - that excluded the cost of housing and gave greater than proportionate weight to goods whose relative price was falling, such as tradables. This has had inevitable consequences that must be allowed to unwind.

Loosening monetary policy to deal with the consequences of the losses from sub-prime etc. was not the right approach though, if there were a sharp change in consumption and savings behaviour, this might well justify a fall in interest rates. Given the downward international pressure on interest rates, and Britain's status as a small open economy, he thought that a 0.25% cut would seem to be in order now, but no more.

Comment by Tim Congdon
(London School of Economics)
Vote: Hold
Bias: Neutral

Tim Congdon said that during the credit crisis he had asked for a ½% cut, but the situation has changed with the fall in the value of sterling. The UK economy has a positive output gap of perhaps ½% to 1%, which argues that a relatively mild slowdown will be sufficient to keep inflation on target. At current rates there will be a sharp slowdown in broad money growth. Asset price weakness has been severe in some areas (such as commercial property, and property, financial, retail and cyclical sectors of the stock market). But – given the apparently ample money balances – this seemed to be best explained as a shock to confidence (i.e., a rise in the desired ratio of money to assets). He voted to hold, with a neutral bias.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Cut by ¼%
Bias: Neutral

John Greenwood said that events in the market for credit were sufficiently severe to create a significant downturn in economic activity. He voted to cut by ¼% in February with a neutral bias thereafter.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral

Andrew Lilico said that the December cut in rates was due to credit market conditions and was clearly an error. The Bank of England had not allowed interest rates to rise high enough and therefore the possible extent of any rate reduction is limited. The inflation target is more important than slowing growth. The dominant risk to growth comes from falling house prices leading to weakened consumption. He voted to hold in February and had a neutral bias subsequently.

Comment by Ruth Lea
(Arbuthnot Banking Group and Global Vision)
Vote: Hold
Bias: To ease

Ruth Lea said that the Bank faced a clear dilemma. On the one hand, there were signs of slowdown and the housing market seemed to be turning down. But it was worth remembering that an overheating economy (and housing market) was the reason for the Bank to raise rates from mid 2006 to mid 2007 and indeed, before August’s ‘credit-crunch’ crisis, it was widely expected that official interest rates would be raised further. The surprise was that the housing market was as resilient for as long as it was.

On the other hand, inflationary pressures were intensifying reflecting high commodity prices exacerbated by a weakening currency – which may, in turn, help Britain’s appalling trade data. Too little attention had been paid to the falling pound. Under these circumstances, the Bank should behave cautiously and, on balance, hold rates in February. Bank Rate at 5½% was, however, on the high side and her bias was towards cuts.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Cut by ¼%
Bias: Neutral

Kent Matthews said that he was persuaded by the argument that credit market conditions would translate into a significant slowdown in the economy. However, it is also clear there are dangers in cutting interest rates too rapidly. Therefore the Bank’s policy of cutting interest rates in stages is the correct policy. Bank Rate cuts are unlikely to be translated into cuts in lending rates on one-for-one basis and therefore the cuts in rates are a means of shoring up declining consumer confidence and housing market pessimism. He voted to cut Bank Rate by ¼% in February with a bias to hold thereafter.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Tightening

David B Smith said that the December rate cut was an error, in his view, because it had risked de-stabilising sterling, and wondered whether the Monetary Policy Committee (MPC) would have sanctioned a rate cut had they known the size of the current account deficit in the third quarter and the adverse revisions to earlier data. Broad money growth in the UK and the OECD had been rapid, and in the case of the OECD area as a whole had been accelerating. This was not at all like the collapse of around one quarter in the absolute levels of bank credit and money seen in the US in the early 1930s. Furthermore, inflation expectations had been rising, both in Britain and overseas. This meant that, not only was the supply of real broad money balances growing rapidly in the world as a whole, but the demand for money might well be falling, because of the reduced real return from holding interest bearing deposits caused by lower money-market rates and higher inflation.

There was also a serious issue of policy inconsistency in Britain, with fiscal policy already far too lax and likely to be relaxed further in the next few years because of the postponed general election. The risk was that people believe that a 1930s type slump was imminent when the real danger was a global ‘stagflation’, similar to the one observed after Nixon went off gold. He voted to hold Bank Rate in February with a bias to raise rates in the future. He added that a necessary pre-condition for easing monetary policy in Britain, without taking undue inflation risks, was the implementation of a ‘Type 1’ fiscal retrenchment package, in which government spending was reined back, there was no increase in the tax burden, public capital formation was not cut, and labour market regulations were reduced. From a political perspective, he could see no prospect of that. Rather, he feared that a surreptitious, but highly damaging, ‘Type 2’ package of tax-raising measures would be attempted by the present government. He was surprised that more people were not concerned by the fiscal constraints on the MPC’s freedom of action.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Cut by ½%
Bias: To ease

Peter Warburton said that the credit crisis has tightened monetary conditions, as borne out by the Bank of England’s relatively new ‘Credit Conditions’ survey. An adjustment of 50 basis points is needed to allow for a widening of banks’ margins. Otherwise retail and commercial borrowers will find little relief. He expected a sharp slowing of economic growth. He said that action is needed now to forestall the downturn and voted to cut by ½% with a bias to further easing. He thought that Bank Rate had scope to fall to 4½% during the course of this year.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Cut by ¼%
Bias: Neutral

Trevor Williams said that rapid broad money growth remained a worry. The world economy is reacting to a bubble correction in the US economy, in housing and credit market. From the British perspective the higher inflation path occurs because of the openness of the economy. The output gap is not the sole drive of inflation and other factors, such as the exchange rate, also matter. This argues for interest rates to be held, as a weaker currency may drive up inflation pressure. But immigration in recent years has made the capacity of the economy a lot more flexible. Thus the output gap measure may be positive, but increased immigration had increased the capital stock though this was not yet being fully factored into measurements of the output gap. This link explains the current low rate of wage inflation, even as unemployment continues to fall modestly. He voted for a cut with a bias to hold if the economy did not slow down but he believed that the economy will slow down.

Votes in Absentia

The SMPC sometimes allows a small number of votes to be cast in absentia and adds their written submissions to the record of the meeting, to ensure that exactly nine votes are cast. On this occasion no such vote was required since nine SMPC members were present at the physical meeting.

Policy response

1. On a narrow vote of five to four the committee voted to cut Bank Rate by ¼% in February.

2. In particular, four members voted to cut the base rate by ¼% and one voted for a cut of ½%.

3. Of the five who voted for a cut in February, four had a neutral bias from March onwards and one had a bias to further cuts.

4. Four members voted to hold Bank Rate at its current position, with two having a neutral bias, one having a bias to cut, and one having a bias to raise interest rates.

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 e-mail poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other current members of the Committee include: Patrick Minford (Cardiff Business School, Cardiff University), Tim Congdon (London School of Economics), Gordon Pepper (Lombard Street Research and Cass Business School), Anne Sibert (Birkbeck College), Peter Warburton (Economic Perspectives Ltd), Roger Bootle (Deloitte and Capital Economics Ltd), John Greenwood (Invesco Asset Management), Peter Spencer (University of York), Andrew Lilico (Europe Economics), Ruth Lea (Arbuthnot Banking Group and Global Vision) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that a full set of nine votes is always cast.

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The outcome of the most recent Shadow Monetary Policy Committee (SMPC) monthly E-Mail Poll (in conjunction with the Sunday Times) is set out below. The recommendations are made with respect to the UK Bank Rate decision to be announced on Thursday 10 January.

On this occasion, four SMPC members voted to leave Bank Rate unchanged, while five members voted for a reduction. As happened last month, the rate cutters were split, with three desiring a reduction of ¼% but two wanting a cut of ½%. This would deliver a rate cut of ¼%, if the normal Monetary Policy Committee (MPC) voting procedure was adhered to. The same was true of the December SMPC recommendation, which was