Independently-submitted research Archives
Sunday, August 31, 2014
IEA's shadow MPC votes 6-3 for rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its email poll closing Thursday 27th August, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended by six votes to three that Bank Rate should be raised on September 4th, including four votes for a rise of ½% and two for a rise of ¼%.

Those advocating a rise acknowledged that inflation is low and wage pressures are limited. Their case was that with growth strong and unemployment falling, this is an excellent opportunity to attempt some limited normalisation of interest rates (thereby reducing the economic distortions such low rates create) whilst still maintaining them very low and monetary policy in general highly accommodative.

Those that preferred to keep rates on hold noted that not only is inflation low, but pipeline inflationary pressures are also low, as are wage growth, money growth and credit growth. For them there remains inadequate reason to raise yet.

The SMPC is a group of economists who have gathered quarterly at the IEA since July 1997. That it was the first such group in Britain, and that it gathers regularly to debate the issues involved, distinguishes the SMPC from the similar exercises carried out elsewhere. To ensure that nine votes are cast each month, it carries a pool of ‘spare’ members. This can lead to changes in the aggregate vote, depending on who contributed to a particular poll. As a result, the nine independent and named analyses should be regarded as more significant than the exact overall vote. The next two SMPC e-mail polls will be released on the Sundays of 28th September and 26th October, respectively.

Votes

Comment by Roger Bootle
(Capital Economics)
Vote: Hold rates
Bias: No bias

The UK housing market, the weakness in the Eurozone and the UK balance of payments continue to provide important risks. However, with inflation low and potentially falling further – perhaps even forcing Governor Carney to write a letter explaining why inflation has fallen below 1% - there is no good reason to raise rates yet.

The amount of slack in the economy is difficult to observe directly and one should be wary of hubris in declaring that the elimination of slack is a good reason to raise rates. If the underlying potential growth rate had fallen, there should be more evidence in the labour market (employment and wages). If rates are kept low and there is no slack, wages will rise and inflationary pressure will be visible in good time to allow rates to be raised in response. There is no need to rush.

Comment by Jamie Dannhauser
(Ruffer LLP)
Vote: No change
Bias: No bias
One year view: Bank Rate at 0.75%; QE unchanged

The UK economy is growing rapidly. While GDP has been expanding at an annualised rate of 2¾-3¼% in recent quarters, private sector activity, which monetary policy can influence, has been surging ahead. Annualised growth of around 4% has been registered in each of the last two quarters. Official for National Statistics (ONS) data may even understate the strength of the recovery: there has been a puzzling disconnect between official figures for goods and services exports and the numerous surveys published by private sector providers. The construction sector has also been underperforming of late, despite buoyant qualitative indicators.

Prospective growth in the near-term looks set to remain well above its historical average. Were this a normal economic environment the case for monetary policy tightening would be overwhelming but current circumstances are far from normal. After the deepest downturn in two centuries, Britain’s recovery, all things told, has been very disappointing. Only recently was the early 2008 peak in output achieved. Despite an exceptional dose of monetary stimulus, overall monetary conditions are not yet consistent with a sustained period of above-trend growth: nominal broad money growth remains stuck at around 4%; while bank lending to the private sector has started to grow, prospects for a revival in monetary growth are not assured. The release of substantial pent-up demand has provoked a rapid response in output. However, the conditions for a lasting upswing, while much closer to being met than a year ago, cannot be taken for granted.

There remains an intense debate about the degree of slack in the economy. The current central banking fad for focusing on labour market indicators is unhealthy; but for the moment the conclusions drawn from it are reasonable. The lack of a revival in productivity in recent quarters is puzzling: one surely has to have less confidence in a strong endogenous response in potential GDP. However, it still seems likely that effective supply will in part be determined by the strength and persistence of the recovery in demand. The ongoing weakness evident across a range of nominal indicators – CPI inflation, wages, output price inflation, unit labour costs – seems hard to square with the idea that there is little slack in the economy. Anecdotal reports suggest pricing power is still limited. Moreover, the recent weakness of inflation is notable given evidence that consumer-facing firms have been increasing margins over the last year.

Disinflationary pressures from stagnant commodity prices and the rise in sterling are considerable. Given the normal lags, there could be sizeable additional downward pressure on CPI inflation through 2015. Indicators of pay growth at the margin have picked up but average earnings growth remains lacklustre. Exporters do not report a hit to volumes from the rise in the pound, but do suggest that any further move from here would act as a constraint. An early rise in Bank Rate would surely help sustain the pound’s appreciating trend. No move at this point in time or in the near-future is warranted. One 25bps hike within the next twelve months appears reasonable given the likely profile for the UK economy, however.

Comment by Andrew Lilico
(Europe Economics, IEA)
Vote: Raise Bank Rate by ½%
Bias: To raise further; QE neutral
One Year View: 1¾%

The basic pattern of the UK economy has not changed for nearly a year. Quarterly growth is consistent with above-3% annual growth. Monetary growth remains low (though lending did pick up in the three months to June 2014). Unemployment continues to tumble. International risks remain. Inflation is not rising yet. Wage growth is weak. The government budget deficit remains high. These factors were collectively sufficient to justify a rate rise a year ago and they remain sufficient today. All that has changed is that, by being sustained over time, they have given policymakers greater confidence that they were not a passing moment.

Given the key role that the signals from monetary policy changes play in managing the real economy, it will be important for the first rate rise not to be misinterpreted. The MPC should not wait until inflationary pressures force rates up. That would make the first rate rise a bad news story. It would also mean that economic agents would quickly price in a long series of rises. Instead, the first rise should be a baby step towards normalisation, take in an economic environment where policymakers still had the scope to keep rates lower if they chose to do so. That should have been done long ago. But there is perhaps still time for at least a little pause after the first rise and still some scope for the first rise to be a chosen small step to normalisation rather than the first forced step in a series of rapid rises.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise rates by ¼%; no further QE but can be held in reserve for the next euro crisis
Bias: To raise

Although there are short-term arguments for keeping rates on hold so as to avoid hindering the recovery, an earlier rise would both reduce the risk of more rapid rises being necessary later and also create scope to cut rates in the event of some negative shock. At the same time, keeping rates so low is likely to be distorting efficient decision-making by economic agents and damaging productivity. A small initial rise is now appropriate.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate 0.5% and start to reduce the stock of QE gilts
Bias: Further rate rises and more run-down of QE
One year ahead: No view

Central banks have remained extremely nervous about the strength and self-sustaining power of the recovery. The Fed still maintains it will keep printing money, if at a slower rate, while interest rates remain on the floor. The Bank of England has stopped printing money but is loath to raise rates, though two members of the MPC have now voted that it should make a start. The ECB is faced by falling inflation and ongoing weakness of the euro-zone (fuelled by problems with the banks and credit supply) and so is thinking of ways to increase monetary stimulus now that rates cannot be driven any lower. It is no wonder that equity markets are so buoyant, with growth proceeding (even in the euro-zone to a small degree) and yet no prospect of monetary tightening.
Into this picture have stepped the sanctions on Russia over Ukraine, virtually mandated by the tragic shooting down of flight MH17. Problems in China continue to fester, with bad debts accumulating, growth slowing and a destabilising campaign by the new leadership of Xi Jingping against ‘corruption’ (among his old guard opponents). In this environment there will be setbacks to world growth.

The parallel to consider is the early 1980s. Then too there had been bad recession, the oil crisis of the mid-1970s and then the recession of 1980-82 as world inflation was tamed by tight money. Unemployment was high around most of the West; in the UK it reached 12%. World commodity prices, both oil and non-oil, had reached huge peaks in real terms and were just beginning to come off them. Then from around 1982 until 2006 the world economy grew relentlessly, year in year out, with no general recession until the global crisis starting in 2008. Of course, there were regional recessions and difficulties such as: a small US pause in 2001 on collapse of the dotcom boom; in the UK the ERM-provoked recession of the early 1990s, and the Asian crisis of 1998. But individual countries and regions will always have their own particular episodes of difficulty or overreach. The point is that was an astonishing quarter-century of uninterrupted world growth, which was then due to come to a brutal stop in the following crisis.

Why the long expansion and why the following stop? It is usual to treat expansion as if it is normal and the stop as due to bank bust after credit excesses. Whatever the role of banks in worsening the crisis was, this reading is naïve. Could we really expect world growth to barrel on regardless for another quarter century - some ‘normal’ continuation of rapid global growth? Surely not, as commodity prices were signalling that the world was running out of resources. When this commodity scarcity started to slow growth down, would one not expect banks to lose money on bets made when growth was fast and unchecked? Thus the bank crisis was as much brought on by world slowdown as world slowdown was worsened by bank problems.

The post-1982 expansion mirrored rather faithfully the post-WWII expansion; it too was largely uninterrupted for 25 years and came to halt in a commodity crisis of the 1970s. These developments also mirror earlier business cycles going back to the late 19th century. This is the subject of ongoing work. Meanwhile it seems that since WWII a pattern can be seen in the behaviour of the world economy and the commodities that ultimately power it. It takes time and high prices to generate the large-scale capital and research effort needed to increase the supply and economise on the demand for commodities as growth proceeds. There seems to be a cycle of plenty fuelling fast productivity growth in the non-commodity economy; this plenty arising from previous large investments in commodity production and associated technology. Then as growth proceeds capacity in commodities is used up, prices rise until shortages become acute again. There is then a stop on growth, and a ‘crisis’. With prices so high commodity investment resumes and the cycle repeats itself. Today we appear to be at the start of such a cycle. Prices of commodities have peaked but are coming down as investment in plant and technology begins to occur.
With the Great Recession non-commodity output is well below its previous trend, helping commodity prices to fall. Growth is thereby encouraged but the commodity bind may well not be repeated for another quarter century.

This means that monetary policy needs to return to normality fairly soon. Growth and recovery look assured (expect for the euro-zone which the great mistake of monetary union will continue to haunt for some time to come). Central banks in the majority of countries need to worry about triggering another boom by losing control of monetary conditions. As before I suggest raising interest rates in small steps, moving steadily towards normality; and the gradual selling-back of the Bank’s huge holding of government bonds.

Comment by David B. Smith
Vote: Raise Bank Rate by ¼%; hold QE
Bias: To raise Bank Rate in small ¼% increments
One Year View: Depends on May 2015 election outcome; on a no-policy change assumption, raise Bank Rate to 1% to 2% by next summer, and carry on until 2½% to 3½% is achieved

In the olden days of Keynesian demand management – and politically induced business cycles – a Chancellor of the Exchequer this close to a general election would have felt reasonably complacent when confronted with an annual growth rate of 3.2%, ‘headline’ retail price inflation of 2.5% (and 1.6% on the officially preferred CPI), and an 820,000 (2.8%) increase in Labour Force Survey (LFS) employment over the past year. Indeed, some aspects of the recent UK data are reminiscent of the nation’s golden age under the Conservative governments of the 1950s and early 1960s. During the twelve years from 1953 to 1964 – i.e., after the Korean War induced inflation of 1951 and 1952 had abated and the Chancellor RA Butler’s liberal market reforms had been implemented – UK economic growth averaged 3.6%, retail price inflation averaged 3% and claimant count unemployment averaged 408,000 (1.4%). The latter figures can be compared with the 1,007,500 (3.0%) recorded in July 2014.

However, there are four major differences between the UK’s current economic performance and that of the golden age. Some of these help to explain why the Coalition parties are not doing better in the opinion polls. The first major difference is that the favourable performance of the 1950s and early 1960s was sustained for well over a decade. This contrasts with the current situation where growth has only picked up recently and from a low output base. Using the present chained 2010 price national accounts, real GDP has grown by only 1½% per annum since 2010, when the Coalition took office, while non-oil GDP has expanded at an annual rate of 1¾%. These increases would have been classed as a ‘growth recession’ before the first oil price shock in 1973. Likewise with inflation, where annual CPI inflation only returned to its 2% target as recently as December 2013, following a long period of overshooting.

The second major difference is that both the current account balance of payments and the public finances were in broad balance throughout the 1950s and early 1960s. This contrasts with the current situation, which is one of extremely large deficits by historic standards. Furthermore, there is little sign of any improvement in the recent data. Thus, the UK trade deficit on goods and services was running at an annualised rate of £24.8bn in the first six months of 2014, compared with a deficit of £28.5bn during 2013 as a whole, while the underlying PSNB totalled £32.4bn in April to July 2014, compared with £23bn in the corresponding period of fiscal 2013-14. The need to finance these twin deficits for the foreseeable future, and to maintain unbroken financial market confidence while doing so, gives rise to serious reservations about the sustainability of present policies, let alone what would happen under a putative left-wing Labour administration.

The third major difference between the present situation and the golden age is the larger role of the contemporary state. In addition, rather than having a supply-side enhancing ‘bonfire of controls’, as the early 1950s Churchill administration did, the Coalition has presided over a damaging ‘bonanza of controls’, including in the financial area, albeit often at the behest of the European Union. The constant re-definition of national output by the official statisticians makes it hard to be precise. However, it looks as if general government expenditure was absorbing around 36% to 37% of GDP throughout much of Britain’s economic golden age compared with some 52% at its peak in 2009-10 and 2010-11, 50% in 2013-14 and around 49% currently (the GDP measure used excludes indirect taxes and government subsidies for consistency). There are good reasons from supply-side economics to believe that the increased share of national output absorbed by government since the golden age has crowded out private capital formation, and with it embodied technical progress, leading to the slow growth of output per head which has puzzled many commentators.

The fourth major difference with the golden age, which does absolve the Coalition to some degree, is the less benign international background, particularly in our main Continental European export markets. This uncertain background has the potential to de-stabilise a small, open and trade dependent economy, such as Britain’s, and was referred to several times in the Governor’s Inflation Report press conference. A specific problem is the apparent difficulty of financing international trade in a situation where counterparty trust has not recovered from the financial crash. Increased official regulations are another influence encouraging commercial banks to concentrate purely on their domestic markets. Businessmen tend to blame the poor price competitiveness associated with a strong pound for their export problems. However, the statistical evidence suggests that competitiveness effects are weak and slow acting, while the demand effects represented by the volume of international trade are relatively powerful and rapid. The volume of aggregate imports in the Organisation for Economic Co-operation and Development (OECD) area as a whole – which is a reasonable and timely proxy for real world trade – was only 7.3% higher in the first quarter of 2014 than it had been in the first quarter of 2008. However, it was 4.2% greater than at the start of 2013. It is possible that the helpful effects of this development on UK exports are yet to work through.

These serious supply side issues facing the British economy have been emphasised because the looming May 2015 general election means that the already low standards of political discussion of economic matters are likely to descend into pure political hyperbole in the coming months. Whoever wins the 2015 election will have their options constrained by the fact that, having inherited the worst ever peacetime fiscal crisis from the previous Labour government, the Coalition has only done the bare minimum required to keep the show on the road in the short run – but nothing like enough to restore a healthy and sustainable long-run performance. However, all comments on the UK economy are subject to the caveat that the current figures may look very different once the ONS has introduced the new ESA-2010 chained 2011 price national accounts on 30th September. Some preliminary figures covering the period up to 2009 show that the new figures have made the boom-bust cycle associated with the financial crash look less extreme in both directions.

Unusually, the ONS did not release an expenditure breakdown of GDP when it published its second estimate for 2014 Q2 on 15th August; this represents a serious problem for macroeconomic modellers who usually build up their forecasts from this data. However, the latest output based measure of GDP introduced revisions back to 2011 Q1. These revisions have typically been upwards by 0.2 percentage points in the more recent quarters. This means that the old expenditure figures, which have not been updated, are clearly inaccurate and that any output gap (economic slack) is smaller than was previously believed. However, the main story is the need to beware of the risk of a major re-writing of recent economic history and the current economic conjuncture after the new ONS accounts are released on 30th September and people have had time to digest them. The latter may take several weeks because of the complexity of the changes. All existing macroeconomic forecasting models will almost certainly have to be re-built from scratch, for example.

The highly uncertain international background and the likelihood of major data revisions in the near future provide two valid reasons why the MPC might wish to hold Bank Rate in September on a ‘wait and see’ basis. It is also probable that there are further benign inflation developments still to come as a result of the recent reduction in the price of crude oil and the continuing effects of the stronger pound. It has been argued previously that the latter are underestimated in the official forecasting framework, which seems more appropriate to a large Continental economy than a small, open and trade-dependent one. Certainly, the latest producer output price data – which show core output prices (excluding food, beverages, tobacco and petroleum) up only 0.9% in the year to July while total output prices eased by 0.1% over the same period and total input costs fell by 7.3% – appear to be more consistent with ‘Scandinavian’ models of the price level, which emphasise the importance of the exchange rate and overseas prices, than the Bank’s nebulous concept of economic slack. There is also the much commented on question of the very weak trend shown by average earnings, with total earnings in the second quarter actually 0.2% down on the year. Nevertheless, there may be question marks over the official data. Furthermore, one might expect earnings to lag the main business cycle; in part, because new wage settlements usually only occur annually.

This commentary was prepared before the Scottish referendum to be held on Thursday 18th September and it was necessary to assume that the ‘no’ vote prevails; otherwise, this comment would have become an extended exercise in scenario analysis. The opinion polls suggest that the Scottish referendum vote will be close enough for the issue to remain a political running sore for many years, even if the ‘no’ vote wins. However, the forthcoming 2015 general election is also casting a long foreshadow over the current monetary policy decision. This is because the reaction in the financial markets to the election outcome is likely to be bi-modal or even multi-modal. A Conservative victory, or a renewal of the present Coalition, would presumably lead to a period of capital inflows, a stronger pound and justify a lower Bank Rate than otherwise. A Labour victory would, however, be likely to induce some capital flight – unless the party was credibly pledged to an ultra-orthodox fiscal and monetary stance, which seems unlikely – a lower exchange rate and possibly require a higher Bank Rate for a given inflation target than would be the case otherwise. One question facing the Bank, therefore, is whether they would rather go into the period of putative election turbulence next May with Bank Rate still at ½%, risking a reputation damaging series of rate hikes after the election, or whether they should have slightly higher rates by then, leaving open the possibility of cuts if sterling bounced after the election.

On balance, the political and reputational risks suggest that, if the nettle of a higher Bank Rate has to be grasped in the foreseeable future, it is better to do it imminently while doing everything in the authorities’ power to mitigate any adverse effects on business confidence. This suggests that the initial rate increase should be a ¼%, rather than the ½% advocated by some SMPC colleagues and that future increases should be phased in as a series of small ¼% increases every couple of months. The annual growth of the M4ex broad money definition was 3.9% in the year to June. This is broadly in line with the trend since last November, and implies that monetary growth is not so slow as to indicate a rate hold is required. Finally, the 10.2% annual increase in the ONS house price index over the same period was slightly down on the 10.4% rise in May, but remains rapid by most normal standards, and provides a further justification for a moderate monetary tightening sooner rather than later.

Comment by Peter Warburton
(Economic Perspectives)
Vote: Raise rates by ½%
Bias: To raise Bank Rate in stages to 2%

The Bank of England’s Monetary Policy Committee (MPC) has lost its nerve and lost its way. To defend its interest rate passivity with reference to the stances of the US Federal Reserve or the European Central Bank is to deny its independence of action. Central banks in Australia, Canada, Scandinavia and Asia have made numerous adjustments to their interest rate benchmarks during the past 5 years. The Bank of England’s timidity and predictability has spawned complacency among tracker-rate borrowers and dismay among tracker-rate savers, whose interest income has been decimated.

The MPC has failed to respond to a variety of economic signals that have been associated consistently with Bank Rate rises pre-2008. None of the ‘headwinds’ and ‘dynamics’ that Governor Carney has recently (23rd July) identified as obstacles to a Bank Rate increase, either individually or in combination, amount to a veto over the process of interest rate normalisation from its emergency low level.

The appreciation of Sterling is often advanced as a reason why Bank Rate cannot be raised. Sterling has appreciated 10% on a trade-weighted basis over the past 12 months, gaining 10% against the US Dollar and 12% against the Euro. Surely, this misses the point: it is market expectations of higher Sterling interest rates – informed by the MPC’s previous reactions to economic signals – that have propelled the currency upwards.

Governor Mark Carney’s major reshuffle of Bank personnel has been a costly exercise in terms of loss of experience and expertise. However, the new members of the MPC have the opportunity to plough the deep furrows left behind by 5 years of sterility and to usher in the normalisation of interest rates that should properly have begun a year ago. Indeed, with one exception, the IEA’s Shadow MPC has voted to raise Bank Rate consistently since February 2013.

The costs of neglect are not always immediately apparent. There are numerous costs and risk arising from the failure to begin the interest rate normalisation. Four spring to mind: heightened medium-term inflation risk with the particular risk of labour market overheating; additional fiscal costs as savers are de-motivated and fail to make adequate financial provision for later life; elevated financial stability risks as retail investors reach for yield in risky assets, and money market dysfunctionality as liquidity is hoarded rather than traded in a zero-interest rate environment.

Over the past 5 years, the rewards to entrepreneurship in the UK have been poor. Policy-based investing has trumped all other investment styles. Companies that have returned capital through share buybacks and enhanced dividend payouts have outperformed those that boosted their capital expenditures. Indeed the weakness of investment spending can be traced, in part, to the adoption of unconventional monetary policy and the amplification of uncertainty regarding the prospective real return on invested capital.

Comment by Mike Wickens
(University of York, Cardiff Business School)
Vote: Raise Bank Rate by ½% and decrease QE to £250bn
Bias: Start to unwind QE and slowly raise interest rates as the economy grows

The decision facing the MPC has not changed in the last month: should the current levels of price and wage inflation determine the current outcome for policy, or should the Committee look further ahead and respond now to the increasing strength of the economy and hence the likelihood of higher price and wage inflation in the not too distant future? In earlier years the MPC would have decided to tighten monetary policy on the grounds that it takes time for policy to work. In recent years the MPC seems to have stopped looking very far ahead and been much more influenced by the current inflation levels.
What has changed is that two members of the MPC with business and macroeconomic forecasting experience have voted for an increase in interest rates. This is encouraging for those of us on the Shadow MPC who have been urging such a step for some time.

It remains clear that the current policy of cheap and plentiful money has not brought about as much of a real economic recovery as the MPC expected. The main effect seems to have been to raise asset prices, particularly house and equity prices. The recovery that is now gathering pace is due more to increased business investment, which reflects confidence in the future, than in a monetary stimulus to household consumption.

The MPC appears to pay little regard to the need to return interest rates to long-run equilibrium levels or to unwind QE. As it would be best to do this in an orderly way, this strengthens the case for tightening monetary policy sooner rather than later.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking, University of Derby)
Vote: Hold; no change in QE
Bias: Neutral

There have been two big pieces of news in the UK since the last meeting of the Monetary Policy Committee (MPC) in July. One is the split on the MPC itself. After a long period of unanimity that rates did not need to change, Martin Weale and Ian McCafferty voted for a rate hike - the first time any MPC member has broken ranks in favour of a rate rise since July 2011. This ended any perceived ‘taboo’ surrounding the subject. But the overall tone of the minutes themselves when they were published two weeks later were much more dovish than the 7:2 split vote in favour of leaving rates on hold suggested. The other big news is that wage inflation continues to fall, as pipeline price inflation abates further.

Starting with the MPC decision at the August meeting, for the majority of the Committee, there were a number of reasons for keeping rates on hold. These include the weakness of inflation; the downside risks to growth; the vulnerability of the household sector; the possibility of an unwelcome appreciation of sterling, and structural changes in the labour market. It appears several members attach particular importance to the latter, citing the possibility that rising participation of older workers (and other factors) may have led to a structural increase in labour supply. If so, this could continue to bear down on wage growth and inflation and negate the need for a rise in interest rates. For these members, broadly speaking, more convincing signs of a rise in inflation were needed to justify raising rates.

By comparison, the minutes devoted relatively little coverage to the arguments of the two dissenting voters. Their decision was based on the assessment that unemployment is continuing to fall rapidly and that survey evidence of tightening labour market conditions raises the prospect that wage growth may pick up. They also felt that given the historic lags in both wages and policy, it would be inappropriate to delay tightening just because prevailing wage growth is weak. Overall, for these two, the continued absorption of spare capacity poses an upside risk to inflation which a modest policy tightening would counter. They also argue that a small rate increase now would reduce the likelihood of having to raise interest rates more aggressively in the future – a key goal of the MPC’s current forward guidance. They are unlikely to convince enough of their colleagues to follow suit and vote for a rate hike at least this year in my view. Take the financial market view based on break even rates, which have fallen along the curve. It suggests that financial markets are lowering the bet that price inflation will break out any time soon.

The reason is that it is hard to see where the inflation pressure is coming from in the UK or globally: the other piece of news. Oil prices are resting at just under $103 dollars a barrel and global commodity prices are weak. Wage inflation is negligible, with labour supply outweighing labour demand.

UK CPI inflation resumed its downtrend in July, with the annual CPI dropping from 1.9% to 1.6%, almost fully reversing the previous month’s surprise rise. The drop in inflation occurred amid a sharp fall in oil prices and anecdotal reports of aggressive supermarket prices wars. In the previous month, headline inflation had jumped from 1.5% to 1.9%, primarily in response to what was believed to be delayed discounting by clothing retailers. This, indeed, appears to have been the case, with a 5.6% fall in clothing and footwear prices leading the decline in July inflation. Non-seasonal food and alcohol prices also posted sharp falls, with the weakness of both likely to have been at least partly due to the World Cup. Notably, despite a sharp fall in oil prices over the past month, energy and transportation prices rose more rapidly than we expected. Petrol prices rose by 0.5% on the month, while airfares rebounded by 14%m/m. The latter are highly volatile, however, and should fall back over the coming months as seasonal price increases reverse.

Other measures of inflation also eased back, albeit by slightly less than the headline CPI. The “core” rate of CPI inflation (excluding food and energy) dropped 0.2ppt to 1.8%, while the RPI and RPIX fell from 2.6% to 2.5% and from 2.7% to 2.6%, respectively. The relatively smaller drop in the headline RPI than CPI was largely due to shifts in the relative weights of the two measures – in particular clothing and footwear, where price declines were especially steep, accounts for 6.2% of the CPI but only 4.5% of the RPI.

This suggests that UK CPI inflation is likely to drop below 1.5% by the end of the year. Pipeline price pressures continue to ease, with factory gate input and output prices dropping in July by 1.6%m/m and 0.1%, respectively. Over the past twelve months, PPI output prices, which lead CPI goods price inflation, have risen by just 0.2%. The combination of falling energy prices, the lagged impact of sterling’s strength and continued price discounting suggest CPI goods price inflation, currently 0.8%, is likely to fall further. In the services sector (which accounts for 46% of the CPI) inflation remains stickier. In July, service sector inflation was unchanged at 2.5%. Nevertheless, it is still well below 3%+ rate of inflation experienced over much of 2013. With wage growth stagnant, and the strength of sterling and fall in oil prices likely to exert an indirect effect, the risks to service sector inflation is also biased to the downside.

By the end of the year, annual CPI and RPI are likely to have dropped to 1.2% and 2.3%, respectively. The relative underperformance of the RPI over the balance of the year is largely due to rising house prices. Over the following year, the continued absorption of economic slack, coupled with a fading of energy and exchange rate base effects, is likely to push both measures of inflation a little higher, but the CPI is still expected to remain below the MPC’s 2% target throughout both 2015 and 2016. On this basis, I vote to leave rates on hold and the APF at £375bn.

Policy response

1. On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in September. The other members wished to hold.
2. There was disagreement amongst the rate hikers as to the precise extent to which rates should rise. Four voted for an immediate rise of ½% but two members wanted a more modest rate rise of ¼%. On standard Monetary Policy Committee voting rules, that would imply a rise of ¼% would be carried.
3. All those who voted to raise rates expressed a bias to raise rates further.

Date of next poll
Sunday September 28th 2014

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is Andrew Lilico (Europe Economics, IEA). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Ruffer), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Patrick Minford (Cardiff Business School, Cardiff University), David B Smith (Beacon Economic Forecasting), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking and University of Derby). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, August 03, 2014
Shadow MPC votes for half-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

At its meeting of Tuesday 15th July, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended that Bank Rate should be raised on Thursday 7th August, including five votes for a rise of ½%.

Those urging a rate increase took the view that with GDP growing strongly, then even though inflation is low and monetary growth weak, the case for emergency interest rates has lapsed and there should be some normalisation.

They viewed with scepticism the idea that rate rises would seriously derail the recovery, with some members doubting whether initial rate rises would be reflected in rises in the structure of market rate to any significant degree. One member (switching from a hold to a raise vote) noted the growth in aggregate lending in the second quarter of 2014 took it to a five year high.

Those urging rates remain unchanged felt there was no urgency about raising rates and if inflationary pressures or credit or asset price bubbles do in due course emerge, there would be time and scope to raise rates in response. They were sceptical about the view that keeping rates near zero for an extended period is intrinsically damaging to growth or financial stability. Their view was that rates will rise eventually, but there is no reason to raise them yet.

Minutes of the meeting of 15th July 2014

Attendance: Roger Bootle, Anthony J Evans, John Greenwood, Andrew Lilico (Chairman), Vandana Patel (Economic Perspectives observer), David B Smith, Peter Warburton, Trevor Williams.

Apologies: Philip Booth (IEA Observer), Tim Congdon, Jamie Dannhauser, Graeme Leach, Kent Matthews (Secretary), Patrick Minford, David H Smith (Sunday Times observer), Akos Valentinyi, Mike Wickens.
Chairman’s Comments

As a result of refurbishments to the IEA the meeting was held at the offices of Europe Economics. The Chairman and host Andrew Lilico opened proceedings by putting forward two issues to discuss. The first was a proposal by Philip Booth to make more explicit comments regarding the activities of the Financial Policy Committee (FPC). Andrew Lilico offered some considerations. He argued that the SMPC is focused on monetary policy, and that some members may feel the remit of the FPC is outside of their expertise.

He also suggested that whilst attempting to broaden the focus of the SMPC is understandable (especially given the lengthy period in which the MPC have maintained the policy stance), this could be the wrong time to change the emphasis given that rate rises are on the horizon. David B Smith added that many SMPC members already factor FPC considerations into their decision, for example in terms of how regulatory issues feed into monetary aggregates. He pointed out that several SMPC members have highlighted problems relating to regulations, albeit in terms of their implications for money and credit. There was general agreement amongst the members present that the SMPC isn’t confined to the brief of the MPC, and it is legitimate to discuss regulatory matters provided it is pertinent to monetary policy. Trevor Williams offered his agreement, saying that the role of the SMPC is to consider all channels, and that this incorporates issues that the FPC would discuss. He said that there doesn’t need to be a specific attention to the FPC and that the SMPC is based on monetary policy for a reason.

Andrew Lilico summarised the conversation by saying that the SMPC should neither be deterred from nor seduced into discussing the FPC. Anthony J Evans asked for clarification as to whether the intention was to generate more media attention and Andrew Lilico replied to say that there was a belief that some issues could be more formally put with explicit reference to the FPC, and that it would be a way of extending the discussions. David B Smith pointed out that the FPC has a different schedule from the MPC and that would impact the SMPC’s ability to make timely comments. Roger Bootle emphasised that there is a necessity to discuss the impact of FPC opinions on SMPC decisions, and Andrew Lilico suggested that one way forward would be to encourage the person compiling the monetary situation to incorporate explicit reference to the FPC in their presentation.

The second issue that Andrew Lilico raised was a proposal by Jamie Dannhauser to incorporate a more detailed comment about the preferred path of interest rates. Currently when members submit a vote they express a bias. However now that forward guidance has been adopted it might help clarify the position of each member if they add detail to that bias, and suggest a projection of interest rates – for example where they would like interest rates to be in one years time. Anthony J Evans expressed a concern that one of the criticisms of forward guidance is that it generates an illusion of certainty, and that it might be confused as an attempted forecast. Andrew Lilico agreed that the projection should be kept as an “ought”, and added that this would be useful for when interest rates do start to rise, and debate turns to at what rate they will be expected to return to. David B Smith commented, saying that an element of this idea is already in operation, as members are free to offer as detailed a discussion of their bias as they wish. He also expressed concerns about formatting issues, but Andrew Lilico believed that it would be feasible to represent each members view in terms of (i) a vote; (ii) a bias; (iii) an opinion about where interest rates should be in 1 years time.

There was a general support amongst the members present for the idea, with the caveat that members would not be obliged to provide a judgment (in the same way that they are not currently obliged to express a bias). A decision was made to canvass opinion from members not present. Following these two operational discussions, Andrew Lilico asked Trevor Williams to commence his presentation.

Monetary situation

Trevor Williams distributed a comprehensive presentation and provided commentary. He began by offering an overview of what he considered to be some key themes. He said that there was a genuine recovery under way driven by high asset prices and a somewhat surprising reduction in volatility. He also drew attention to a slowdown in China, concerns about Q1 GDP growth in the US, and subdued earnings growth. He said that near zero interest rates and central bank liquidity were contributing to high risk appetites and questioned whether bubble activity was taking place. He pointed to OECD and IMF estimates of remaining output gaps.

He then turned to the monetary backdrop and pointed out that the growth rate of M2 (year to year) is now negative in the UK. Roger Bootle asked for clarification on the composition of M2 and Trevor Williams confirmed that it contains time deposits but unlike M3 it does not contain CDs and large wholesale deposits. He then pointed out that M2 was growing in the US and Japan (but that velocity was falling in Japan and there were concerns over bank lending). He revealed that M2 is growing at 2% in the Eurozone but that this is driven by monetary growth in Germany. France is almost 0% and Spain is negative. Indeed the M2 growth rates for Portugal, Italy and Greece are also negative. Trevor Williams summarised this information by saying they demonstrate worrying trends and imply doubt about the strength of the recovery.

With regard to the BRICs, M2 growth is solid, although in Russia it has been more volatile and decelerated recently. Trevor Williams pointed to the fact that Russia is highly dependent on a flow of funds and that makes it susceptible to capital flight. Andrew Lilico questioned whether M2 is the appropriate measure given that real GDP is growing in the UK at 3% despite low M2 growth. Trevor Williams replied that this could also be used to express concerns about the sustainability of such a growth rate.

In addition to looking at growth rates of monetary aggregates, Trevor Williams argued that stocks can be useful since they are less prone to showing temporary trends. He showed that the M3 stock in the UK was stagnant since late 2009, and Roger Bootle intervened to query whether this also suggested that M3 is flawed. Andrew Lilico added that real GDP has had a rocky journey since 2009 and M3 fails to reveal anything. Trevor Williams replied to say that there may be long and variable lags, and that it implies that real GDP isn’t on a consistent recovery path. Andrew Lilico raised the possibility that as of 2009 there was lots of money in the economy, and therefore since then it has not been necessary for money growth to precede growth in the real economy.

Trevor Williams then showed that by contrast the stock of M2 had been rising at a sustained rate, whereas Euro M2 was essentially flat. Peter Warburton added that different measures of the money supply have very different growth rates, and velocity figures can differ substantially. Trevor Williams expressed concerns that Portugal, Greece and Spain were showing limited ability to increase bank lending and that growth performance is lowest were lending is low. He acknowledged that there are regulatory factors at play as well.

Trevor Williams then drew attention to debt levels, explaining how UK household debt had fallen but was now starting to pick up again, and that there’s been little improvement in the fiscal deficit. Andrew Lilico recalled research that he’d conducted in 2009 on optimal levels of household indebtedness and questioned whether the existing deleveraging might be considered sufficient. He also asked Trevor Williams if he could explain why UK growth was strong in 2013 despite a contraction in bank lending, and Trevor Williams suggested higher confidence and greater product market flexibility relative to European countries with similar levels of lending. Peter Warburton added that corporate bond issuances have been stronger in Italy than elsewhere, and David B Smith queried the country-by-country breakdown of the Eurozone money supply given that in a currency union money is supposed to be perfectly substitutable. Trevor Williams responded by saying that there is part of the money supply that doesn’t flow across borders.

Next, Trevor Williams turned to growth and inflation. He said that there are concerns about the sustainability of the UK growth rate, although a recovery is clearly taking place, and that core inflation is well contained. Roger Bootle challenged whether inflation was as contained as many forecasters has predicted, pointing out that today’s figures showed a large jump to 1.9%. Trevor Williams presented data showing that US corporate profits were at their highest levels since the 1950s, and that labour market recovery is being driven by the private sector. He concluded that only the US and Germany could be said to be at “escape velocity”, which he defined as returning to pre-crisis GDP.

When challenged by Andrew Lilico to explain why that is a good measure, he pointed out that it’s not worse than any other. In terms of nominal incomes pay is still lower than in 2009, and in per capita terms it’s the same as 2005. Trevor Williams suggested that Eurozone growth may be slowing slightly, and starting to peter out. He asked where future growth is likely to come from, pointing to possible traction in GFCF, and claimed that the exchange rate wasn’t overvalued (but perhaps needed to be weaker). He also suggested that Japan may be about to provide an answer to the question of whether debt matters, given the present experiment taking place. He referred to a fiscal and monetary arrow, but only a structural “dart”. John Greenwood added his expertise on Japan pointing out that recent inflation has been driven by a 3 percentage point rise in consumption tax and a devaluation of the Yen. Peter Warburton added that recent CPI growth is likely to fall back somewhat, but services CPI is strong.

In terms of financial trends Trevor Williams explained that volatility had collapsed, markets seem to have bought Mario Draghi’s promise to do “whatever it takes”, with the probability of a Greek exit falling from 100% in 2012 to 0% now. Almost all asset classes showed positive returns in 2014, and whilst interest rates have risen in some emerging markets Trevor Williams claimed that this was a prudent response to booming credit.

The final section of his presentation looked at UK trends. CBI, BCC and PMI measures all suggest that the UK recovery has a solid base and consumption has been buoyed by rising house prices. Trevor Williams asked whether there was evidence of the supply side gaining traction and pointed to a 10% rise in business investment in the first quarter of 2014, but reaffirmed that inflationary pressures were low when looking at pay data. There was a discussion about pay measures and Andrew Lilico pointed out that figures for average weekly earnings would be released the day following the meeting. The final charts showed that inflation expectations are well-anchored and that even though unemployment has fallen it is still significantly above where it was in 2008.

Discussion

Andrew Lilico thanked Trevor Williams for his presentation, and opened up the floor for discussion. Peter Warburton began by making some points that he felt underlined the debate. He said that the sustainable growth rate is conditional on existing supply side decisions, and that inflation risk in the system should be judged against the sustainable growth rate. He expressed concerns that the current growth of the UK economy might be significantly higher than the sustainable rate (perhaps twice as high) and that this recovery bears an inflation risk. He added that it is only if you think you can claw back the cumulative output loss since 2008 that you can be complacent about inflation. Monetary policy actions should be judged against the achievable, non-inflationary growth rate. He expressed severe concern about the fact that the government’s budget projections are based on an assumption of rapid growth.

When queried by Andrew Lilico, he said that he would deem a 2.5% growth rate with interest rates at 1% as being preferable to a 3% growth rate with interest rates at 0.5%. He said that consumer confidence surveys show that respondents believe that life is normalising and growth is back, but that this isn’t soundly based. Ultimately he believes that policy makers have an obligation to help frame and calibrate reasonable expectations. He expressed concern for households that are assuming debt that they may find hard to finance in future.

Roger Bootle said that he was concerned about the impact of any interest rate rises on sterling and suggested that there would be valuable things to learn prior to rates going up. Andrew Lilico countered this view by saying that there were also risks associated with waiting too long. Indeed if policymakers are behind the curve and forced into sharp rises this could be catastrophic. He suggested an asymmetry on the part of those who consider the economy to be highly fragile and unable to cope with moderate rate rises, but less concerned about the risks of acting too late. David B Smith alluded to the 1970s view that monetary policy was either “too little too late” or “too much too late”. Roger Bootle said that unlike the 1970s the biggest danger now – especially in the Eurozone – is deflation. Andrew Lilico questioned whether inflation may be the bigger danger, presenting an idea that in 2008 there was lots of money in the system, but for various reasons (regulatory constrains chief among them) it didn’t show up as inflation. But with QE on top of this perhaps there is a similarity to the 1970s. He also utilised BIS discussions about the possibility of high inflation or high deflation, and Roger Bootle characterised this as an each way bet. Anthony J Evans said that in a regime of emergency monetary policy it isn’t ludicrous to believe that the central bank can increase risk such that there’s higher probability of bad events in both directions.

John Greenwood then reminded the group that there is some context that needs to be considered. He used the example of Sweden, who raised rates too early, and then had to backtrack. He believes that there is plenty of time to judge the situation, and that several years of wage growth would be required prior to raising rates. There is not sufficient evidence that credit can be created without emergency stimulus and therefore the recovery is not truly self-sustaining.

Andrew Lilico drew upon further BIS commentary, saying that over the medium term most economists would agree that growth is higher if interest rates are above zero. He pointed out the danger that if policymakers do not even try to get back to a rate that is consistent with a maximum medium term growth rate, you could get locked into low growth. Roger Bootle expressed sympathy with aspects of the BIS view, but pointed out that ultimately it comes down to the relative strength of different factors. He repeated previous requests to be shown where the evidence is for the types of Ponzi scheme that critics of low interest rates fear. David B Smith suggested the public finances of every major government, on the grounds that they weren’t sustainable. Roger Bootle replied to say that if the implication is that there needs to be simultaneous monetary and fiscal tightening there would be a real catastrophe. Andrew Lilico defended the BIS view by saying that low interest rates prevent low value projects from being liquidated and therefore capital is inefficiently allocated. He suggested that 5 years is a very long time to consider retaining supposedly “emergency” monetary policy, but Trevor Williams responded by saying there was a clear and present danger from raising rates now.

Peter Warburton then switched attention to the US, saying that he felt the drive for lower unemployment and focus on labour market slack is a monochrome style of policy. He pointed to numerous sectors already showing high wage inflation, and diminished policy sensitivity to inflation. He wondered what the inflationary condition the world economy would be when it enters a new cycle of defaults.

Votes

Comment by Roger Bootle
(Capital Economics)
Vote: Hold Bank Rate
Bias: To raise Bank Rate
1 Year View: ½%

Roger Bootle said that he was intrigued by supply side intuitions about the sustainable growth rate. He said that if there was a massive negative shock to potential growth this should show up in the labour market, but the resilience of the employment figures are impressive and bode well. He continued to say that we was concerned about the housing market, and the balance of payments – especially given the depressed demand from Europe. He said that he anticipated significant forthcoming shocks to sterling, and for inflation to remain low (possibly hitting 1%). He said that it was too early to raise rates but his bias is to raise interest rates “later”.

Comment by Anthony J. Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ½%
Bias: To raise Bank Rate further
1 Year View: 1%-2%

Anthony J. Evans said that recently there has been a window of opportunity to begin nornalising interest rates and advantage should be taken of this. He agreed that M2 and M3 demonstrate concerns about monetary growth but pointed to M4x which is reasonably strong and Divisia measures which are above 10%. He said that provided the money supply isn’t contracting, that growth prospects are strong, and that inflation is not falling below target, there is scope for rate rises. He agreed that there was some uncertainty about the impact of raising rates now, but this would constitute a necessary policy experiment. He said that he is becoming less concerned about house price inflation having spoken to estate agents recently who seem to think buyers are starting to factor interest rate rises into their mortgage decisions, and that the summer period will see slightly less activity. He believes that there is not an overly convincing case to raise rates, but similarly there is not an overly convincing case for them to be at 0.5%. Therefore he thinks it appropriate to move them back towards normal levels.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold
Bias: No bias
1 Year View: No view

John Greenwood believes that the economy can afford to wait until the threat of inflation is more tangible. He suggested that is it misleading to treat the present situation as being similar to 2004-2008. Although house prices and asset prices were rising rapidly then it was a result of rapid credit growth, and alarmists were correct to be worried. However now it is a consequence of low interest rates, which have in fact harmed the credit creation process. The US only started to see an increase in lending in March 2011, and it only started to pick up properly in January 2014. Repo financing and issues of commercial paper are completely dormant relative to 2004-2008, suggesting that we are not experiencing a similar bubble. He didn’t believe that there is a real danger in keeping rates where they are, and expects growth to fall. A period of wage increases would be desirable, and there is little chance of inflation exceeding the 1% band around the target.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%
Bias: To raise Bank Rate further
1 Year View: 1¾%

Andrew Lilico said that we should be seeking opportunities to normalise whenever possible and that 3% growth is a good opportunity. He believes that the burden of proof shouldn’t be on those advocating a rate rise but on those who advocate keeping interest rates so far from the natural rate.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ¼%
Bias: To raise by ¼% increments over the next few months
1 Year View: 1%-2% and then carry on until 2½%-3½%

David B Smith said that it was noteworthy that UK growth had outperformed OECD growth recently and that the Beacon model forecast this to continue (with 2.2% growth in the OECD compared to 2.8% in the UK). He was not concerned about inflation expecting it to be 1.1% in the final quarter of this year and 2.4% the following year. He expressed a large concern about the next stage in the move to the European System of National Accounts (i.e. ESA 2010). He noted that there would be substantial changes to the value figures – with money GDP being revised up by 3.6% - as well as to the volume data, which will move on to a 2011 chained basis. He also added that since there will be a gap in the expenditure estimates until the new 2011 measure is introduced on 30th September there will be a period of several months in which occur right when the Bank of England is expected to start raising interest rates).

David B Smith said that people have overeacted to the random volatility in recent CPI data, and that while house price inflation was rapid and accelerating, PPI was low and he expected growth to decline in the second half of this year. He also drew attention to real interest rates and argued that there has been a tightening as a result of lower rates of UK inflation relative to other trading partners. He also pointed to impending political uncertainties such as the Scotland independence vote, the General Election, and a potential European referendum. He is concerned by the slow rate of M4x but believes normalisation of interest rates is appropriate.

Comment by Peter Warburton
(Economic Perspectives)
Vote: Raise Bank Rate by ½%
Bias: To raise Bank Rate further
1 Year View: 1½%-2%

Peter Warburton said that interest rates should have been increased a year ago and that a taboo has formed around changes to Bank Rate. He expressed doubts that any change in Bank Rate would be fully reflected in the structure of market interest rates. It is probable that additional spending by savers will compensate for a loss of discretionary spending by those whose debt obligations rise. He also made the point that rate rises would only make sense in an international context, and therefore his vote is based on an expectation that other countries will do likewise. He added that lots of debt-related vulnerabilities remained but these would not have a material effect on economic growth until Bank Rate reached around 2%.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold
Bias: No view
1 Year View: No view

Trevor Williams said that growth has traction but is not yet inflationary and there is a real danger of slipping backwards. He believes that rates should only rise when there is positive traction on wage inflation (in terms of real earnings). He believes that when interest rates do go up they may peak at 2%-3%.

Votes in absentia

The following two votes were provided in absentia by members unable to attend the physical meeting.

Comment by Tim Congdon
(International Monetary Research)
Vote: Raise Bank Rate by ½% and hold QE
Bias: Increase Bank Rate further, perhaps to 2% by the end of the year
1 Year View: No view

For some quarters UK ‘real side’ indicators have been positive, even strong, while the banking system has continued to struggle and money growth has been weak. But in the last few months bank credit to the private sector has started to expand again, causing money growth to run at a 4% - 5% annualised rate. (In the year to June M4x increased by 3.9%; in the three months to June it increased at an annualised rate of 4.6%. In the year to June bank lending outside the intermediate other financial corporations (M4Lx) was up by 1.1%, but all of this occurred in the three months to June. In the three months to June the annualised growth rate of M4Lx was 4.6%.)

It is possible that the rise in bank credit in the last few months – which seems to be a clear break from the preceding five years – is only a blip. However, a more plausible view is that, with interest rates at only a little above zero, stronger growth of bank credit – and hence a reasonable rate of money growth without the prop of QE – is the new trend. The data need to be watched, but I expect that further base rate rises will be prudent in the rest of 2014, reaching perhaps 2% by the end of the year.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½% and gradually claw back QE
Bias: To raise further
1 Year View: No view

The relaxation of credit conditions brought about by Funding for Lending and Help to Buy, reversing previous regulatory policy decisions that had frozen the credit channel, remain a key part of the general UK recovery. But talk of a “house price boom” is over-done. It is still more a correction than a boom. The attempts by regulators to reign in the housing market with special measures on such things as mortgage affordability, via ‘caps’ of one sort or another, are both unnecessary in themselves and focus upon the wrong tools. It would be far better to tackle monetary overheating directly by tightening monetary conditions towards normality.

The recovery looks sustainable. Monetary policy is too loose given the UK’s fairly strong growth, including the housing recovery. Rates should be raised and QE clawed back.

Policy response

1. On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in August. The other three members wished to hold.
2. Of those favouring a rise, five voted for an immediate rise of ½% but one member wanted a lesser rise of ¼%.
3. All those who voted to raise rates expressed a bias to raise rates further. One of those who voted to hold rates had a bias to increase rates in the near future.

Date of next meeting
Tuesday 14 October 2014

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is Andrew Lilico (Europe Economics). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Patrick Minford (Cardiff Business School, Cardiff University), David B Smith (Beacon Economic Forecasting and University of Derby), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, July 06, 2014
IEA's shadow MPC votes 8-1 to hike rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its email poll closing Wednesday 2nd July, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended by eight votes to one that Bank Rate should be raised on July 10th, including five votes for a rise of ½% and three for a rise of ¼%.

Those advocating a rise acknowledged that the economy is not yet over-heating, money growth is low, and inflation overshoots are not an immediate risk. They did not propose raising rates to cool down the economy but, instead, sought to withdraw some of the excess monetary stimulus introduced at the time of the financial crisis so as to allow the price mechanism to allocate loans and capital. The current strategy of keeping interest rates very low whilst using bank regulation to prevent money and credit growth was loudly condemned.

For several of the members the Bank of England has already waited far too long before raising rates, with some criticising its “neglect” whilst others focused upon the confusion created by the signals from forward guidance. The main way to signal should be by changing a price — the interest rate — not by speeches or regulatory changes.

The member that preferred to keep rates on hold noted that not only is inflation low, but pipeline inflationary pressures are also low, as are wage growth, money growth and credit growth. For that member there was simply not enough reason in the data to raise yet.

Votes

Comment by Philip Booth
(Institute of Economic Affairs)
Vote: Raise Bank Rate by ½%
Bias: Further rises

The situation has not changed greatly from last month, though inflation has fallen again. However, we should remember that the 2% target for Consumer Price Index (CPI) inflation is symmetrical and we should not be worried about inflation dipping below it. Certainly, the Bank of England was very sanguine when inflation went above target.

It is quite clear that the economy is returning to normal in terms of business investment, confidence and so on. We can therefore expect the level of interest rates necessary to keep a given monetary stance to normalise. It is, though, ridiculous to try to predict, as the Bank of England seems to be trying to, what the appropriate level of interest rates might be in many years time and whether equilibrium interest rates will settle at (for example) 2.5% or 5% over the coming decade. Certainly, the Bank of England has not covered itself in glory when it comes to forecasting and prediction in recent years.

Perhaps the Bank would do well to focus more on the present level of interest rates necessary to hit the inflation target two years out. There are dangers in raising interest rates too quickly. However, given the leverage of many households, there are, perhaps, greater dangers in leaving interest rates at too low a level and then having to raise them quickly. There are also huge dangers from the Central Bank implying that interest rates might well be left very low for a prolonged period and then having to raise them. Influencing expectations in that way may well induce borrowing in ways that are not sustainable in the long term and then, when interest rates are raised, the damage will be that much greater.

I would therefore raise interest rates slowly starting now, with an increase of ½% in the first place. Regarding Quantitative Easing (QE), the decision with regard to QE should be driven by what is happening to the quantity of broad money. The stock of M4ex should be monitored correspondingly on a month-by-month basis. However, the existing stock of QE should be kept where it is for the moment. My bias would be to raise interest rates further in due course, although I have no quantitative bias with regard to QE, only a conditional one.
I would like to add that it is a travesty that the Bank of England and the government are simultaneously raising capital requirements for bank mortgage lending, underwriting the risk of mortgage lending using taxpayers' money, keeping monetary policy very loose and talking about restricting private sector bank credit to the mortgage market. The Bank should set monetary policy appropriately and then allow the markets to determine how to allocate credit. Ted Heath and Harold Wilson will be chortling in their graves.

Comment by Anthony J. Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ½%
Bias: Further rises

CPI growth has slowed to 1.5%, but this is only generating anxiety given the extended period of time in which it has been allowed to go above target. If the inflation rate continues to fall, then this would be a cause for concern, but the Bank of England’s Inflation Attitudes Survey suggests that expected inflation remains above 2%, and therefore there’s scope for this to come down. There are some mixed messages coming out of the monetary aggregates. Eurozone M3 is worryingly low and the UK measure is now contracting slightly. M4ex continues to grow within a band of 3%-5%. This isn’t sufficiently high to fret about credit-induced booms, but it’s also not indicating that monetary policy is too tight. My preferred measure of the money supply – MA – has seen the growth rate fall dramatically since the beginning of the year. It was showing double digit growth in late 2013 but has since fallen to 1.84%. However, this has been driven by a one off adjustment made in January 2014 due to “improvements in reporting at one institution”. This demonstrates a downside of looking at relatively narrow measures (since they are less robust to one off adjustments), but also reminds us that indicators can behave in odd ways and we shouldn’t be over reliant on any single one.

Economic growth continues to be strong. The final estimate of 2014 Q1 puts business investment growing by 10% more than the same time last year, and 5% more than the previous quarter. This rate is unlikely to be sustained but shows signs that the recovery has a foundation. The growth rate of NGDP rose throughout 2013 and continued into 2014, almost hitting 5% in Q1. Although this seems too little too late for those desperate to reach the pre crisis trend path, I believe that horse has bolted. Real GDP growth is higher than it has been for several years, and from where we stand today if anything this might be considered too high.

A fear of rate rises shouldn’t prevent a tentative step into exit strategy being made. There is a real danger that so far forward guidance has been interpreted to mean, “you don’t need to worry about interest rate rises yet”. But this conflicts with the necessity to factor in future interest rate rises to current decisions. Higher debt burdens don’t need to be paid today, but they do need to be planned for. The Governor of the Bank of England has suggested that the new normal may be around 2.5%, whilst the Deputy Governor for Monetary Policy has expressed the view that the long-term rate will still probably be around 5%. Regardless of where one thinks rates will be in the long term (and indeed how long that is), there is a general consensus that moderate rate rises will start happening within the next year or so. My concern is that we shouldn’t wait that long.

Whilst the economy is healthy, it is worth testing the waters to ensure market participants are factoring future rate rises into current decisions. Economic commentators seem to give the impression that any increase in the Bank Rate will automatically feed into all other interest rates. In fact, it’s only people on tracker mortgages that will see an immediate change (and let’s also note that the risk of a rate rise has already been factored into the interest rate they’ve currently been paying). For people on variable rate mortgages it will depend on that particular transmission mechanism, and there are lots of unknowns about the extent to which banks have already begun to factor in rate rises. Having said this, it seems that some lenders are starting to increase their fixed rate mortgage offers. But this also suggests that there may be a free lunch whereby the Bank of England acquires the communication benefits of a rate rise without passing on the costs of higher interest payments.

Either way, there are over 1 million households that have never experienced an interest rate rise. If they’ve been anticipating interest rate rises, then the costs of a moderate rise now will be low. If they haven’t, this would indeed be costly. But it implies an even bigger cost to come when rates approach their normal levels (even if this is just 2.5%). The bigger the shock of an interest rate rise, the more important to confront it early. With inflation subdued and earnings growth only just starting to pick up, there is a danger that if the Bank shocks markets it will threaten the recovery. But for the recovery to be sustainable interest rates need to be at their natural rate. It is notoriously difficult to estimate this, but I believe it is around 1.8%, and therefore monetary policy remains too loose.

Comment by Andrew Lilico
(Europe Economics, IEA)
Vote: Raise Bank Rate by ½%
Bias: To raise further; QE neutral

With strong construction, manufacturing and service sector PMIs continuing in June, sector quarter growth in excess of 0.8% seems assured. Consumer confidence is at a nine-year high. The housing market is racing, with prices in the most recent quarter up 8.7% on a year earlier (on the Halifax index). Unemployment is down to 6.6% and expected to fall further.

The real economy boom is still not feeding through into faster money or credit growth. Broad money (M4ex) grew at just 3.6% in the year to May 2014, down from 4% three months earlier. Aggregate lending (M4Lx) has stopped shrinking (as it was doing earlier this year, contrary to the talk of “debt-fuelled growth”) but still only grew 1.1% in the year to May 2014 (though that was its strongest growth since 2012). CPI inflation was down to 1.5% in May (though that may pick up from around July as international oil price rises feed through).

There is thus certainly no need to raise rates in order to “cool the economy down”. Inflation is low. Money growth is poor. GDP growth of 0.8% is solid but not spectacular and shows no signs of getting out of control yet. There is no overheating, yet or upon the horizon, that would justify anything remotely close to tight monetary policy.

However, the argument for raising rates is not an argument for tight monetary policy. The reason to raise rates is (a) that we no longer require the epic emergency levels of monetary support — with all monetary spigots twisted to maximum — that were the reasons interest rates were cut to near-zero and QE was begun in 2009; (b) that near-zero rates damage growth over the medium term, introducing distortions to economic decision-making, retarding the liquidation of inefficient companies and investment projects and facilitating new mal-investments, and the longer rates are kept too low the worst such distortions become and the greater the pain when rates finally do rise; (c) that rate rises when the economy is doing well could be interpreted as good news and boost short-term growth whereas if policymakers wait until they are forced to raise by bad news (e.g. rising inflation) that will be a bad signal that may damage short-term growth, and (d) raising rates from near-zero gives policymakers scope to cut rates if the economy experiences a negative shock whereas with rates already zero any negative shock cannot be offset by rate cuts.

The steer the Bank of England governor has been offering is that, even when interest rates rise, they will not return only to 2% to 3% at peak, rather than the 5% or more that was normal pre-crisis. Since the equilibrium rate of interest is (as a first iteration estimate) approximately given by the sum of the medium-term growth rate and the inflation target, at a 2% inflation target a 2% to 3% equilibrium interest rate would imply the Bank believes the UK’s medium-term sustainable growth rate is only 0% to 1%. That is much too pessimistic.
Recovery may be choppy and we may well see another recession later in the 2010s, but with public spending coming down and the debt imbalances of the 2000s being worked off, the sustainable growth rate should return to 2% to 2.5% by the latter 2010s, implying an equilibrium interest rate of above 4.5% not 2%. If inflation gets going a little, in an otherwise healthy economy the interest rate peak could be above the equilibrium rate. We should not swing from the excessive optimism of the 2000s to permanent pessimism now.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise rates by ¼%; no further QE but can be held in reserve for the next euro crisis
Bias: To raise

There has been little that has changed in the economy in the space of a month, except for the mixed messages coming out of the Bank of England. At first, there was a recognition that interest rates may rise sooner rather than later. More recently, there has been a backtracking with the message that the appreciation in Sterling had to be moderated. The markets have already factored a rise in rates and Sterling has appreciated by around 10%. The rise is inevitable; the uncertainty is about the timing.

The longer the Bank delays the stronger the probability that the rise in rates would be larger. The argument for raising rates is a supply-side one and is therefore not dictated by short term objectives. The efficient intertemporal allocation of resources requires that real rates of interest have to be positive. Investment needs to be diverted from low productive to high productive sectors and the market for savings has to provide a positive real yield.

These are of course medium term to long term considerations and it can be argued that a rise in interest rates will hinder the nascent recovery. Certainly, there will be pain for those who indebted themselves on the basis that mortgage rates will remain low for several more years or to those firms that exist on cheap bank credit. But there is also evidence of a short term nature that points to a developing recovery which gives added impetus to the more medium term arguments for raising rates. The pain can be mitigated by raising rates in small stages to wean those enterprises out of their dependency on low rates, but the longer the delay the greater the likelihood that the inevitable raise in rates will be higher.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate 0.25% and start to reduce the stock of QE gilts
Bias: Further rate rises and more run-down of QE

We have a largely new Monetary Policy Committee and it seems to be learning on the job, side by side with a brand new Financial Policy Committee (FPC), endowed with ‘macro-prudential controls’. The Bank of England is the location of both these Committees, a logical development brought about by the crisis. Before the ill-fated ‘Tripartite’ set-up created by Gordon Brown in 1997 which split powers over monetary, financial and regulative policy between the Bank, the FSA, and the Treasury, all these powers had been wielded by the Bank in consultation with the Treasury. Hence, what has been done now by George Osborne in the wake of the crisis is to return all these powers back to where they once were. The only difference is that their exercise has become more formalised and ‘transparent’; also the regulations that are now being implemented are recent and complex.

Currently, the conventional view is that developments in the housing market (e.g. prices and mortgage lending) was not controlled adequately by monetary policy in the run-up to the 2008 financial crisis and so instead need to be controlled by additional direct intervention (e.g. regulatory measures enacted via the FPC). Yet there are two key objections to this view that both seem to me to be strong. First, monetary policy could have been conducted in the past so that the credit and housing boom would have been moderated, had policymakers chosen to do so at the time. And second, direct intervention may create its own costs in the distortion of market behaviour.

Turning to the present situation I welcome the decision by the FPC to go softly on intervention in the mortgage market. Their remarks effectively amount to no more than what the mortgage providers themselves and the markets would be doing anyway - namely keeping an eye on the high loan/house-value borrowers. Having said this, these borrowers are in most cases fairly low risk as they have a lifetime of earnings ahead, i.e. high ‘human capital’. Intervening against them would be to handicap some of the more dynamic agents in the economy.

At the same time, can one discern in the confusion created by the Governor’s many conflicting comments on future monetary policy that there is a hardening of the MPC’s approach to interest rates and QE? I hope so and for long have been arguing that it is high time to ‘normalise’ monetary policy. The economy is picking up rapidly at a time when the best estimate of spare capacity is quite low; the labour market is buoyant and not far from the 5% unemployment rate at which, roughly, full employment prevails. It seems rather clear that the economy is no longer in the intensive care that justifies emergency low rates and a massive overhang of official liquidity.

It is usual in these situations, when memories of the recession are still fresh, for many people to argue against ‘premature tightening’. However, this is also a dangerous time to listen to such arguments. The strongest point in their favour is the slow growth of the money supply and the glacial growth of credit that is associated with this slow growth. The problem is to interpret these developments. There has been a wave of new regulation which has impacted massively on bank behaviour, forcing banks to shrink their balance sheets aggressively. Now we seem to be entering a phase when firms are finding ways of substituting away from bank credit; the surge in the mortgage market is the only vibrant part of the credit scene, and ironically in view of all the concern being expressed about housing is also low risk-weighted in bank regulation.

While still slow, broad money growth (on the favoured M4ex definition) has picked up in the past year to a pace comparable with that of nominal GDP. So if it is also distorted downwards by substitution due to the new regulatory environment, then its message reinforces the case for monetary normalisation.
To conclude, I am in favour of moving towards a cautious normalisation of monetary conditions, with an immediate rise in interest rates of 0.25% and a move to reducing the Bank’s portfolio of gilts. In future months this process should continue.

Comment by David B. Smith
(Beacon Economic Forecasting, University of Derby)
Vote: Raise Bank Rate by ¼%; hold QE
Bias: Avoid negative regulatory shocks to the financial sector; gradually raise
Bank Rate up to 2% to 2½%, and quietly run off QE as stocks mature

There was a time when central bankers were considered stern and unbending gentlemen who uttered few words in public and only carefully chosen ones at that. Nowadays, with their speeches, podcasts and press conferences, some central bank representatives appear in danger of becoming a part of ‘celeb’ culture. Clearly, openness and transparency are good things. Furthermore, central bankers are now generating the massive income transfers within their societies – e.g., from savers to borrowers – that were considered traditionally to be the role of re-distributive fiscal policies; policies that were themselves highly politically controversial. This means that central bankers have to explain themselves to the people who have suffered collaterally from their policies, in order to maintain social acceptance for measures taken in what is perceived to be the wider public good.

However, there are also risks in a high media profile designed to service the 24-hour news media. One risk is that the central bank discredits itself if it seems to be flip-flopping from one stance to another. Policies such as forward guidance rest on the implicit assumption that central banks can know more about the future than private agents – in other words, that “the gentleman in Whitehall really does know best”, to quote a later 1940s Labour minister. Unfortunately, there is little evidence in terms of its forecasting record that the Bank of England can look further ahead than other people, despite the massive resources, including some two hundred economists, it devotes to the endeavour. This is probably because accurate economic forecasting on a sustained basis is philosophically impossible in the first place.

The other risk associated with placing constant new utterances in the public domain is that it adds to the uncertainty facing economic agents in the private sector. Economic decisions to invest in productive activities, such as capital formation, education and training, not only reflect current economic circumstances, and/or the most-likely central scenario, but also the risks attached to the outlook. Governments that run large budget deficits and show no stomach for cutting back on public spending are effectively telling private agents that their tax burden will go up in future but not how, where or when, for example. Similarly, politicians who engage in anti-business rhetoric, or propose arbitrary price controls, are adding to the uncertainties of doing business and leading to sub-optimal levels of capital formation in the sectors concerned.
Likewise, the Bank of England appears to have entered the zone where its numerous comments are adding to the uncertainties about future interest rates. Such statement-induced uncertainty discourages productive investment by the private sector and thereby reduces future aggregate supply. The supply-side damage caused by an overly discretionary monetary policy explains why people sometimes prefer heavily-constrained ‘rules-based’ policy making. One example is that some US commentators are now claiming that the old ‘gold standard’ would have provided a better monetary anchor than the machinations of the US Federal Reserve since the early1970s. Another is the long-term stability orientated approach implemented by the Bundesbank between the 1970s and European Monetary Union, which would be the author’s preference.
The revised first quarter national accounts data, released on 27th June, added more detail, and some significant revisions, to the statistics from 2013 Q1 onwards but did not massively change the underlying picture. In the light of the new figures, the UK is expected to grow by 2.8% this year, 2.2% next year and 1.9% in 2015, before settling at around 1.8% to 1.9% in subsequent years according to the latest runs of the Beacon Economic Forecasting (BEF) model. One unusual feature of the BEF projection for 2014 is that the British growth rate exceeds the 2.2% projected for the Organisation of Economic Co-Operation and Development (OECD) area as a whole. This is historically unusual but it also happened in 2013, when the UK grew by 1.8% and the OECD by 1.3%. However, OECD growth is expected to overtake Britain’s next year, when an OECD growth rate of 2.8% is expected, and also in 2016 when OECD growth is predicted to be 2.1%. In the longer term, OECD growth is expected to run consistently some ¼% to ½% higher than Britain’s. Nevertheless, Mr Osborne will be able to go into the May 2015 election campaign with the claim that he is presiding over a better than average performance where developed-country growth is concerned.

However, a major fly in the ointment is the continuing size of Britain’s twin deficits on the balance of payments and the government’s fiscal accounts, where recent figures have been disappointing. This gives rise to concerns about the sustainability of the recovery beyond the May 2015 election. Thus, the balance of payments data, released alongside the GDP figures on 27th June, revised up the 2013 current account deficit by £1.7bn to £72.8bn and announced a deficit of £18.5bn for the first quarter of this year, while Public Sector Net Borrowing, defined to exclude the temporary effects of financial innovation, was £20.1bn in the first two months of the current financial year (i.e., April and May 2014) compared with £14.5bn in the first two months of fiscal 2013-14.

One detail from the latest national accounts is that the volume of general government capital formation is running well below the figures projected by the Office for Budget Responsibility (OBR) in the March Budget documents. Thus, real government investment is reported as £7.1bn in 2014 Q1 measured in ‘chained’ 2010 prices compared with an OBR forecast of £8.5bn, representing a shortfall of 16½% (however, these are very erratic figures). This investment shortfall suggests that, not only are the public accounts only coming right at a glacial pace, but that the positive growth-enhancing parts of public spending have been crowded out. One dreads to think what would happen to the public finances, and financial-market confidence in the management of the UK economy, if a putative Labour government tried to increase public spending after the May 2015 election, starting from such an unsustainable base.

The May inflation data showed the annual rise in the CPI easing from 1.8% in April to 1.5% in May. However, it is likely that the extent of the deceleration was exaggerated by the timing of Easter and other special factors. Also, the most recent hike in the price of oil will probably not appear in the official figures until the July CPI is compiled, or possibly later. However, it is also likely that inflation has turned out lower than expected because the importance of Sterling as an influence on the domestic prices is badly underestimated in ‘output gap’ models of the inflationary process, such as those preferred by the Bank of England. The latest BEF projections show annual CPI inflation easing to 1% in the final quarter of this year but rising to 2.1% in late 2015 and 2.5% in the final quarter of 2016, before broadly sticking around this rate for several years thereafter. Other indicators of current UK inflationary pressures, including average earnings and producer prices also remain at or below 1% and there is little justification in the current data for wanting to raise Bank Rate.

However, monetary policy is meant to be both forward looking and take account of the balance of risks on all possible scenarios. There is also the issue that the extreme medical intervention that may be appropriate immediately after, say, a cardiac arrest will itself prove fatal to the patient if persisted with for too long. The 9.9% annual rise in the Office for National Statistics measure of UK house prices in the year to April; the strength apparent in the price of some other financial markets, and the evidence of suppressed inflation in the balance of payments figures, suggest that it is now time for a less extreme treatment regime. The annual increase in the M4ex broad money definition admittedly has slowed from the recent peak of 5.2% recorded in May 2013 to 3.8% in both March and April 2014. This is hardly a ‘Boom, Boom Britain’ headline rate of increase. However, it seems enough to sustain the recovery, particularly given the very unattractive returns from holding money on deposit, which have probably reduced the demand to hold money.

The conclusion is that Bank Rate should be raised by ¼% in July and then increased cautiously in a pre-announced fashion, by ¼% every second month or so, until it reaches 2% to 2½%. Likewise, QE should be allowed to unwind gradually as stocks mature, through a process of partial re-placement. A final comment is that there is almost no justification for attempting to offset the financial consequences of an unduly low Bank Rate by imposing direct controls on the lending and borrowing decisions of financial institutions and adult citizens. Such policies represent a classic example of ‘the gentleman in Whitehall knows best’ syndrome; were tested to destruction in the 1960s and 1970s, and totally failed then. One reason is that the politicians and HM Treasury officials – who then largely set rates – found it more politically convenient to slap on additional controls than to raise Bank Rate. At a time when inflationary expectations were rising anyway because of oil price shocks and other factors, this policy preference was a major contributor to inflation getting out of control in the mid 1970s.

Comment by Peter Warburton
(Economic Perspectives)
Vote: Raise rates by ½%
Bias: To raise Bank Rate in stages to 2%

Notwithstanding the sluggish pace of most credit and monetary aggregates, there is no doubt that there has been a nominal acceleration of the economy. Nominal GDP growth was 4.4% in the year to Q1 and 5.8% annualised over the past 6 months. The UK authorities have wakened the sleeping credit dragon from its slumbers and are basking in the warm glow of its breath. Yet it would be a travesty to consider this mild uptick in household credit growth as posing any kind of systemic threat.

The new recommendations of the FPC appear quite innocuous, confirming that it is not the Bank’s intention to hit the economic recovery on the nose. The limit of 15% for the proportion of high (more than 4.5 times) loan to income multiples is far from a binding constraint. The stipulation that new mortgages should be stress-tested for a 3 percentage point rise in Bank Rate is reasonable enough, considering that it does not lay down what assumptions should be made for the spread between Standard Variable Rate mortgages and Bank Rate. A narrowing spread as interest rates normalise would be a reasonable assertion. Also, lenders are free to assume faster growth of borrowers’ incomes to help them through the stress test.

The inflationary side effects of this experiment in delayed interest rate reaction will not be far behind. What passes for patience on the part of the MPC is a neglect of duty. The cost of unsettling inflation expectations will be felt very quickly in the Sterling fixed interest market and the absorption of the UK still-massive debt issuance programme may soon become problematic. The weakening of the overseas bid for gilts could readily bring Sterling down from its high perch and the UK’s benign inflation dynamics would be turned upside down.

In my view, the MPC has been dangerously distracted by the concepts of domestic slack and spare capacity and should have been raising Bank Rate a year ago. Throwing sand in the wheels of the UK mortgage market (via the Mortgage Market Review) or deploying macro-prudential tools allow the Bank to insist it is reacting to the improving market conditions, but there is no defence against the charge that interest rate normalisation has been neglectfully delayed. An immediate increase in Bank Rate of 0.5% is appropriate, with a bias towards further increases.

Comment by Mike Wickens
(University of York, Cardiff Business School)
Vote: Raise Bank Rate by ½% and decrease QE to £250bn
Bias: Start to unwind QE and slowly raise interest rates as the economy grows

Despite inflation being below the 2% target, nearly all of the signals are that the economy is recovering rapidly. Although goods prices have not reflected this yet, house and asset prices, which are forward-looking, have. This has caused the Bank for International Settlements to warn of “euphoric” financial markets. It says that they are detached from reality, but it is more likely that excessive liquidity and growing confidence in the future has caused a huge portfolio switch from bonds and idle reserves to equity.

This has caused some confusion in the MPC. Having announced that interest rates would remain unchanged in the immediate future, Governor Mark Carney warned that interest rates were likely to rise before long which caused a strong increase in the value of Sterling. To general confusion the Governor then reverted to his previous stance of no immediate change. At the same time Financial Policy Committee announced that macro-prudential concerns about rising house prices required constraining the availability of loans through limiting mortgage leverage ratios. In other words, even though it agrees that that there is a problem, the Bank continues to prefer quantitative non-price to its price instrument, the interest rate.

Further insight into the thinking of the MPC was revealed by departing Deputy Governor Charlie Bean, who indicated that even when interest rates are raised it would take several years before they were restored to hitherto normal levels such as 5%.

My own view is that, in order to minimise market distortions such as the current surge in asset prices, interest rates should reflect market forces and policy should rely as little as possible on non-price constraints. As interest rates take time to affect the real economy and sharp increases in interest rates tend to increase market distortions through inertia and falsifying expectations, the long hike in interest rates envisaged by Charlie Bean should start now and non-price QE should be reduced now.

Under Mark Carney monetary policy has become quite confusing and has lost its clarity. First there have been the opaque overrides, then the unemployment threshold debacle and now the gyrations on interest rate expectations. All of these may be interpreted as the use of non-price monetary instruments. The sooner monetary policy returns to normal the better.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking, University of Derby)
Vote: Hold; no change in QE
Bias: Neutral

The UK economy continues to recover at a solid pace. Recent data suggest that Q2 growth will be close to 0.8% expansion recorded in Q1. It could be even slightly faster than that, depending on how much net trade detracts from growth in the quarter. What does this mean for monetary policy? That should also depend on the inflation outlook, and the risks to growth. CPI inflation posted a weaker than expected outturn in May, falling to a 1.5% annual rate from 1.8% April. This is well below the Bank of England’s 2% target - the sixth consecutive month this has occurred and the slowest rise since October. Retail Price Index inflation also declined, from 2.5% to 2.4%, its lowest rate since December 2009. Service sector inflation fell to just 2.2% - the slowest annual pace since the official harmonised series began in January 1997. The fall in service sector inflation was due principally to weaker transport prices. Goods price inflation held at 0.9% - the lowest since October 2009. Notably, pipeline price pressures were also subdued. Annual producer input prices contracted by 5.0%, while output price inflation slowed to just 0.5%. Although the price inflation rate may remain little changed over the near term, Sterling’s strength and subdued pipeline price pressures are expected to keep downward pressure on it over the coming quarters.

More generally, the underlying inflation backdrop remains subdued. The lagged impact of Sterling’s strength and the softening in global commodity prices is still feeding through - as evidenced by a further fall in producer input prices in May. At the same time, however, ongoing economic recovery is likely to lead to a gradual decline in the degree of economic slack. That said, wage inflation remains very weak, rising just 0.7% in April. It should not be forgoetten that the long term unemployment rate remains relatively high, posing a downward pressure on wages that some seem to ignore. For now, we believe there is enough spare capacity for companies to respond to increases in demand without putting up prices. Meanwhile, headline money supply growth was -0.6% year on year in March, with a decline month on month of 0.2%. No wonder there is little inflation risk.

There are also risks to growth, although they are mainly from overseas. This includes slow growth in Europe, Ukraine, the Middle East, Asia and the financial risks from overpriced financial markets suddenly tumbling to earth as the US Fed moves to a less loose stance.

After intense speculation following the Governor’s Mansion House speech in June, the MPC voted unanimously to keep policy unchanged at the June meeting – an outcome that surprised some following the Governor’s more hawkish Mansion House speech. The tone of the minutes was a little more hawkish than at the last meeting, with the MPC expressing “surprise” at the low probability attached by the market to a rate rise this year. The MPC reiterated that the timing of the first rate rise would depend on inflation developments, which in turn, would depend on the MPC’s view on the absorption of spare capacity. Although the prevailing weakness of inflation and wage growth set a fairly high bar, the MPC noted that the surprise strength of the labour market and economy posed a clear upside risk. There appears to have been particular relief in financial markets that the decision to leave policy unchanged was unanimous at the June meeting. I also happen to believe that there are first mover risks (just look at how the pound has risen), and the risk of tighening too soon, as Japan did a decade ago. That said, I vote to leave rates at 0.5% but acknowledge that the monthly data are becoming increasingly important to focus on with regard to the timing of when Bank rate rises.

Policy response

1. On a vote of eight to one, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in July. The other member wished to hold.
2. There was disagreement amongst the rate hikers as to the precise extent to which rates should rise. Five voted for an immediate rise of ½% but three members wanted a more modest rate rise of ¼%. On standard Monetary Policy Committee voting rules, that would imply a rise of ½% would be carried.
3. All those who voted to raise rates expressed a bias to raise rates further.

Date of next poll
Sunday August 3rd 2014



What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is Andrew Lilico (Europe Economics, IEA). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Patrick Minford (Cardiff Business School, Cardiff University), David B Smith (Beacon Economic Forecasting and University of Derby), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking and University of Derby). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, June 01, 2014
IEA's shadow MPC votes 5-4 for quarter-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its email poll closing Wednesday 28th May, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended by five votes to four that Bank Rate should be raised ¼% on June 5th, including four votes for a rise of ½%.

For those members advocating a rise, the return of strong economic growth implied that the need for emergency levels of low rates had passed, that there was the danger that sustaining such low rates would eventually drive a rapid expansion in credit (though it was acknowledged that credit is not in boom yet), and that the period of extremely low rates had distorted the supply-side of the economy in ways that have damaged productivity and might limit the ability of supply to respond quickly to the recovery in demand.

For several of them, interest rate normalisation is being, as one put it, “neglectfully delayed”. Conversely, the idea that credit pressures or rapid house price rises should be contained by regulation was seen as wrong. Prices and interest rates, not regulation, should discipline demand and risk-taking in a market economy.

Those advocating holding rates noted that monetary growth is modest; credit is stagnant or even contracting; inflationary pressures are low, and the sectoral picture for real economy growth is patchy and insecure. In their view there was no urgency to raise rates but there would be risk – the risk of derailing the recovery just as it began.

Votes

Comment by Philip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate by ½% and hold QE
Bias: Increase Bank Rate; QE to depend on behaviour of broad money

The 2% target for Consumer Price Index inflation is symmetrical. Therefore, we should not be worried about inflation dipping below it: it is important not to treat the target as a floor. As the economy returns to normal in terms of business investment, confidence and so on, we can expect the level of interest rates necessary to keep a given monetary stance to normalise (i.e. move towards 5%). Given the leverage of many households, there are significant dangers in leaving interest rates at too low a level and then having to raise interest rates quickly. There are also huge dangers from the central bank implying that interest rates might well be left very low for a prolonged period and then having to raise them. Influencing expectations in that way may well induce borrowing in ways that are not sustainable in the long term and then, when interest rates are raised, the damage will be that much greater.

I would therefore raise interest rates slowly starting now, with an increase of ½% in the first place. Regarding Quantitative Easing (QE), the decision with regard to QE should be driven by what is happening to the quantity of broad money. The stock of M4ex should correspondingly be monitored on a month-by-month basis. However, the existing stock of QE should be kept where it is for the moment. My bias would be to raise interest rates further in due course, although I have no quantitative bias with regard to QE, only a conditional one.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate and pause QE
Bias: To tighten

The British economy continues to do reasonably well, with strong employment growth that is partly due to significant immigration of working-age people finding work. The international background has proved more difficult than was the consensus expectation at the start of 2014, although the US economy is growing well and should have a good second half. The Eurozone is still struggling, with several economies subject to deflation. Weak commodity prices and a supermarket price war signal further beneath-target UK consumer inflation in the rest of 2014.

Some commentators and even the Governor of the Bank of England, Mark Carney, have expressed concern that the very low of interest rates may stimulate an unsustainable credit boom. However, official data show that nothing of the sort is actually happening. In the year to January 2014 M4ex lending (i.e. bank and building society lending to the UK private sector, excluding that to intermediate “other financial corporations”) rose by a negligible 0.2%. In the six months to March the stock of such lending fell, although only very slightly, with the annualised rate of decline being 0.8%. The numbers are surprising and difficult to square with, for example, the relative buoyancy of the London housing market. (It is possible that UK assets are being purchased from money balances held in foreign banking systems, where credit growth is stronger. The aborted Pfizer take-over of AstraZeneca is an illustration of the possibilities. Other smaller cross-border corporate deals, with an element of bank finance, are proceeding.)

The stagnation of bank credit might have been expected to be accompanied by similar stagnation of the quantity of money. The data show that in the year to January M4ex was up by 3.1%. In association with practically zero short-term interest rates, this very low rate of money growth was consistent with healthy asset price gains, robust balance sheets, decent demand growth and rising employment in 2013. However, to talk of a general boom would be premature and misguided.

Indeed, the three-month annualised rate of change of M4ex in March was 2.9% after a fall in M4ex in March itself. This was not too bad compared with 3% - 4% numbers for much of late 2013 and 5% - 6% numbers in the opening months of 2013. All the same, with money growth apparently decelerating, the case for an early increase in base rates is less than clear-cut. On the other hand, the seeming strength of the real economy argues against a resumption of “quantitative easing” operations. The implied verdict is “steady as she goes”.

The British banking system – like the banking systems of other countries – is still restraining balance-sheet expansion, in order to come closer to the Basel III capital requirements.

However, it must be said that – if bank credit to the private sector were now to start growing at a moderate pace (say, 3%-a-year annualized and certainly 5%-a-year annualised) in association with similar or perhaps somewhat faster growth of broad money – the case for a small rise in interest rates would be persuasive.

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

The recovery of the British economy has been broadening over recent quarters, but the sustainability of the recovery is not yet certain. Improvement in some areas continues to be offset by weakness in others, and for this reason any precipitate action to raise interest rates or tighten monetary conditions now – which inevitably would affect all sectors – would likely cause a significant setback.

In 2013 real GDP growth finally started to return to more normal rates of growth, averaging 0.7% increases each quarter (or 2.7% annualised) with roughly equal growth of personal consumption (0.55% or 2.2% annualised) and real exports (0.59% or 2.3% annualised), but much stronger growth of fixed capital investment (2.11% or 8.7% annualised). The GDP figures for 2014 Q1 (0.81%) showed a similar pattern for the domestic demand components (consumption 0.77% and investment 2.75%), but exports (-1.02%) weakened, probably reflecting continued slow growth in Europe and the strength of sterling over the past year. However, while the overall GDP figures were encouraging, the detailed picture in different sectors casts doubt on whether the economy has reached self-sustaining momentum. Key areas of weakness include employment, wages, the housing market outside London and the south-east, and credit growth.

The labour market has improved notably in quantitative terms, but there is still a long way to go before the normal quality of employment is restored. For example, employment as defined in the Labour Force Survey continues to rise, reaching 30.4 million in February, 2.9% above its pre-crisis peak in April 2008, and workforce jobs growth has expanded to 32.7 million, 1.7% ahead of its pre-crisis peak in 2008 Q2. The problem here is that although the employment rates (employment as a fraction of the working age population) have recovered almost to their pre-crisis level of 73%, many of these jobs are part-time jobs, and surveys consistently show that those with jobs would like to work longer hours, or have full-time jobs. At the same time unemployment has dropped from a peak of 8.6% in October 2011 to 6.8% in February, but youth unemployment among those aged 18-24, although down from its peak of 20% in November 2011, is still at 16.9%.

Similarly, and for broadly the same reasons, wage growth has been disappointing, persistently declining in real terms since June 2008, a period of almost six years. Only recently has there been an indication of a possible return to real increases in average weekly earnings, but it has not yet materialised. For example, in the period December to February average weekly earnings (including bonuses) increased 1.7% over the preceding year while the CPI averaged 1.9% over those same months – implying negative real earnings growth. In March average weekly earnings slipped to 1.5%, but the CPI increased to 1.6% – implying negative real earnings growth again. Fortunately, the sluggishness of real earnings has been counterbalanced by increases in the total number of jobs, helping to boost overall spending power in the economy, but several quarters of real earnings growth should be permitted before the authorities contemplate rate hikes.

In the housing market only London and the south-east have seen strong house price rises since the start of 2012, with prices up 24% in London and 10% in the south-east since December 2011 (according to the ONS indices). In Scotland, Wales, the south-west, north-east and west-midlands house prices (based on the same ONS mix-adjusted series) are broadly unchanged compared with their levels in mid-2008 or mid-2010. As the governor of the Bank of England recently suggested, there are essentially two housing markets in the UK: London and its immediate surroundings, and the rest of the UK. The London market is driven by global factors – the health of the global financial sector, the search for safe havens and safe property rights, as well as domestic financial forces such as low interest rates. House prices in the rest of the country are driven by the same domestic factors – incomes, interest rates, the availability of credit etc. – but the global or foreign element is far less significant. But low interest rates without a credit boom do not signal a bubble.

Finally, credit growth remains extremely weak, if not declining – despite the two government credit promotion schemes (“Funding for Lending” and “Help to Buy”). The new gross loans to the housing market have been recovering modestly and, according to the Bank of England’s latest data, were running at £17.1 billion per month in the three months January-March. This compares with an average of just over £30 billion per month in the first half of 2007, the pre-crisis peak of mortgage lending. In other words, the current monthly rate of lending is only slightly more than half the peak rate. Furthermore, the increase in gross loans for new mortgages is more than offset by declines in credit elsewhere – either repayments of outstanding mortgages, or reductions in lending to the non-financial corporate sector, or especially to the financial sector. Over the past year total M4 lending has declined by 4.6%. Again, to emphasise the scale of this problem, whereas gross new mortgage loans increased by £51 billion in the first three months of 2014, M4 lending declined by £47 billion.

In this environment the Bank should hold rates stable at 0.5%, and be prepared to undertake additional asset purchases if monetary growth or bank credit plunge again. Bank Rate should not be increased while money and credit growth are so anaemic. Rate increases at this stage would damage the prospects for economic recovery, and should be delayed until the recovery is substantially more secure.

Comment by Graeme Leach
(Legatum Institute)
Vote: Hold
Bias: Neutral

As spring turns to summer the economy is warming up, but like the weather, not as much as we would like. One of the key variables suggesting a pick-up in GDP growth over the 2014-15 period was the acceleration in M4ex money supply at the end of 2012 and into 2013. However, the momentum in M4ex has weakened over recent months, recording growth within the 3.5 to 4% band, when it had looked as if it might edge up towards the base of the Bank of England’s 6-9% target range. So there is more money available for spending, but not a lot more.

The relationship between nominal GDP growth and M4ex is far from simple, but stronger nominal GDP growth would require an increase in monetary velocity. So what might trigger an increase in velocity? Certainly consumer and business confidence has picked up and there is room for further reduction in the savings ratio – possibly helped by house price effects on consumer confidence. Of course any price effect on confidence could just be picking up the impact of improved real earnings on both confidence and house prices. Either way there is scope here for faster velocity.

With inflationary pressures weak there seems little need to tighten policy in 2014, even with an output gap which is probably now quite small. But this doesn’t mean there is no concern for inflation. Supply-side rigidities mean that the underlying potential growth rate of the UK economy is probably just under 2% and so a small output gap could be exhausted by the end of this year. The conundrum for next year is whether or not a moderate uptick in the UK will be matched by a slide towards deflation on the continent? If parts of the Eurozone slide into deflation, with an associated risk of a resumption in the euro crisis, UK monetary policy won’t begin to be normalised until 2016 at the earliest.

Comment by Andrew Lilico
(Europe Economics, IEA)
Vote: Raise Bank Rate by ½%
Bias: To raise further; QE neutral

The signs of boom are all around us, except in the lending data. Four-quarter GDP growth is above 3%. Retail sales grew 6.9% in the year to April — the fastest such growth since the heady days of 2004. Consumer confidence is at its highest level since records began in 1998. Yet the preferred measure of aggregate lending (the M4Lx series) is contracting, down 0.4% in the four quarters to March 2014 — and other measures of lending such as that excluding securitisations are contracting at an accelerating pace, down 4.3% in the year to March 2014 from just 0.3% contraction as recently as November 2013.

Broad money (M4ex) growth is a little healthier, at 3.7% in the twelve months to March 2014, but still probably lower than policymakers might like. Inflation is below target, and the overall picture still recommends highly accommodative policy.

The question, though, is what “accommodative” means in the current UK macroeconomic context. Does it any longer mean “the absolute maximum stimulus that can be provided through interest rates”? I say no. I want a highly supportive, extremely loose monetary policy. But I do not see (and have not seen for the past two years) what case there could be for believing us still to be in an emergency when the maximum possible accommodation was required. Obviously, those setting policy have not agreed with me.

But I am now at a loss to know what would persuade them to seek to normalise rates. Must we actually wait until inflation starts to race ahead of target, even though we know that rate rises may only start to have a material impact months after they occur? Must we wait to raise rates even though rates will not become tight (i.e. will not dampen down upon growth or inflation, as opposed to stimulating them further) until they exceed at least 3% and possibly 5%, meaning waiting until inflation actually begins means that gradual rate rises would imply a large inflation overshoot and probably the need to induce a recession to get inflation down?

The irony is that I actually do not object to the strategy of waiting too late to raise and letting inflation go too high. Merely, I would prefer to wait at around 1.75% interest rates, rather than 0.5%. The sooner we can escape the clutches of the strange phobia of shifting from 0.5%, the better.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%
Bias: To raise further in small steps; QE neutral

The economy is showing the signs of recovery that has excited everyone into believing that the long recession is over and the time for a rise in interest rates is drawing near. Clearly, it is better to have some growth than no growth but this recovery is not like others. This growth has occurred without any improvement in productivity which remains flat. The recent growth in GDP has been matched by an almost equivalent growth in employment. The recent retail sales figures underline the consumption led growth that is driving the pick-up. Nothing wrong with that, as household spending has nearly always led the recovery but unlike other recoveries growth is not matched by productivity improvements.

The upshot of this is that the recovery is fragile and has no supply-side response. The long period of low interest rates has inhibited the market from re-allocating resources from the low productive sectors surviving on cheap credit to the high productive sectors that need the investment funds to expand capacity. The correction to the current misallocation of savings resources will take time for capacity to build up and the supply-side to respond and keeping interest rates at its current level does not help.

However, there are other, more short term reasons for raising interest rates. If the Bank believes that a house price bubble is in the making, using quantitative rules to control mortgage lending (like the Corset of a bygone period) is less efficient than simply raising the price of credit. At the current very low interest rate, except for QE monetary policy has lost all traction, so in the case of another euro flare up there is no place for interest rates to go removing the psychological effect of a sharp cut in rates. Investment spending is unlikely to be influenced by small upward adjustments in rates and it is clear that sterling has already discounted a rate rise. There is nothing left but for policy to follow through.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½% and gradually claw back QE
Bias: To raise further

The housing market is now recovering strongly; at the same time the economy is also moving into relatively strong growth close to the 3% per annum mark. It is the relaxation of credit conditions brought about by Funding for Lending and Help to Buy that have pushed up the housing market; previously it was frozen by the blocking of the credit channel. It is now a key part of the general UK recovery and coalition politicians will interfere with it at their peril.

Already cries are being heard from various quarters that there is an uncontrollable ‘house price boom’. This is far from the case when one considers how far the market has fallen. It is more a correction than a boom. According to the Cardiff models it should reach ‘trend’ by the end of 2016. Even London is only just back to where it was before the crisis - the trend for London is above the national one of around 3% per annum. Much of the comment on housing is subject to ‘money illusion’ - that is, people do not correct for the general rise in consumer prices in evaluating the housing market. Once this correction is made, national prices are still well below their previous peaks, between 20 and 40% below depending on the region.

The Bank of England is speaking about housing ‘overheating’ with a forked tongue. On the one hand, there is the Monetary Policy Committee (MPC) with Governor Carney leading it in arguing for continuing monetary ease; this dovish attitude sits uneasily with the strong growth we are seeing in both the economy and housing. On the other hand, the prudential regulators are flexing their muscles suggesting they will intervene with special measures on such things as mortgage affordability, via ‘caps’ of one sort or another. The latter will cause market distortions and ultimately be evaded by the usual market processes. It would be far better to tackle monetary overheating directly by tightening monetary conditions towards normality: they are just abnormally loose at present, given the signs that the excessively draconian bank regulation is being sidestepped increasingly by the government’s special measures and the growing internet lending presence.

How vulnerable is the recovery? Until recently export and investment have been weak; the first related to the Eurozone’s continued weakness, the second reflecting uncertainty about recovery. Both may now be giving way to better things: the Eurozone is at last pulling off the bottom. Business surveys suggest that firms are feeling the need to invest as the recovery proceeds. In short the recovery looks sustainable. Furthermore, with an election looming the coalition is going to take no risks with any dampening down of the housing market.

In particular, real house prices (i.e. after inflation) nationally will recover from their below-trend position gradually over the next few years; I do not foresee a massive boom in prices but rather a steady but unexciting recovery. Much the same is true of UK regions generally - the main exceptions are the London, Northern Irish and Scottish markets which are affected by strong particular factors - London by the strong expansion of City business services, Northern Ireland by the well-known issues there, and Scotland by the unsettling bid for independence.

My judgement on monetary policy remains that it is too loose given the resumption of fairly strong growth, including the housing recovery. My suggestion would be for interest rates on government short term debt, i.e. Bank Rate, to go up by 0.5% initially and then in small steps; and for QE to remain on hold for now and thereafter be gradually clawed back. Intervention in the mortgage market should be avoided.

Comment by Peter Warburton
(Economic Perspectives)
Vote: Raise Bank Rate by ½%
Bias: To raise Bank Rate in stages to 2%

The May MPC minutes contained further proof that the modus operandi of the Bank is now “unconstrained discretion”. Having abandoned any semblance of a Taylor rule reaction function and broadened the reference framework for “forward guidance”, the Bank is flying blind with neither broad monetary discipline nor inflationary anchor. The appreciation of Sterling continues to act as a considerable restraint on the forces of domestic private sector inflation, but this factor cannot be regarded as permanent. The size of the current account deficit, over 5% of nominal GDP in the second half of 2013, is approaching that of public sector net borrowing (6.6% of GDP), earning the UK the “twin deficit” epithet. For the time being, the kindness of strangers allows us to exchange newly-minted sterling fixed interest securities for our external payments deficit.

“Key considerations facing the Committee over the next year or so were the margin of slack and pace at which it was eroded, and the effects of the components of that slack on inflation. The central view of most Committee members was that the margin of spare capacity remained in the region of 1% - 1% of GDP, although it had probably narrowed a little since February.” The characterisation of the policy judgement in these terms is reminiscent of the worst days of fine tuning from the 1960s and 1970s. I maintain that “slack” is so riddled with measurement error that it cannot serve a practical policy purpose.

Notwithstanding the sluggish pace of most credit and monetary aggregates, there is no doubt that there has been a nominal acceleration of the economy. Nominal GDP growth was 4.4% in the year to Q1 and 5.8% annualised over the past 6 months. The UK authorities have wakened the sleeping credit dragon from its slumbers and are basking in the warm glow of its breath. The inflationary side effects of this experiment will not be far behind. What passes for patience on the part of the MPC is a neglect of duty.

The cost of unsettling inflation expectations will be felt very quickly in the Sterling fixed interest market and the absorption of the UK still-massive debt issuance programme may soon become problematic. The weakening of the overseas bid for gilts could readily bring Sterling down from its high perch and the UK’s benign inflation dynamics would be turned upside down.

In my view, the MPC is dangerously distracted by the concepts of domestic slack and spare capacity and should have been raising Bank Rate a year ago. Throwing sand in the wheels of the UK mortgage market (the MMR) or deploying macro-prudential tools allows the Bank to insist that it is reacting to the improving market conditions, but there is no defence against the charge that interest rate normalisation has been neglectfully delayed. An immediate increase in Bank Rate of 0.5% is appropriate, with a bias towards further increases.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking, University of Derby)
Vote: Hold; no change in QE
Bias: Neutral

At first blush, the second estimate of Q1 GDP appears to have been broadly as expected. Both the quarterly and annual rates of growth were left unchanged at 0.8% and 3.1%, respectively – the strongest annual rate since Q4 2007. But looking below the surface, the expenditure breakdown is at best mixed. The improvement was driven yet again by consumer spending (0.8%). And while business investment posted another welcome improvement (+2.7% q/q), the recovery was marred by a fall in exports (-1.0%) and, more importantly, a sharp rise in inventories.

Inventories rose by £2.8bn last quarter, compared with £1.9bn in Q4. Taken in isolation, the rise contributed 0.2% points to the rise in GDP growth in Q1. Sharp rises in inventories in the National Accounts are often initially due to the so-called alignment adjustment, which is the balancing item used to reconcile estimates of output GDP with expenditure GDP. Typically, these get reallocated over time to some other component of expenditure and the inventories data are revised lower. Notably, however, the alignment adjustment was negative in Q1 to the tune of almost £700mn. In other words, the actual rise in reported stocks in Q1 was around £3.5bn, following a similar outturn in Q4. Viewed this way, the magnitude of the rise in inventories is somewhat concerning. It may be that the rise in stocks is a justified response to the anticipated pick-up in demand over coming quarters. At the very least, however, it raises the possibility that output growth may not have to be quite as strong over the coming months to meet the rise in demand.

Another slightly troubling feature of the release is the drop-back in imports and exports, both of which fell by around 1% q/q. The fall in imports looks odd given the strength of domestic expenditure (especially stocks) in Q1. The weakness in exports is perhaps easier to explain given the weakness of the exchange rate; the challenges still facing our key export markets in Europe, and the surprisingly sharp rise in Q4. Still, the difficult external environment is unlikely to dissipate anytime soon. As we have argued for some time, the prospect of a marked improvement in net external trade looks limited – leaving the onus for demand, and by implication GDP, growth on consumer and business spending.

Notwithstanding these reservations, it is difficult to be too negative about an economy that posted its fourth consecutive quarter of above trend growth in Q1. While the composition of expenditure highlights some of the changes still faced, GDP growth in Q2 is unlikely to be materially weaker.

Public finance data also raised some question marks about the health of the economy. Despite the strong rise in GDP over the past year, the key underlying measure of the budget deficit rose by £11.5bn, £2bn higher that it was in April 2013. The ONS attribute the deterioration to a drop in tax receipts and deterioration in the financial position of local authorities. If sustained, the inability of the UK’s fiscal finances to respond to a cyclical improvement in the economy would only add to the suspicion that a large proportion of the deterioration is structural and could require even greater fiscal austerity.

What does this mean for policy? That depends on the inflation outlook. CPI inflation posted a stronger than expected outturn in April, rising to 1.8% from 1.6%. Downward contributions from food, drink & tobacco and hotels & restaurants prices were more than offset by upward contributions from transportation (airfares +17.9% m/m), with clothing and footwear prices (+1.0% m/m) also firmer than expected. These largely reflect the late timing of Easter this year compared to last. To the extent that prices have been boosted temporarily by the late Easter, the impact should reverse next month.

More generally, the underlying inflation backdrop remains subdued. The lagged impact of sterling’s strength and the softening in global commodity prices is still feeding through - as evidenced by a further fall in producer input prices in April. In the twelve months to April, producer input prices declined by 5.5%. As energy price base effects start to wane, headline CPI inflation is expected to drop back again, towards 1.4%, over the summer. However, this will mark the nadir. The downward impetus to import prices should start to slow as the lagged impact of sterling’s strength steadily fades. At the same time, ongoing economic recovery is likely to lead to a gradual decline in the degree of economic slack. For now, we believe there is enough spare capacity for companies to respond to increases in demand without putting up prices. Meanwhile, money supply growth slipped further in March. The M4ex three month annualised rate eased to 2.9%. This means that the average for Q1 was just 2.7%, from 4.5% in Q4, 3.5% in Q3, 3.7% in Q2 and 4.4% in Q1 2013. In month on month terms, the rate fell 2.3% and the 12 month rate was minus 0.3%. No wonder there is little inflation risk. That all means, for now, that my vote is to leave rates on hold and keep QE at £375bn.

Policy response

1. On a vote of five to four, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in June. The other four members wished to hold.

2. There was only modest disagreement amongst the rate hikers as to the precise extent to which rates should rise. Four voted for an immediate rise of ½% but one member wanted a more modest rate rise of ¼%.

3. All those who voted to raise rates expressed a bias to raise rates further. One of those who voted to hold rates had a bias to increase rates in the near future.

Date of next poll
Sunday July 6th 2014

Tuesday, May 06, 2014
IEA's shadow MPC votes 5-4 for quarter-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

At its meeting of Tuesday 15th April, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended by five votes to four that Bank Rate should be raised ¼% on Thursday 8th May, including four votes for a rise of ½%.

Those urging a rate increase offered a variety of rationales. Some expressed the view that it would be better to start rate rises when the economy is going well and raising rates can be seen by consumers and investors as a sign of economic improvement than to wait until inflation or other problems force a rate rise which would then be regarded negatively.

Others said that low rates are encouraging a misallocation of capital between firms and encouraging policymakers to use additional regulation to discipline economic behaviours that would be better disciplined by the price mechanism and market forces if interest rates were a little higher. Others suggested that rapid rises in house prices indicated that sentiment is in danger of becoming carried away and a “shot across the bows” is needed.

Some of those urging rates remain unchanged noted that inflation is low, output remains depressed below peak, and that we are still early in recovery. Factors such as rapid house price rises should be seen at this stage as corrections to past falls rather than as signs of excess. Credit growth remains lower and the banking sector remains fragile. One of those voting for a hold, however, expressed the concern that large UK asset price movements might reflect higher monetary growth in emerging markets than is yet visible in the data, and said that if rapid house price rises in the UK continue he might be inclined to recommend a rate rises within the next few months.

Minutes of the meeting of 15th April 2014

Attendance: Philip Booth (IEA Observer), Tim Congdon, Jamie Dannhauser, John Greenwood, Andrew Lilico (Chairman), Kent Matthews (Secretary), Patrick Minford, David B Smith, Akos Valentinyi, Trevor Williams.
Apologies: Roger Bootle, Anthony J Evans, Graeme Leach, David H Smith (Sunday Times observer), Peter Warburton, Mike Wickens.

Retiring Chairman’s Valedictory Comments

David B Smith, the retiring Chairman, thanked all the members of the IEA’s shadow committee who had engaged with him in the successful production of the monthly SMPC reports over the past eleven years but especially those who had submitted their copy on time and without requiring reminders. He also recorded his gratitude to Lombard Street Research, particularly Pippa Courtney Sutton and her successor Tom Crew, who had put out the long stream of monthly SMPC reports so efficiently. David next thanked Rosa Gallo at Economic Perspectives, who had done an impeccable job of proof reading, often against tight deadlines. Philip Booth expressed the thanks of the members for David B Smith’s long chairmanship and presented him a certificate of appreciation signed by the members along with a cheque made out to his chosen charity ‘Newborns Vietnam’. David B Smith thanked the members for their generosity. He added that, in case anyone was wondering about his choice of charity, it was because one of his daughters in law came from Da Nang where the charity operated. David B Smith then passed on the chairmanship to Andrew Lilico.

New Chairman’s Comments

Andrew Lilico said that he did not propose to make any radical changes to the organisation and suggested that the proceedings move swiftly on to the monetary situation. He called on Akos Valentinyi to make his presentation.
Monetary situation

Akos Valentinyi referred to the circulated charts and began with the world situation. Turning to the chart of world economic growth and its decomposition he said that the world economy is picking up speed but there is a lot of heterogeneity in the contribution and what is striking is that in 2014 Western Europe is expected to make a strong positive contribution. The USA is expected to grow by more than 2.5 per cent, offsetting some of the slow-down from China. Oil prices have stabilised and world inflation is likely to stay around 3%. The Ifo world economic survey indicates improvements in the USA and Western Europe but again in the case of Europe there are large differences. While the EU is expected to grow moderately, Italy and France are stagnating, but UK and Eastern Europe show signs of improvement. The chart of the changes in the fiscal pattern in the EU shows that the great Keynesian experiment that was tried in the early stages of the recession have been reversed.

Turning to the domestic economy, UK inflation is declining and even during the time after the recession when inflation was on an upward trend Tim Congdon had correctly predicted that inflation would fall. The figures show that both goods and services inflation is declining. Producer prices in particular show a sharp decline in inflation. The data shows no evidence of inflationary pressure. The Bank of England survey of inflation expectations show a consistent pattern of expected future inflation lower than perceived past inflation which indicates an anchoring of inflation expectations. Labour productivity growth is slower than the rate of increase in unit labour costs which does not portend well for the supply side.

On the demand side, exports are growing well and also household spending is growing steadily but investment remains sluggish. Tim Congdon said that net exports are still weak. Akos Valentinyi said that the reason for focussing on exports is to reflect the growth of external demand. Regarding the components of consumption, Akos Valentinyi referred to the charts shows spending on durables growing strongly. Jamie Dannhauser said that the price of many household electrical goods such as flat screen TVs had fallen suggesting a hedonic price effect. Akos Valentinyi said that the pattern of the savings rate is that it rises in the early phase of the crisis but it has fallen recently indicating growing household demand.

Turning to the supply side, the service industries are showing robust growth. The construction sector remains a problem and manufacturing which had seen earlier signs of recovery have slowed. The growth in exports has been largely non-financial services and IT services but there has also been a recovery in precision equipment. The double-dip, soon to be erased by ONS revisions, was largely the result of North Sea oil production and manufacturing.

The decomposition of productivity show that some sectors have improved over the 2005 base with manufacturing above services but construction lagging behind. Unemployment is falling and likely to breach the magic 7% figure. The Beveridge Curve for 2001-2013 shows a structural shift from 2010. John Greenwood said that a similar pattern can be seen for the USA. The shifts in the Beveridge curve maybe a permanent or temporary effect that indicates a growing skills mismatch. What it says is that vacancies are going unfilled because of skills shortage.

Figures for the money stock show that the whole dynamic of this variable has changed markedly. M4 has slowed down like no other recession. Charts showing the growth of nominal GDP against M4 growth, isolating outliers for the two periods 1963-1999 and 2000-2013, show that the responsiveness of nominal GDP growth to money growth has weakened in the latter period. Andrew Lilico said that the distortions to the M4 figures of items that were off-balance sheet that had subsequently returned to the balance sheet make the charts difficult to interpret and that an alternative series might give a clearer indication.

Akos Valentinyi summarised his presentation by stating that the UK economy shows signs of robust growth but weaknesses remain on the supply side. Productivity remains a problem as does the growth of bank credit and M4 which continue to indicate a fragile recovery. His recommendation is that the economy is in a strong enough position to withstand a rise in interest rates.

Discussion

Andrew Lilico thanked Akos Valentinyi for his presentation. He began by challenging Akos Valentinyi to provide a credit channel explanation of growth in 2013 alongside a declining fiscal deficit. He said that if the policy recommendation is a rise in the bank rate what specifically guides this recommendation. Kent Matthews said that the credit channel view would concentrate on the dearth of private sector investment and the failure of credit growth to reach the sectors that are productive. According to the credit channel view the recovery is not sustainable without a supply-side response from increased investment generated by higher credit growth. Jamie Dannhauser asked if the natural rate of interest has fallen because of the recession. He said that IMF research suggests that there has been a fall in the equilibrium rate of interest. David B Smith said that demographics played an important, but often unduly neglected, part in the determination of the long-term growth rate and the natural rate of interest. Countries with relatively rapid increases in the population of working age would generally have faster economic growth and higher real interest rates, other things being equal. Andrew Lilico added that changes to the working age population affects the growth of potential GDP and said that the natural rate of interest fell in the mid-2000s but it is now rising. If the future growth rate is to rise then it is likely that the equilibrium real rate of interest will also be higher.

Andrew Lilico said that he was optimistic about long term growth. The reason is the fall in government consumption, and the increase in the retirement age that will lead to a rise in the labour force. Also the financial sector which had been impeded is on the point of recovery. Tim Congdon said that 2008 will represent a watershed in the history of the UK banking system. He said that progressive liberalisation was being reversed with increased re-regulation which has led the banks to slow the growth of their balance sheets. He asked the question, had the pattern changed. The banking figures would suggest not. On the contrary, there is quite a lot of regulation coming through. However, on the macro front there has been some positive growth of broad money and asset prices have recovered. The question for him was why there is a bubble in London house prices. Much of this activity is being driven by foreign cash buyers. He said that this could appear in data on foreign currency deposits. While financial sector exports are lower than in 2008, other services have been growing strongly and this is the London story. Trevor Williams said that only 15% of buyers are foreign but the real problem is the lack of supply.

As Patrick Minford had to leave the meeting early he asked for his vote to be taken at this stage. He said that he agreed with Akos that the economy was improving and that it was imperative that monetary policy return to normalcy and that he favoured a 50 basis point rise in rates and QE be reversed. Andrew Lilico asked the committee for other opinions and a general call for votes.
Jamie Dannhauser said that he was struggling with the story about the equilibrium rate. He accepted that construction was very weak but business services excluding finance have been flying. His concern is the sustainability of this growth rate. Global inflation is moderate. The great worry is the external sector. He said that he views the UK as a small open economy. The eurozone problem has come off the boil but it worried him how the UK economy would react to a rise in the interest rate. He said that an example of overreaction is the dominance of investor sentiment by Fed policy. He said the economy was not strong enough to warrant a rise in rates at this stage.

Votes

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate and pause QE
Bias: To raise interest rates

Tim Congdon said that inflation prospects are good in all the main economies. Indeed, the prospect is for deflation in several countries in late 2014. Since that will justify monetary policy easing, his surmise was that 2015 will be a strong (or at least an above-trend) year for world activity. However, he expressed the concern that large UK asset price movements might reflect higher monetary growth in emerging markets (especially those in which Basel rules are not enforced) than is yet visible in the data, and said that although it remains too early to recommend a rate rise at this stage, if rapid house price rises in the UK continue he might be inclined to recommend a rate rise within the next few months.

Comment by Jamie Dannhauser
(Ruffer LLP)
Vote: Hold Bank Rate and QE
Bias: Neutral

Jamie Dannhauser said that much of the debate about the equilibrium interest rate was confused, but that on balance he believed that it was lower than pre-crisis. He accepted that construction activity had recently been weak but business services excluding finance were growing rapidly. His concern is the sustainability of this growth rate beyond the near-term. Global inflation is moderate. The major downside risk to the UK economy lies in the external sector. He said that he views the UK as a small open economy. The Eurozone problem is not as bad as it was but he remain worried over how the UK economy would react to a rise in domestic interest rates. He said there was a good chance of further currency appreciation if the Bank moved ahead of
the US Federal Reserve, as some Shadow MPC members were suggesting. He said the economy was not strong enough, or sufficiently re-balanced, to warrant a rise in rates at this stage.

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

John Greenwood said that the economy has experienced one year of good growth and therefore it is too early to reverse policy. House prices are rising but there is a need to distinguish between a bubble caused by very low interest rates and one caused by the growth in credit. The scale of speculative borrowing is small and this would soon evaporate once rates start to rise. However, the overwhelming story is that credit aggregates and broad money are not growing so this is not a bubble that the authorities should be worried about. Large sections of the economy are weak. The time to worry is when M4 starts to grow in the 8-9% a year range. This is just a bounce back in the economy. He said that interest rates should stay on hold with no need to unwind QE.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%
Bias: To raise further; QE neutral

Andrew Lilico said that the economy was still very weak and policy should remain extremely accommodative. But the case for emergency levels of accommodation had lapsed. Moreover, it is better to raise rates under conditions when there is nothing bad happening to the economy, so that this can be interpreted as a positive sign, rather than a negative one from being reactive (e.g. to rising inflation or excessive lending growth) – this would reduce the risk that interest rate rises would be disruptive. The need is to move rates earlier rather than later.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%
Bias: To raise further; QE neutral

Kent Matthews said that the rate of interest is not just a macroeconomic tool but also the relative price by which current consumption is traded for future consumption. It is also the rate which benchmarks investment projects that should be funded from those that should not. While he accepted that there are macroeconomic risks in raising the rate of interest the microeconomic distortions of a low rate of interest has created financial repression and a misallocation of resources that need to be reversed to encourage a supply-side response. In the current situation the flow of funds from poor investments to good investments is not occurring because the banks are failing to act as efficient financial intermediaries. There are a myriad of reasons for this including the increase in regulation but principally, low interest rates have created an environment where banks continue to lend to firms that should be allowed to fail diverting funds from firms that should be funded. He also believed that the recovery was fragile but this fragility is a supply-side phenomenon that can only be addressed through the gradual return to normality where the real rate of interest signals the true price of future consumption. He said that he did not know whether the equilibrium real rate had fallen as a result of the recession but he was sure that it is higher than what it is now. He said that he could not believe that companies that have made medium term investment plans would be put off by a small rise in interest rates even if this signalled a further rise. Investment plans are forward looking and companies must have factored in a rise in rates sometime in the future anyway and therefore he voted to raise interest rates by ¼% with a bias to further increases and no QE.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½% and reverse QE
Bias: To raise further

Patrick Minford said that the economy was recovering and that it is time to reverse policy on interest rates. Rather than use the rate of interest to slow down the rate of house price inflation, the Bank of England has constituted committees to design regulations to control house prices. Further regulation is not what the market needs.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%
Bias: To raise further

David B Smith said that he was surprised that there had not been more discussion about the forthcoming rebasing of the UK national accounts in late June. The somewhat limited information that had come out of the ONS so far suggested that this will be one of the biggest ever upheavals to the way that the economy is measured and one that could substantially change the perceived view of Britain’s economic performance in recent years. The available information suggested that the re-defined ONS figures will make UK economic performance look noticeably stronger since the onset of the recession, possibly eliminating the alleged output gap that had been used to justify maintaining Bank Rate at ½%. He added that the ONS house price figures released that morning (15th April) almost justified a rate hike on their own, with the UK year-on-year increase accelerating from 6.8% in January to 9.1% in February and the equivalent figures for London alone picking up from 13.2% to 17.7%. He remained concerned by the general deceleration in M4ex broad money since the summer of 2013. However, the latest data showed an increase in the annual growth of M4ex from 3.1% in January to 3.7% in February, so it was conceivable that the pace of money creation was quickening again.

David B Smith added that that morning’s consumer price data included the fact that the tax and price index (TPI) had risen by a relatively modest 1.4% in the year to March, compared with the 1.7% increase in the year to February. The TPI corrects RPI inflation, which was 2.5% in the year to March, for changes in the burden of direct taxation. It would almost certainly not be statistically correct to apply the 0.9 percentage point gap between the RPI and the TPI to the 1.6% annual rise in the CPI in the year to March to give a ‘CPI/TPI’ annual rise of 0.7%. Nevertheless, it was possible that the pressure on employees’ living standards was being overstated by the widely employed comparison of average earnings with the CPI, which ignored the rise in tax thresholds. He thought that the so-called NAIRU in the UK (i.e., the unemployment level at which inflation tended to accelerate) was being reduced by benefit reforms and other labour supply policies. Furthermore, he welcomed the fact that Mr Osborne was starting to look at the supply-side benefits from tax cuts at long last. The latest OECD Economic Outlook suggested that there would be a substantial reduction in the ratio of aggregate OECD general government expenditure to GDP next year, which should have the beneficial effect of ‘crowding in’ private activity. However, he was sufficiently concerned about the signs of speculative excess building up in the UK property market (and elsewhere in financial markets) to believe that a warning shot across the bows was necessary to manage speculators’ animal spirits. David B Smith voted to raise Bank Rate by ½% in May, with a bias towards a series of phased, modest increases subsequently.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½% and no unwinding of QE.
Bias: To raise Bank Rate

Akos Valentinyi said there were three reasons for raising rates and that the situation demanded a careful assessment of the risks. The risks of a rate rise had to be balanced against the downside risk of not raising rates. First, the UK has shown robust signs of growth. The downside risks from a rise in rates are not very large but postponing a rise creates greater risks. Second, insolvency rates have fallen and are now lower than the previous recession. A rate rise will have a forward looking effect by signalling a return to normality. Third, asset price rises are signalling more than a bounce back. He voted to raise rates by ½% with no unwinding of QE presently.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold; no change in QE
Bias: No change

Trevor Williams said that he agreed with Jamie Dannhauser and John Greenwood. The health of the financial sector is much misunderstood. The banks are engaged in a search for yield. Raising rates will not solve this problem. The economy is still smaller than what it was in 2008. Unemployment is still high. Investment has not risen and a rise in rates will kill the recovery plans of companies. A bounce in the economy should not be mistaken for a permanent rise in growth. A rise in the rate will prick the London bubble but outside London house prices are not rising as rapidly. Unaffordability will be the reason why house prices inflation in London will be tamed. The Financial Policy Committee is designing new regulations to curb the housing market and affordability will figure strongly in the future growth in house prices. He voted for no change in rates and no change in QE.

Policy response

1. On a vote of five to four, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in May. The other four members wished to hold.
2. There was only modest disagreement amongst the rate hikers as to the precise extent to which rates should rise. Four voted for an immediate rise of ½% but one member wanted a more modest rate rise of ¼%.
3. All those who voted to raise rates expressed a bias to raise rates further. One of those who voted to hold rates had a bias to increase rates in the near future.

Date of next meeting
Tuesday 15 July 2014

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is Andrew Lilico (Europe Economics). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Patrick Minford (Cardiff Business School, Cardiff University), David B Smith (Beacon Economic Forecasting and University of Derby), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, April 06, 2014
IEA's shadow MPC votes 6-3 again for half-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, which was finalised on Tuesday 1st April, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 10th April.

This time, all six SMPC members who voted for an increase wanted to see a rise of ½%. Unlike in previous months, nobody advocated a ‘compromise’ ¼% increase in April. This more hawkish stance was partly to compensate for past delays in raising rates. However, one third of the IEA’s shadow committee still wanted to hold Bank Rate at ½%.

There were a number of reasons why a majority of the IEA’s shadow committee wanted a Bank Rate increase. One consideration was the belief that the home demand recovery had advanced far enough – relative to weak potential supply – for the need for ‘emergency use only’ interest rates to have passed.

The twin deficits on the balance of payments and the government’s fiscal position were seen as imposing further limits to monetary stimulus, if market confidence in British government securities and sterling was to survive.

Potential destabilisers included the political uncertainties over the next year or so and the disappointing progress with respect to fiscal retrenchment. Most comments on the March Budget welcomed the liberalisation of personal pensions. However, public borrowing was expected to come down more slowly than the Chancellor expected, even if current policies were persevered with after the May 2015 election.

Several SMPC members expressed concern about the apparent slowdown in the annual growth of M4ex broad money since mid-2013, even if some recovery was apparent in the February 2014 figure.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate by ½% and hold QE.
Bias: Increase Bank Rate; QE to depend on behaviour of broad money.

The 2% target for Consumer Price Index (CPI) inflation is symmetrical. Therefore, we should not be worried about inflation dipping below it: it is important not to treat the target as a floor. Also, we should be looking forward a couple of years. As the economy returns to normal in terms of business investment, confidence and so on, we can expect the level of interest rates necessary to keep a given monetary stance to normalise (i.e., move towards 5%). There are significant dangers in leaving interest rates at too low a level and then having to raise interest rates quickly. This could set the economy back several years.

I would therefore raise interest rates slowly starting now, with an increase of ½% in the first place. Regarding Quantitative Easing (QE), the decision with regard to QE should be driven by what is happening to the quantity of broad money. The stock of M4ex should correspondingly be monitored on a month-by-month basis. However, the existing stock of QE should be kept where it is for the moment. My bias would be to raise interest rates further in due course, although I have no quantitative bias with regard to QE, only a conditional one.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate and QE stock.
Bias: Alter Bank Rate and QE to maintain stable growth of M4ex in the low or mid- single digits at an annual rate
.

The British economy is doing reasonably well at present, against an international background which is more difficult than expected by the consensus forecast at the start of 2014. Falls in base metals prices and some slippage in energy prices reflect weaker-than-forecast growth in China and other developing economies, as well as continued stagnation in the Eurozone. The good news on commodity prices and a supermarket price war signal continued beneath-target UK consumer inflation.

Some commentators and even the Bank’s Governor, Mark Carney, have expressed concern that the very low interest rates may stimulate an unsustainable credit boom. However, official data show that nothing of the sort is actually happening. In the year to February 2014, M4ex lending (i.e., bank and building society lending to the UK private sector, excluding that to intermediate ‘other financial corporations’) declined by 0.1%. In the three months to February, the stock of such lending also fell, although only very slightly, with the annualised rate of decline being 0.5%.

The stagnation of bank credit might have been expected to be accompanied by similar stagnation of the quantity of money. The data show that M4ex was up by 3.7% in the year to February. In association with practically zero short-term interest rates, this low rate of money growth has been consistent with healthy asset price gains, robust balance sheets, decent demand growth and rising employment. However, to talk of a general boom would be preposterous. The London housing market has been very active and ‘bubble’ is a word justified by central London property prices. But this is only part of a larger national property market which is not experiencing a bubble at all.

The three-month annualised rate of change of M4ex in February was 3%, compared with 3% to 4% numbers for much of late 2013 and 5% to 6¾% numbers in the opening months of 2013. With money growth possibly decelerating, the case for an early increase in base rates seems unconvincing. On the other hand, the seeming strength of the real economy argues against a resumption of QE operations. The implied verdict is “steady as she goes”. The British banking system – like the banking systems of other countries – is still restraining balance-sheet expansion, in order to come closer to the Basel III capital requirements.

Comment by Graeme Leach
(Legatum Institute)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

The latest figures for the M4ex money supply measure, which excludes the distorting effects of deposits with so-called ‘intermediate other financial corporations’, showed an easing in the twelve-month growth rate from around 5% last November to 3.1% at the beginning of 2014, although it has since picked up slightly to 3.7% in February. Does this sluggish monetary expansion suggest that the outlook for nominal GDP is easing? Not in 2014. One reason is that alternative monetary measures – such as divisia money, which weights the different forms of bank deposit according to how liquid they are – are telling a stronger story.

A shift from time deposits to more liquid short-term deposits has helped accelerate household sector divisia money from 4.3% in October 2012 to 8.5% in February 2013. For private non-financial companies, divisia money growth has accelerated from 5.3% to 13.6% over the same seventeen months. These numbers suggest firm nominal GDP growth this year, supported by a reversal in the real income squeeze – due to falling inflation and stronger productivity led earnings growth – improved economic confidence and wealth effects from the housing market.

With inflation heading south in 2014 – due to a wide range of factors including a continued output gap, the recent appreciation of sterling, global commodity price movements, the response of energy utilities to political pressure and supermarket price wars – towards 1.5% or below by year end, thereby reducing the pressure on the Monetary Policy Committee (MPC) to tighten policy. However, as we move into 2015 the picture looks less favourable with an expectation of a modest upturn in inflation and the first signs of a normalisation of monetary policy.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; keep QE at £375bn for now.
Bias: To raise Bank Rate.

The UK appears to be well into a boom now. UK 2014 growth appears likely to be around 3% and some estimates for 2015 have been in excess of 3.5% even with interest rate rises. As 2013 base effects dropped out, inflation has fallen slightly below target through one-off factors, but should provide no comfort. If inflation of 0.1 or 0.3 of a percentage point below target is a reason not to raise rates, why wasn’t inflation of 1% to 3% above target a good reason to raise them? If inflation being below target now is a pretext for not raising rates, we are saying that the inflation target is not symmetrical – that inflation being below 2% is much worse than inflation being above 2%. No explicit such indication exists in the target as set.

The latest Office for National Statistics (ONS) estimates for GDP vary markedly according to whether one uses expenditure-based or output-based figures. On the expenditure basis, national output is now just 0.7% below the pre-crisis peak but it is still 1.9% down on an output basis. Either way, though, the pre-crisis peak seems certain to be exceeded this year. Similarly, given the growth rate of potential output is currently probably still below 2% – although it should return to around 2.3% in the next two to three years as the Office for Budget Responsibility (OBR) suggests – growth of 3% to 3.5% in 2014 should eliminate 1.5% to 2% of any remaining output gap. In other words, we are likely to reach equilibrium output later this year.

The policy ideal is to reach equilibrium output with inflation on target and interest rates at their equilibrium level, also. The equilibrium interest rate is, at a first iteration, given by the sum of the inflation target and the rate of growth in potential output. So if potential output is growing at 1.5% and the inflation target is 2% then ideally we would have reached equilibrium output with an interest rate of 3.5%. Instead, rates are ½% and there remains great reluctance to contemplate moving them at all – indeed the effort of forward guidance remains that of persuading markets that rates will rise even later than the very late stage they still expect.

This is not healthy. If we reach potential output with interest rates at 3% (or perhaps more) below their equilibrium level, that can only induce inflationary boom and mal-investment with another recession necessary down the line. A strange terror has arisen about changing rates at all, as if a ½% Bank Rate were some magical unstable figure that, if deviated from at all, would bring disaster upon us. It’s just an interest rate number. The taboo needs to be broken. The sooner it is broken the better for the economy.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE by £25bn per month.

The latest data is supporting a UK forecast for 2014 of around 3% growth. Services are growing strongly, business investment is kicking in, and even exports are beginning to look stronger. The housing market boom has triggered tut-tutting noises from the Financial Policy Committee (FPC). The current account of the balance of payments has gone to a deficit of over 5% of GDP. None of this is a reason for embarking on heavy monetary restraint, however. The current account deficit is partly related to a drop in returns on foreign investments, related to sell-offs in emerging market stocks during the recent ‘Fed taper’ furore. Anyway, the measurement of invisible net exports is notoriously unreliable. Real house prices are still well below their past peaks.

The point really is that the data suggest it is time to move away from massive and unprecedented monetary ease. It would be pathetic if the Bank, out of fear of a ‘re-normalising’ of monetary conditions, turned instead to direct controls on house lending for example – which is now being broadly hinted at. We know that such controls distort the market and are liable to be ineffective because of market ingenuities – when money is plentiful it finds its way into many channels.
About the only reason left for not tightening money somewhat in the direction of ‘normal’ is that bank lending is still being weighed down by the regulative backlash from Whitehall and the international community led by the Basel III agreement. Yet we know that large corporations are deliberately reducing their take-up of bank loans on grounds of expense. Small and medium-sized enterprises (SMEs) are another matter. However, here too there are the stirrings of revolution: ‘peer-to-peer lending’ is growing rapidly as it becomes better organised and more familiar. Their needs are now high on the political radar and may well get the same Osborne treatment as housing did with Help to Buy. As so often, markets are undermining regulation, in this case by bypassing the banking system, in the process building up a ‘shadow banking system’ in the west, to rival the one in China.

Critical as I have been of the bank regulative backlash, in common with many colleagues on the SMPC, I do not feel that we can use it any more as a reason for refraining from moving monetary conditions back towards normal. The Bank’s ideas on forward guidance – which amount to a desire to keep money as loose as possible for as long as possible – have been a recipe for monetary disaster in past historical episodes. They are the classic cliché of too little too late in tightening that marked so many episodes back in the 1960s and 1970s; each time a Keynesian central bank was reluctant to slow a recovery because it got too close to its political masters, nervously longing for a recovery as strong as possible. Today’s politicians and central bankers will scornfully reject any analogy with those highly inflationary periods. Nevertheless, they are foolish to do so, because at the start of the 1960s too there was no inflation to speak of. Our policies today remind one of the excesses of stimulation after the 1970s oil crisis against a 1960s background of low inflation.

Thus again I would suggest that we should move to a raising of Bank Rate, by ½% now because of past delays; followed by a bias to further small moves of ¼% each in the following months. By the end of this year I would expect rates to be over 2%. Turning to QE, it seems to me that the total Bank holding of gilts must be steadily reduced. There are two main reasons for this. The first is simple monetary arithmetic: bank reserves are excessively high and conducive to poor lending practices. As the recovery turns into boom, banks will be sucked in by these vast reserves.

The second is political: too many commentators are attracted by the idea of ‘consolidating’ the Bank’s holdings with the Treasury’s debts, on the fiscal grounds that such a ‘monetisation’ tax would be harmless and reduce the pressure of debt on future spending and taxation. The longer this Bank holding lies around, apparently without dire consequences, the more traction this argument will gain. This directly parallels the arguments of the Weimar politicians before the great hyper-inflation that engulfed them. It is essential in my view that this holding be got rid of fairly fast now to stall such a frightening set of possibilities.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid negative regulatory shocks; break up state-dependent banks more aggressively; raise Bank Rate to 2% to 2½%, and gradually run off QE.

There have been three major domestic developments since last month: the 19th March Budget; the release of revised fourth quarter UK GDP figures and the new balance of payments data for the same period, released on 28th March, and Governor Carney’s re-organisation at the Bank of England. None of these developments has substantially altered the prospects facing the UK economy or required major adjustment to last month’s view about the desirable rate of interest. However, the revised GDP data have already slightly invalidated the OBR Budget day forecasts, because of revisions to the starting point for the OBR’s projections. If anything, the balance of payments figures for the fourth quarter released alongside the revised GDP figures, which showed the current account deficit averaging some 5½% of market-price GDP in the second half of last year, suggest that the case for a hike in Bank Rate is stronger than it was previously. However, the possible slowdown in the growth of M4ex broad money supply since mid-2013 suggests that any monetary tightening needs to be cautious and phased in gradually.

The 2014 UK Budget followed on unusually quickly from last year’s December Autumn Statement. There was little in the way of surprises during the intervening period to change the broad parameters set out in the Chancellor’s earlier report. The main Budget event was the freeing up of pension funds and the extension of the limit on ISAs. Both reflect sensible market liberalising reforms and should be welcomed. However, the manner of the announcement, as a political ‘coup de theatre’, caused serious windfall losses for individual annuity providers. Responsible Chancellors – as distinct from ‘mere’ politicians – should avoid the imposition of windfall losses and gains because of the arbitrary political risk that they introduce into commercial transactions. It might have been better if the Budget pension changes had been preceded by a consultation paper, especially as some people will have taken out annuities shortly before the Budget who would have waited if the measures had not come as a surprise. More generally, the problems faced by annuitants were largely caused by the sustained abnormally low Bank Rate and QE; this is because annuity yields are a ½ a percentage point or so above the fifteen or twenty year gilt yield. So, what we have here is a reform that largely occurred because of the distortionary effects of official policies elsewhere. Another cause was the Conservatives’ political desire to keep older voters on side and out of the embrace of UKIP, of course.

Mr Osborne’s cuts in the duties on beer and bingo have attracted some derision as being a reversion to Harold MacMillan era ‘toff paternalism’. However, both measures can be defended on the ‘Laffer curve’ grounds that the previous duty rates were so high that they were leading to the slow demise of the pub trade and bingo hall industry. Until now, the Prime Minister and the Chancellor have suffered from a tin ear when it came to the adverse effects of high tax rates on the supply-side of the economy. The off-shore oil and gas industry has been another situation where increased taxes have led to a contraction in output and reduced revenues for the Exchequer. Indeed, the UK economy as a whole may be on the wrong side of the aggregate Laffer curve nowadays. This implies that Mr Osborne should have been bolder in reducing high marginal tax rates. One urgently needed reform is to replace the present ‘slab structure’ of stamp duties with a threshold structure similar to income tax, so that the new higher rate only applies above the threshold. It is significant, from a political viewpoint, that the Conservatives ratings in the opinion polls were enhanced after they had introduced a significant market liberalising measure in the Budget.

Unfortunately, the detailed numbers given in the Annex to the OBR Budget report suggest that the Chancellor’s fiscal arithmetic is as dependent on the politician’s disreputable friend ‘Rosy Scenario’ as last year’s Autumn Statement. Between 2013 Q4, when the OBR forecasts commence, and 2019 Q1 (when they end), the OBR forecasts show the volume of general government consumption – which accounts for roughly one half of total government expenditure – falling by a total of 4.3% and its cost rising by 1.1% during a period in which the volume of tax-rich household consumption is forecast to rise by 12.9% and its price by 12.2%. During the same period, the volume of general government investment is expected to rise by 7.1%, according to the OBR, while real business investment is projected to rise by 50.6% and private dwellings by 58.2%. Likewise, the cost of general government investment is forecast to decline by a total of 6.7% between 2013 Q4 and 2019 Q1, while the price deflator for all fixed investment (including by government) is forecast to rise by 6.8%. The projected longer term outlook for the public finances is heavily dependent on the compounding effects of these OBR forecasts over the next half decade. However, such parsimony is unlikely to be achieved, even if the coalition remains in office after the May 2015 general election, let alone under a Labour government.

The OBR forecasts incorporated the second estimate of 2013 Q4 GDP, released on 26th February. The revised estimate, published on 28th March has altered the picture as far as the 2013 Q4 starting base for the OBR forecasts is concerned. In particular, the volumes of household consumption, general government consumption and real GDP at market prices in the fourth quarter have been revised down by 0.3%, 0.5% and 0.1%, respectively, while the volume of imports has been revised up by 0.9% and the figure for exports by a noteworthy 2.9%. There have also been a noticeable downwards revision to the volume of stock building in 2013 Q4, and an upwards revision of 4.9% to ‘non-profit institutions serving households’, which includes a large slug of (part) publically funded institutions, including universities and charities. The real ‘nasty’ in the 28th March ONS data releases, however, was the upwards revision of just over £3bn to the estimated current account deficit in the first three quarters of last year and the announcement of a £22.4bn deficit in the fourth quarter, to give an annual total of £71.1bn in 2013 compared with an upwards revised £59.7bn in 2012. Net exports of goods and services actually improved from a deficit of £33.4bn in 2012 to one of £26.6bn last year. However, these gains were offset by a jump in the deficit on investment income from £3.8bn to £20.5bn and an increase in the deficit on government transfers from £16.3bn to £20.5bn.

In the light of the new information, the latest forecasts generated by the Beacon Economic Forecasting (BEF) model suggest that UK GDP will grow by an average of 2.7% this year – compared with a downwards revised 1.7% in 2013 – 2.3% next year, and 2% in 2016, before settling on a trend growth rate of 1.8% or so in subsequent years. These growth forecasts are within spitting distance of the OBR ones for the next year or so of cyclical recovery. Nevertheless, the longer-term growth trend is well below the 2.5% assumed by the OBR, with consequent adverse implications for public borrowing. The BEF macroeconomic model suggests that CPI inflation will ease to 1.5% in the final quarter of this year, before rising to 2.2% late next year, and 2.7% in late 2016. Longer term, CPI inflation is expected to fluctuate within a 2¼% to not quite 3% band in the later years of our decade-long forecast horizon. Bank Rate is expected to rise gradually, possibly hitting ¾% by the end of this year, 1½% late next year, and 2¾% subsequently, with low interest rates overseas helping to hold down borrowing costs in this country.

However, the balance of payments is likely to remain a continuing worry, even if there is some improvement in net investment income – where the UK used to run a substantial surplus – with a current account deficit of £65.5bn expected for this year, £68.6bn in 2015, £75.2bn in 2016 and with continuing large imbalances thereafter. Unfortunately, the outlook for Public Sector Net Borrowing (PSNB) has become confused by the number of different definitions now being employed. On our preferred definition, which excludes the Bank of England Asset Purchase Fund and Special Liquidity Scheme (ONS data bank code J511 with sign reversed), the PSNB is expected to be £110.3bn in 2014-15, £100bn in 2015-16 and £91.7bn in 2016-17. Thereafter, the PSNB continues to fade away slowly. However, that reduction is conditional on the assumption that the volume of general government current expenditure is held constant at its 2013 Q4 level throughout the next ten years.

The political risks to the economic outlook were discussed in last month’s SMPC submission. However, the scale of the twin deficits likely to confront the UK authorities after the May 2015 general election poses major problems for a putative Labour government, which would probably not be given any benefit of the doubt by the financial markets. A Labour administration could face the bi-modal policy choice of either unambiguously strong fiscal orthodoxy or a stabilisation crisis and a run on the pound. Unfortunately, there is little evidence that Mr Milliband and Mr Balls are even thinking about the unpleasant choices they would face if they achieved office, let alone that they have prepared an appropriate response.

Turning now to monetary policy, and Mr Carney’s reform of the Bank of England, the striking thing to a former Bank employee from the late 1960s and early 1970s, is that some of the shunting around of personal appears to be a revival of the idea of the Bank of England ‘lifer’, who was expected to move to any department of the then Bank over a four-decade career, rather than stick within a particular specialisation, such as economics. This approach had the disadvantage that it was not always possible to keep in touch with the latest developments in a particular narrow field but had the great benefit that Bank officials were not simply ivory tower intellectuals but knew how to implement their ideas in the messy real world of financial markets and regulatory supervision. This model for a Bank career was destroyed by the tri-partite dismemberment of the Bank that followed the granting of operational independence three weeks after the 1997 election. The Bank’s earlier dismemberment was one reason why it performed so badly in the run up to the fiscal crisis of 2007 and 2008. Meanwhile, the substantial leakage of excess home demand overseas revealed by the balance of payments deficit suggests that Bank Rate should be raised by ½% in April and then increased cautiously in a pre-announced fashion, by ¼% every second month or so, until it reaches 2% to 2½%. Likewise, QE should be allowed to unwind gradually as stocks mature, through a process of partial re-placement. However, a weather eye should be kept out for M4ex broad money, whose annual growth rate hit a recent peak of 5.2% in May 2013 but had eased back to 3.1% in January, before recovering to 3.7% in February.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ½% and switch £25bn of QE from gilts to infrastructure investments.
Bias: Raise Bank Rate towards 2%.

The flow of positive data surprises (activity and retail sales stronger, inflation weaker) continues to buoy UK asset prices and sterling, creating a virtuous circle for the government and the central bank. The Bank is able to argue that the stronger pound is helping to reinforce domestic pricing discipline. So far, so good. However, the Budget has revealed a worrying lack of ambition in bringing down public sector borrowing in the next fiscal year in the context of a 2.7% projected economic growth rate. From an expected outturn of £108bn for 2013-14, the planned deficit is just £13bn less at £95bn, or 5.5% of nominal GDP. Much heavy lifting in terms of public expenditure restraint has been deferred to the next parliament.

The volume of business investment is projected by the OBR to grow annually by 8% or more in each of the next five years, despite serial and significant disappointments to forecasts in the past three years. The usual blue sky forecasts of 2.5% economic growth year-in, year out, and the acquiescence of inflation to a target that has plainly been relegated, with the entire monetary policy function, within Mark Carney’s restructured governance of the Bank of England. Financial policy is no longer the Cinderella. She has received her invitation to the ball.

It seems that the Bank of England has conceded ground on the potential sustainable growth rate of the UK economy (in its February Inflation Report), but that the OBR is unable to follow suit, despite overwhelming evidence. If the sustainable annual growth rate of the economy is closer to 1.5% than 2.5%, as we believe, then inflationary pressures will accumulate far sooner than the Treasury expects. A ballooning balance of payments deficit is the first port of call, with the risk that sterling will again fall under critical examination by the financial markets. Private sector inflation has levelled off in recent months but has not continued to fall. Commodity price effects, favourable currency effects and fuel duty freezes will not be enough to keep inflation low.

In summary, the case for raising Bank Rate immediately is overwhelming. Forward guidance obstructs the short-term path to higher short-term interest rates but this stance is likely to become untenable as the year wears on. The Bank should also remind the government of its negligence in reducing the borrowing requirement. Swapping £25bn out of gilts into infrastructure investments should do the trick.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Raise Bank Rate by ½% and decrease QE to £250bn.
Bias: Start to unwind QE and slowly raise Bank Rate as economy grows.

Three developments that occurred in the last month are of especial interest to commentators on the macro-economy. The first is the further fall in CPI inflation below its target, to 1.7% in February, its lowest level for four years. At first sight, this may seem to justify the refusal of all but Martin Weale on the MPC to tighten monetary policy. This, however, would be to miss two significant things. The basis of the MPC’s interest rate policy has always been that it takes two years for inflation to fully respond to interest rates. (A new Bank of England paper suggests two to three years.) As it is widely agreed that the economy has already embarked on a strong recovery, with Help-to-Buy causing a marked, and very likely unsustainable, rise in both new housing starts and house prices, the probability is that inflation is set to rise shortly. Now, therefore, is the time to nudge up interest rates in order to maintain inflation at its target level, and not 2015 when inflation would almost certainly be above target.

A further argument is that interest rates must return to normal sooner rather than later, and a smooth transition is less harmful to the economy than a sharp increase later.

The second event of note is the Governor’s re-organisation of the Bank. Particularly intriguing to MPC watchers is the swap in roles of Andy Haldane and Spencer Dale. Does this signal a change in attitudes to monetary policy from the Mervyn King regime in which for many years Spencer Dale has presided as chief economist? Maybe the Bank’s recent poor inflation forecasting record has been a factor.

Although the Bank under-estimated the rate of inflation for a period of about three years from 2010, in its defence it should be pointed out that many one-off, exogenous and unpredictable, events were partly to blame. In general, neither forecasts based on macroeconomic models nor pure time series forecasts are accurate at turning points in the business cycle. This is because turning points are almost entirely due to exogenous and almost entirely unpredictable events. The moral is that the Bank’s inflation forecasts, although the central activity of the MPC, are highly unreliable except when the economy is not subject to large shocks, in which case forecasting inflation does not require great expertise or resources.

Another factor in the job swap at the Bank might be associated with internal opposition to the ill-fated policy of the Governor to link changes in interest rates to the rate of unemployment. Instead of increasing transparency in monetary policy, this Mark 1 version of Forward Guidance only increased it. Its apparent abandonment so soon after being announced will be widely welcomed. One can only speculate about what the reasoning behind the swap was. Let us hope that it was for technical and not personal reasons.

At the same time, it was announced that the Bank would seek to become more open and to engage more with the academic community. This is very welcome. A fuller explanation of the changes in personnel would be one way to start being more open. Prior to Mervyn King’s tenure, initially as chief economist, the Bank had a thriving, though not that distinguished, research output. Over time this has declined. The contrast with the European Central Bank (ECB) is marked: the latter has a huge research output, much of which is contributed by outside academics. I, for one, would like to see the Bank restore its position as a leading centre for research into the macro-economy.

I would also like to see more presentations to the outside world of the Bank’s research, perhaps through regular workshops. The situation is, however, far worse as regards the Treasury. Previously, open to inter-changes with the academic community through the, now defunct, Treasury Academic Panel, with the transfer of macroeconomic policy to the Bank, the Treasury seems to have largely abandoned research on the macro-economy or any dialogue with academics. Perhaps the Bank of England could take a leaf from the Treasury of old and start its own academic panel.

Somewhat ironically, after the above comments, the third event is the Budget and the unexpected change in pension arrangements. This will have huge implications for fiscal policy and the economy generally. It makes it all the more surprising that there was no discussion with external experts, including the academic community, prior to the announcement. Nonetheless, dropping the requirement that people had to take out an annuity on retirement is very welcome as it corrects a major financial distortion that hugely disadvantaged pensioners. It allows pensioners to benefit from the historically better long-term performance of equities than gilts. Recent monetary policy, with its rock-bottom interest rates, has of course been partly to blame for the size of the financial distortion and resulted in a large transfer of wealth from savers (mainly for pensions) to borrowers.

Comment on this change seems to have focused more on the short-term implications than those for the long term. It has been claimed that it will result in increased household expenditure and also increased savings. This appears to be contradictory, but, if returns are higher, then both could be true. The increase in demand for equities may be expected to raise stock prices while the reduction in the demand for gilts may raise long-term interest rates.
Any increase in savings would occur against the background of further fiscal tightening and hence higher public saving. Some commentators have said that if the government seeks to increase savings then households should be induced to reduce savings. This would not be necessary, and both could save more, provided that the country runs a sufficiently large current account surplus when, in effect, net private sector savings would be in foreign assets. However, the UK ran a current account deficit of 4.4% of GDP in 2013, and one of 5.5% in the fourth quarter alone.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking and University of Derby)
Vote: Hold Bank Rate and maintain QE stock at present level.
Bias: Neutral.

On the surface, the economy seems to be on a solid enough footing to justify an immediate rise in interest rates. Growth was 0.7% in 2013 Q4 and for the year as a whole it averaged 1.7%. Consumer demand is expanding. Overall, however, the figures paint a picture of a more balanced economy in the fourth quarter. Business investment was left unrevised at 2.4%, its fourth consecutive quarterly increase. But the big surprise was inventories and exports. Exports were revised up sharply from growth of 0.4% to 2.8%, boosted by a large increase in financial services exports. Overall, net exports are now reported to have contributed 1.0% to fourth quarter growth compared with 0.4% in the previous release, a very big revision.

The corollary to the increase in exports was a downward revision to inventories – hence, overall GDP growth remained unchanged. Inventories include an alignment adjustment – effectively a residual that ensures the expenditure accounts balance with the more accurate output estimate of quarterly growth. As more data have become available, it is clear that a large part of this residual has been allocated to exports. Still, the recovery remains heavily dependent on the consumer. Household spending was revised up a notch in 2013 Q4, from 0.4% to 0.5%. However, and against the backdrop of an ongoing squeeze in real incomes, the household saving ratio fell further – from 5.6% to 5.0%. A declining household saving ratio has been a key theme of the recovery over the past eighteen months and is likely to remain so, especially as households feel confident enough to save less amid rising house prices and a more buoyant economy.

While there are signs that households incomes are gradually recovering, the income generated from the growth in the closing quarter of last year accrued mainly to corporate profits, not wages. Employee compensation in the form of wages and pensions rose by 0.3% in nominal terms in 2013 Q4 – representing its thirteenth consecutive increase – but the gross operating surplus of corporates rose by 5.4%. The relative outperformance of corporate versus employee income has been another key theme of the recovery. From a sector standpoint, the corporate sector remains a net lender to the rest of the economy. The household, and more particularly the public, sectors remain net borrowers.

Irrespective of the upward revision to net exports, falling overseas investment income caused the current account to record a deficit £22.8bn in Q4, which is equivalent to 5.4% of GDP and the second highest outturn on record, even as a net positive trade contribution was recorded. Clearly, the overseas sector is a big net lender to the UK. The implication is that the UK continues to spend more than it earns and, as a result, has to borrow money from abroad. Hence, a sharply increasing current account deficit. For now, financing the current account deficit has been relatively easy. From a structural standpoint, however, the deficiency of domestic savings manifest in a falling saving ratio and a rising current account deficit, pose potential threats to economic recovery. The Budget reforms to pensions and savings will do little alter these trends.
UK economic growth in the first three months of this year seems to have got off to a good start. A fall of 2% in the volume of retail sales in January 2014 did not reverse a rise of 2.7% in December 2013, and was followed by a rise of 1.7% in February. Employment continued to rise and unemployment to fall. Employment gained 68,000. In February, the three month unemployment rate on the Labour Force Survey (LFS) basis was 7.2% and the single month rate was 6.9%.

Actual weekly average hours worked by those in their main job was 32.1m in February, still shy of the 32.8m hours worked in the third quarter of 2008 but edging towards it. Manufacturing output has risen by a solid 0.7% in each of the last three quarters, and the annual rate was 2.8% in the final quarter of 2013. It is worth reiterating that, despite all this, the economy is still 1½% smaller than in 2008. Although this level should be regained this year, it does not make up for the lost output, nor does it take away from the OBR forecast that growth next year will slow from 2.7% this year to 2.3%. Admittedly, the consensus is for 2.5% next year but thereafter the view is that annual economic growth settles at close to 2% than 2½%.

Meanwhile, price and wage Inflation remain low. CPI inflation has been under 2% for two months (it was 1.7% in February) and wage inflation is just 1.3% ex bonuses. A rate rise two years ago would have been unwise and unproductive. It could even have led to worries about deflation. However, this is not to say that a rate rise now would not be necessary, as monetary policy should be forward looking. What argues against it is not just that price inflation is low, and likely to slow further in the months ahead, but that the underlying trends in the monetary statistics are starting to worsen; suggesting that the growth rates we are seeing could be at risk. This is not to say that economic growth is about to collapse: it is not, but the pace of economic growth may slow if these trends do not reverse soon. The Budget did little to change these trends.

In February, total M4 broad money grew by 0.7% on the year, but what is interesting is the detail. Holdings of M4 by households were 3.8% up on the year, and their borrowing rose by 1.5%, suggesting that they are still net savers. A breakdown of the 1.5% showed a rise of 1.1% in borrowing secured on dwellings and one of 4.8% in consumer credit. That does not suggest a runaway consumer or housing market borrowing binge. Private sector non-financial corporations (PNFCs) holdings of M4 rose by 7.6%, representing a continuation of the high trend of savings, while borrowing was down 2.2% on the year. The latter was a continuation of a long-standing trend though not inconsistent with some increase in business investment spending from current savings.

Other financial corporations (OFCs) reduced deposits by 0.8% in the year to February, a slower rate of fall than the 3.4% seen in January. This caused the boost to overall M4 growth from the annual negative rate of 0.2% recorded in January to the positive one in February. In terms of borrowing, OFC’s recorded a yearly decline of 4.1%. Total M4 lending fell by 2.6% in the twelve months to February. M4ex went up by 3.7% in the year in February, but a rolling three month trend suggests that the annual rate of growth may be slowing. With all this in mind, I would vote to leave Bank Rate on hold; and maintain QE at £375bn, with a bias to neutral. There is time enough for rates to be raised to head off any inflation threat.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman, until his forthcoming retirement on15th April, is David B Smith (Beacon Economic Forecasting and University of Derby). After 15th April, Andrew Lilico (Europe Economics) will take over as SMPC Chairman. Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Ruffer), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Legatum Institute), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking and University of Derby). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, March 02, 2014
Shadow MPC wants half-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, finalised on 26th February, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) decided by seven votes to two that Bank Rate should be raised on Thursday 6th March.

In particular, five SMPC members voted for an increase of ½%, two members voted for a rise of ¼%, and two wanted to leave rates unaltered. This pattern of votes would give rise to an unambiguous increase of ½% on the usual Bank of England voting procedures.

The IEA shadow committee’s rate recommendation contrasts with the view taken by Mr Carney at his 12th February Inflation Report press conference. Individual SMPC members had a variety of reasons for not being persuaded by the Bank’s analysis. However, there was a general suspicion that the concept of ‘slack’ used to justify freezing Bank Rate was so immeasurable in practice that it was incapable of operational implementation.

It was also suggested that the Bank’s underlying theoretical model, which justified the emphasis on slack, was itself inadequate as a description of a small, open, trade-dependent economy, with a large socialised sector, and where financial regulation was delivering constant regulatory shocks to the supplies of money and credit. However, some SMPC members felt that it would be desirable to pause and reconsider the process of rate normalisation once the nominal interest rate was in the 2% to 2½% range. There was also a view that the, possibly unrealistic, expectations of Bank Rate stasis created by Forward Guidance meant that any rate increases had to be delivered in a series of small phased doses in order to minimise possible adverse shocks to business confidence.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate by ½% and hold QE.


Bias: Increase Bank Rate; QE to depend on behaviour of broad money.
Although there has been a fall in inflation to just below the 2% target in January, it is the first time that this has been achieved for four years and it makes one wonder whether the 2% target is being treated as a symmetrical target or a floor. Going forward, a rise in confidence and a more generalised return to normal economic conditions suggest that the equilibrium (or natural) rate of interest should return towards more normal levels – perhaps sooner rather than later. There may be dangers in raising rates too quickly. However, there are bigger dangers in keeping rates depressed for too long. Given the shifting nature of forward guidance which is making monetary policy more opaque, keeping interest rates at current levels might signal (indeed, perhaps it is intended to signal) that they will remain very low for many years to come whatever the impact on inflation.

If economic conditions do improve dramatically and a steep rise in rates is needed, the dangers for businesses and households could be considerable. On balance, the dangers of inflation undershooting 1% (i.e., 1 percentage point below target) as a result of modest increases in interest rates in the near future are less than the dangers of leaving rates too low for too long. This is both in relation to hitting the inflation target and also in relation to more general concerns about the economy.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ½%.
Bias: Further rises in Bank Rate.

Throughout the low and slow recovery there have been two different reasons for advocating the normalisation of interest rates. One is that the emergency monetary measures introduced by the Bank of England are somehow akin to tinder that will start to catch fire, and possibly get out of control, once economic activity returns to normal. Therefore, it is safer to start raising rates too soon, rather than too late. Another perspective is that the foundations of the recovery are somewhat weak, and subject to even more negative growth shocks. Keeping rates low during a period of relative calm is not only a de facto commitment to permanently low rates, but also reduces the scope for conventional monetary easing if and when required. Both the ‘escape velocity’ and ‘eye of the storm’ scenarios demonstrate that there are valid reasons to consider raising rates. The Bank of England’s commitment to forward guidance has been an attempt to avoid this conversation. The main problem is that it has been used as a justification for the policy stance, rather than as a means to understand what is driving the thought process governing the decision. Markets and commentators want to understand when rates will rise. ‘Later’ is not a good enough answer.

The utilisation of a 7% unemployment threshold was intended to show that monetary policy would stay looser for longer than markets had previously thought. In fact, it has shown that the necessity for loose monetary policy is lower than the Monetary Policy Committee (MPC) had thought. Instead of confronting this surprise, however, Forward Guidance II has not so much shifted the goal posts but obfuscated them. At least, the unemployment measure was something that we all understood. The Bank’s definition of ‘spare capacity’ is less obvious. MPC member Martin Weale recently attempted to provide his own (loose) forward guidance by stating that rates would begin to rise in spring 2015, and then rise at a gradual rate. The Bank of England has told us not to expect a return to a pre-crisis ‘norm’ of around 5%. However, this overstates the control that they have. There is a conflation of: 1) what the Bank expects to happen to market interest rates; and 2) what the Bank intends to do with the Bank rate. The problem is that they have little credibility over their ability to forecast the former, and an attribution bias around the latter. Ultimately the greater the amount of control that a central bank has over a monetary indicator, the less important that indicator is to economic activity. This is especially dangerous if the public take present rates as a reliable indicator of future rates and build low rates into their expectations and economic calculation.

An interesting issue is whether interest rates should start to rise before QE is unwound. Logically, one might expect the extraordinary monetary policy to be undone before returning to the standard tool. However two reasons suggest that QE should be left alone. Firstly, raising rates would send an important signal to firms and households about the necessity to factor higher rates into their forward planning. If a moderate rate rise would cause problems now, after five years of emergency monetary policy, then it should be confronted as soon as possible. Secondly, one of the biggest problems with the implementation of QE is that it was used in an ad hoc manner. Instead of being tied to clear policy targets – preferably nominal GDP growth, but even unemployment might have been better than nothing – it has been a tool of discretion. Undoing it in a discretionary way may be especially damaging.

Recent news about the Consumer Price Index (CPI) has certainly reduced the argument for rate rises now. However, it has not by much. Price deflation would be a concern, or a dramatic reduction in inflation expectations would be a concern. However, the rate of inflation slowing to the target level (or moderately below, at 1.9% in January) should be no cause for concern in and of itself. In addition, narrow money measures are still growing above 4% on an annualised basis and, although broader measures were slightly lower in December 2013 than previous months, they are not sending any major warning signals. Ultimately, the consensus forecasts for 2014 and 2015 are CPI inflation rates and GDP growth that go beyond a low and slow recovery (when their combined rate touches upon 5% we should be concerned of overheating). If anything, there is potential for a little scorching as we approach the 2015 general election. Raising rates risks choking the recovery, but higher rates would make whatever recovery that does result more sustainable. With the trade-offs that we currently face, that may be the best we can hope for.

Comment by Graeme Leach
(Legatum Institute)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Weak inflationary pressure and a weakening in the Bank of England's chosen money supply measure, suggests monetary policy will remain unchanged for some time yet. The three month annualised rate of growth in broad money excluding Other Financial Institutions (OFIs) slipped to 3.7% in December from 5.1% previously. However, the ‘Divisia’ broad money measure remains strong, rising by 9% year on year in December. Whilst showing a slightly contrasting picture, broad money supply measures suggest UK economic performance is likely to remain firm in 2014. This is likely to be reinforced by an improvement in real earnings growth, as inflationary pressures ease and productivity driven pay awards increase. By the middle of 2014, the UK economy is going to look and feel quite 'perky'.

Despite the optimistic outlook for this year, however, the recovery contains the seeds of its own destruction. Firstly, the faster GDP growth is this year, the greater will be the expectation of a shift towards a normalisation of monetary policy next year. Second, beyond the expectations effect, the implementation of a shift towards normalisation – however modest – in 2015 will directly slow economic activity through the withdrawal of purchasing power from debt constrained households and companies. Finally, supply side constraints – most notably, a decline in the UK's rate of potential output growth over the past decade – probably mean that, whilst any spare capacity could absorb the inflationary consequences of faster growth this year, that is unlikely to be the case next year. In other words, the CPI is likely to move back above the 2% target.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate.

The argument for raising rates has been compelling for some time. With the Bank of England forecasting 3.4% growth for 2014 – which is up a full 1% from the Office for Budget Responsibility (OBR) forecast in December – it has become overwhelming to the point that the Bank is now far behind the curve and there is a need for catch-up. Rates should already be above 1%, and it is tempting to recommend a 1% rise. However, it remains just about best to recommend only a ½% rise in March to begin with perhaps.

What defence could there be of continuing to maintain rates at ½% with four continuous quarters of GDP growth and eighteen months of solid growth already behind us? The Bank claims there is some ‘slack’ in the economy, probably of 1% to 1.5%. This is apparently not equivalent to an ‘output gap’ since it will not disappear as the economy grows at 3% plus for some time. So, presumably, the output gap is believed to be larger — maybe in line with the OBR estimate of 2.2% as of 2013 Q3. Yet, Mr Carney claims that, even when the economy returns to interest rate equilibrium, the new normal will be rates of 2% to 3% not 5%. However, since the equilibrium interest rate is given, at a first iteration, by the sum of the target inflation rate plus the sustainable growth rate of the economy plus an inflation risk premium, a 2% target inflation rate implies a sustainable growth rate of below 1% even over the medium-term. If the Bank believes the sustainable growth rate is that low, given that the OBR believes the sustainable growth rate will be around 2.2% to 2.3% in the medium-term, how can the Bank believe there is currently any output gap at all? The Bank’s entire case is seen by almost all commentators as simply an excuse for keeping Bank Rate unchanged at ½% for as long as it can get away with it.

On OBR numbers, at 3.4% growth the output gap at the end of 2014 would be just 0.8%. Ideally, we ought to seek to reach a zero output gap at the equilibrium interest rate and the target inflation rate – so that output, inflation and interest rates are all on target at the same time. Given the OBR estimate of the medium-term sustainable growth rate rising in due course to 2.3%, which appears more credible than the Bank’s extraordinarily pessimistic implicit figure of well below 1%, the medium-term equilibrium interest rate can be expected to be close to 5%. If interest rates were still ½% at end-2014 whilst there were no output gap, that would imply a huge policy imbalance, with the economy being massively over-stimulated at equilibrium output. The only plausible consequence would be a highly damaging boom-bust cycle, with an eventual recession potentially as bad as that of the early 1980s to follow.

The Bank currently is obtaining some fig-leaf cover for its policy from inflation being below-target, despite being driven by exactly the same sort of ‘one-off factors’ that the Bank said it could safely ignore when they took inflation far above target for years at a time. This raises the important question of whether the inflation target is still symmetrical, as it was claimed to be for so many years. If it is okay for inflation to be driven to 5% (i.e., 3% above target) by one-off factors, why is it not okay for it to be driven to minus 1% (i.e., 3% below target) by special factors? Why is an inflation undershoot of 0.1 percentage points now believed to be a good reason not to raise Bank Rate when an overshoot of 3 percentage points was not considered a good reason to raise them?

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE by £25bn per month.

It has become a cliché of recent commentary to remark that the UK’s recovery has been weak, compared with the past and with other economies. We also see that there is a ‘productivity puzzle’ – productivity has fallen and may still only be rising weakly. Of course the question is, why? The UK economy before the crisis had experienced strong productivity growth since around 1982. Furthermore, it had enjoyed – although that is not really the right word – gruelling supply-side reform more or less continuously since 1979. There had been some recidivism under Labour’s tenure between 1997 and 2010. Nevertheless, as many have said, Blair and Brown were in many ways Thatcher’s children and the reversals put in place mainly were at the margin – e.g., some slight restoration of union protections, and the establishment of a minimum wage. However, the recent evidence from the labour market has confirmed that the UK has considerable wage flexibility, both nominal and real, and that union power is weak even in the public sector. Whether minimum wages are binding on demand for lower-paid labour remains a concern; but it seems that zero hour contracts and part-time work in practice produce a lot of flexibility even at this lower stratum of the market.

My own view of the current situation is that it is the product of four major shocks:
– First, a massive run-up in commodity prices that battered living standards;
– Second, the North Sea, where UK policy attempted excessive and ‘time-inconsistent’ extraction of revenue (i.e., like Oliver they kept on coming back for more);
– Third, excessively tight bank regulation in response to the crisis; this has hit the banking sector;
– Finally, the collapse of the European market for UK manufacturing.
All these are familiar points. However, as David H Smith of the Sunday Times has noted, they account for the fall in productivity and also the strength of employment as due to a shift of UK output composition: the sectors hit hardest were all high-productivity sectors while the service sector which has managed to recover most has absorbed many low-productivity workers.

The middle two factors (oil and bank regulation) were self-inflicted by the Whitehall establishment. Fortunately, there are signs that George Osborne and the Treasury have now understood and are trying to reverse the damage. We have yet another rapprochement with the North Sea industry and we have Funding for Lending and the Help to Buy scheme, which mean that credit to mortgages is starting to flow. Small and Medium Enterprises (SMEs) are still affected by the credit famine and UK broad money growth remains weak. Nevertheless, life is returning. QE seems to be having an impact via asset prices, private equity and the new fast-growing peer-to-peer lending. The biggest problem remains bank regulation; banks continue to shrink their balance sheets, effectively pulling against the monetary recovery.

Factors 1 and 4 (commodity prices and the Euro-zone) are now also reversing. Commodity prices are coming off, under the impact of monetary tightening in emerging markets like China as well as resource productivity growth due to fracking etc. The Euro-zone has also hit bottom and is recovering. The recovery is therefore looking much stronger. SMPC members like Trevor Williams and Tim Congdon have still stressed potential weakness, however, and the need for monetary ease to stimulate credit and money growth; in this they are at one with Bank Governor Carney and his determination to keep money easy and rates low for the foreseeable future. They seem to have a good point in the sense that the money supply figures support their interpretation.

My concern remains that the weakness of the money supply is distorted by bank regulation and is ‘structural’; i.e., that there is an artificial block on credit and money creation that is spawning money and asset substitution, while also raising the costs of particular industries and firms. Some SME businessmen have said that the banks will never be trusted again by SMEs and that they are now looking to the new alternative channels of finance. At the same time, the interest rate structure is heavily distorted by both regulation and the zero bound policy; this is illustrated by the massive gap that has opened up between rates on official paper and rates on lending to private corporations, particularly SMEs. We may well be creating the conditions for an asset price boom while diverting this boom away from general credit and money. The recovery could be strong on the back of this boom while money growth remains weak. We are not there yet but I see no reason to delay in heading off such conditions.
My policy recommendation is to attack these distortions as best we can. First, row back on bank regulation: we do not want to create a ‘shadow banking sector’ but we are doing so already. Second, restore a normal interest rate structure by raising Bank Rate steadily. Third, operate on the money supply via open market operations (including QE); with the current distortions of the statistics it is hard to know exactly what to do with QE but the overhang looks threatening and it should be reduced, while being willing to return to the open market as the statistics clarify. Thus, I favour continuation of the schemes to restore bank credit growth and encourage the banks back into activity; a rise in Bank Rate towards ‘normality’, with upward steps of ¼% starting now; and a reduction of QE in steps of £25 billion per quarter starting now.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: Avoid negative regulatory shocks; break up state-dependent banks more aggressively; raise Bank Rate to 2% to 2½%, and gradually run off QE.

Recent monthly indicators and the revised GDP estimate for the fourth quarter of 2013 released on 26th February – which showed quarterly and annual increases of 0.7% and 2.7%, respectively – have all been consistent so far with the New Year forecasts from Beacon Economic Forecasting (BEF) described in the January 2014 SMPC report. This comes as both a surprise and a relief, given all the traumas that the international and domestic economies have undergone over the past six or seven years and the often inaccurate forecasts that have resulted. However, it may also indicate a wider return to more normal economic conditions as these earlier shocks fade with time. The three main issues arising immediately are: 1) the enhanced political uncertainty likely to be experienced between May 2014 and May 2015; 2) the forthcoming 19th March Budget, and 3) the question of how to interpret the Forward Guidance II launched in the Bank of England’s 12th February Inflation Report.

The three main political concerns facing economic agents are the Scottish independence referendum and the European Elections this year, and the UK general election next year. There seems to be least concern about the European Union elections, to be held between 22nd and 25th May – presumably, because many people do not take the European Parliament seriously, despite its propensity to introduce damaging anti-market legislation. The Scottish referendum, to be held on Thursday 18th September, does seem to be putting the wind up the UK establishment, however. This is partly because the outcome remains unpredictable in a situation where opinion polls are likely to prove unreliable. A personal view is that the overriding concerns in the Scottish referendum for the rest of the UK (RUK) are geo-political and strategic, while the economic issues can be finessed with mutual good will on all sides. However, it is hard to see how RUK would be defensible, if Scotland were neutral, let alone hostile, in the event of any serious conflict. This does not seem a risk at present. Nevertheless, Harold MacMillan’s ‘events’ always tend to come out of the blue. True statecraft requires being concerned with long historical sweeps over decades and not just winning the next election. It is surprising that this crucial strategic interest of RUK in the Scottish referendum has not received more attention.

A specific forecasting worry about the May 2015 general election is that the ‘no policy change’ assumption underlying nearly all macroeconomic projections would be invalidated if Labour won and imposed the policies that currently it is advocating. Furthermore, any additional governmental spending under Labour would be imposed on a high and unsustainable starting point. This is because the Coalition has only timorously reduced the share of government spending in GDP from its all-time peacetime peak in 2009. With a large balance of payments deficit to be financed, as well as budget deficits, the probability of ‘a non-linear’ financial-market event after the May 2015 election looks disconcertingly high. However, a contrary risk is that businesses in politically exposed areas are holding back from investment because of the political and regulatory risks over the next eighteen months. A Conservative victory (or a continuation of the Coalition) might then open the investment floodgates and inject substantial new demand into the economy. The Bank Rate response appropriate to a ‘no policy change’ assumption after May 2015 could cease to be appropriate in other plausible scenarios. However, the Bank’s current preference appears to be to hold Bank Rate throughout.

As far as the 19th March Budget is concerned, it seems better to reserve comment for next month’s SMPC contribution, after the detailed fiscal information in the OBR Budget Report has been fed into the BEF model. Because much of the essential Budget information is tucked away in OBR Annex Tables, most instant Budget comments tend to miss something. While the OBR creates its own independent forecasts at Budget time, these are normally reasonably close to the consensus. The February HM Treasury compilation of independent forecasts shows a consensus growth forecast for this year of 2.7%, followed by 2.4% in 2015, and a projected Public Sector Net Borrowing (PSNB) of £99.3bn in 2013-14, being followed by a deficit of £87.9bn in 2014-15 and £72.6bn in fiscal 2015-16. The consensus forecast then suggests that growth will run at 2.4% per annum between 2016 and 2018, while the PSNB is expected to gradually decline to £19.1bn in 2017-18. However, this assumes that current policies are maintained after the 2015 election, presumably.
In contrast to the MPC minutes, the SMPC report contains individual named contributions. Thus, it was significant that most SMPC members independently expressed reservations about the Bank of England’s original paper on Forward Guidance in our September 2013 report. Many of these reservations have subsequently been proved valid. In particular, the unwarranted emphasis on the Labour Force Survey (LFS) unemployment measure in the 7th August Bank document has now been replaced by a wider range of indicators. This new framework represents a de facto return to the previous, predominantly discretionary, approach. Given how difficult it is to interpret the, often flawed, official statistics, and the extent to which any set of multiple time series can generate contradictory signals, such a discretion-based approach is possibly all that can be done, even if it lacks clarity. However, the bigger picture gives rise to some serious concerns about the macroeconomic approach underlying ‘Forward Guidance II’. This is especially so when the proposals emanate from a central bank – whose prime emphasis should be on inflation control and monetary conditions – rather than from a department of industry, who might be legitimately most concerned with real activity. The emphasis in Mr Carney’s Inflation Report address was on the need to absorb the 1% to 1½% margin of slack that the Bank believes remains in the labour market. This looks disconcertingly similar to the 1960s Keynesian demand-management fine-tuning, which got the UK into such difficulties in the subsequent decade. A specific concern is that the margin of error attached to any estimate of economic slack is likely to be many times greater than the amount of slack that the Bank currently estimates is in existence.

More fundamentally, Forward Guidance II reveals a continuing faith in the US-inspired Conventional Theoretical Macroeconomic Model (CTMM) in which the output gap – however defined – plays a central role. However, the CTMM is horrendously flawed as a description of an open, trade-dependent economy, with a large government sector, and extensive financial regulations impinging on the supplies of money and credit. As a result, the CTMM is a misleading intellectual framework for central-bank decision makers. The CTMM was also responsible for the undue complacency of the US Federal Reserve and the Bank of England ahead of the financial crash, which a more traditional central bank approach would have ameliorated if not obviated (Editorial Note: the reasons were set out in David B Smith’s May 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)).
It is noteworthy also that Mr Carney hardly mentioned inflation in his Inflation Report address, apart from noting the recent undershoot. The Governor also seemed to regard the exchange rate as a nuisance variable that distorted the relationship between the output gap and inflation – rather than as a key part of the monetary transmission mechanism in an open economy – and did not mention the money supply once. Mr Carney argued that the first phase of Forward Guidance had helped the stronger pattern of activity in the second half of last year. However, an alternative explanation is that it reflected the acceleration in the annual growth of M4ex broad money from some 2¾% in the first quarter of 2012 to just over 5% or so in the first half of last year – in which case, the slowdown to 3.7% in the year to December may be a cause for concern about the continuing strength of the recovery.

If it were not for the expectations of a long period of Bank Rate stasis engendered by forward guidance, it would be unambiguously appropriate to start on a progressive but gentle process of Bank Rate normalisation, until a rate of 2% or 2½% was achieved. At that point, Bank Rate would reacquire the leverage over money-market rates that it has lost in recent years and it would be reasonable to pause for consideration. The question is whether such pre-announced modest rate increases would destabilise confidence? The two main worries where business is concerned are probably: 1) rate uncertainty in general, and 2) not knowing where lending costs could peak. On balance, it is hard to see that modest and pre-announced increases in Bank Rate to a known ceiling should be more damaging to confidence than a longer period of stasis, followed by a possibly abrupt catch-up rise in rates, perhaps after the 2015 election. Bank Rate should be raised by ¼% in March, and then increased cautiously in a pre-announced fashion, by ¼% every second month or so. Likewise, the appropriate approach to QE is to allow it to unwind gradually as stocks mature, through a process of partial re-placement, but not to be too aggressive. However, a weather eye should be kept out for M4ex broad money. Any rate recommendation would be distinctly less hawkish if the recent deceleration in its yearly growth rate, which is probably caused by the over-regulation of the financial sector discussed in previous reports, continued.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ½%.
Bias: Raise Bank Rate in stages to 2%.

In its restatement of the policy framework known as Forward Guidance, the “Monetary Policy Committee (MPC) is for the first time providing guidance that it is seeking to absorb all the spare capacity in the economy over the next two to three years.” As anticipated, the Bank of England has steered interest rate guidance away from a narrow focus on the unemployment rate, and broadened the list of variables it considers when making decisions on Bank Rate. Its new framework is based on selected indicators of labour market ‘slack’. It will maintain Bank Rate at ½% until slack is virtually eradicated. The aim is “to close the spare capacity gap over the next few years”. The MPC believes that slack within the labour market accounts for the majority of the 1 to 1½% of total slack within the economy. (At the press conference, this was phrased slightly differently, implying that the labour market accounted for all of the slack, taking account of both unemployment and underemployment.) The Inflation Report asserts that the medium-term equilibrium rate of unemployment is 6% to 6½%. On the basis of a benign forecast of inflation, the MPC asserts that “there remains scope to absorb spare capacity further before raising Bank Rate.”

It is a matter of extreme regret that the MPC is pursuing its hapless quest to define slack and ‘spare capacity’, and has placed these nebulous concepts at the heart of its decision making. In its recent Green Budget publication, the Institute for Fiscal Studies published a table of estimates of the prevailing UK output gap ranging from zero to 6%. This wide variation of opinion as to the degree of slack, if any, in the economy carries drastically different implications for policy settings.

The MPC’s difficulty in defining labour market slack gives it complete discretion to reach whatever rate decision it chooses. Slack is so riddled with measurement error that it cannot serve a practical policy purpose.

Furthermore, the empirical evidence is weak that any of the measures of slack – the amount of it – has a significant role in the determination of inflation. I concede only that an increasing degree of slack is a disinflationary force and a decreasing degree of slack, an inflationary one. Furthermore, it perpetuates the myth that UK monetary policy should be based purely on domestic considerations. Rather, policy should be modified in the light of international inflationary pressures – for example, food and energy inflation – so as to be tighter when such pressures are benign, as now, and looser when they are malign.

One of the best measures of labour market pressure is probably the change in the level of short-duration (less than six months) unemployment. This total represents people recently employed and who are likely to be readily re-engaged. There is at least some (inverse) correlation between this measure and the annual growth of real wages. The flaw in the MPC’s new framework is that it fails to recognise how much faster the economy would have to grow in order to absorb unemployed persons that have been out of work for years rather than months. To wait until all the part-time employees who would prefer full-time work have been accommodated would imply an epic dereliction of duty towards inflation.

It is high time for the taboo surrounding a Bank Rate increase to be swept away. A rise in Bank Rate would not inflict severe damage on consumer, much less business, confidence. Nor would it countermand the assistance to homebuyers that has been provided by the mortgage guarantee. The access to and cost of the best value mortgages would be undisturbed. My vote is to increase Bank Rate by ½%, with a target rate of 2% by end-2014.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Raise Bank Rate by ½% and decrease QE to £250bn.
Bias: Start to unwind QE and slowly raise Bank Rate as economy grows.

The February Bank of England Inflation Report confirms that the economy is steadily improving. Most of the signals are positive. CPI inflation fell to 1.9% in January – for the first time since the depths of the recession in 2009. All major components of inflation contributed to this development, but especially food. The easing in the price of food (much of which is imported) was, probably, itself a reflection of the appreciation of sterling.

The growth of UK non-oil real GDP in the fourth quarter of 2013 sustained its third quarter rate of 0.8%, suggesting that the recovery is likely to be sustained. Household consumption increased by 0.4% in real terms in the fourth quarter, although its annual rate of increase eased from 2.7% to 2.4%. A major contributor to consumption growth has been the continued steady recovery of durable expenditures from their nadir in 2009 and 2010. At the same time, overall household indebtedness has fallen even as the savings ratio declined and household loans increased, while the cost of credit has continued to ease. After a 2% increase in business investment in the third quarter of last year, there was a further increase of 2.4% in the fourth quarter to 8.5% up on the year. Investment intentions surveys suggest a further pick-up in the future.
The main cloud on the horizon until recently has been the poor performance of trade, with the deterioration in net exports shaving 1.1% off real GDP in the third quarter. However, exports were up 0.4% and imports were down 0.9% in 2013 Q4, adding 0.4% to GDP. Sluggish exports probably reflected the weaker growth of the Euro-zone, the 10% appreciation of sterling since last March and the 3½% appreciation of sterling since November. The trade balance is unlikely to show much improvement until the rest of the world has stronger growth.
A further positive sign is the fall in the rate of LFS unemployment close to the MPC’s policy threshold of 7%. With inflation also falling, it reinforces the historic dangers of tying monetary policy to the relation between inflation and unemployment. With unemployment having failed as the single indicator of inflation – as was widely predicted – the MPC appears to have replaced this with twenty-two indicators. The claim that such indicators add transparency to the MPC’s policy actions will be difficult to sustain. It would be wiser to continue to assume that the MPC uses discretion rather than a rule.

With the economy recovering nicely and inflation falling there is a temptation to leave monetary policy unchanged. This is, of course, what the MPC will do. Nonetheless, sooner rather than later, it will become necessary to normalise the level of interest rates and reverse QE. Although conscious of not wanting to stall a nascent recovery, I still think that the time has come to start the process of unwinding. If needed, a cover for this is the rise in the price of existing houses due to the mistaken Help to Buy scheme. At present, the Bank is claiming that it has other quantitative tools ready to use to control this rise. This is, however, a blunt instrument; price signals are better.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking and University of Derby)
Vote: Hold Bank Rate and maintain QE stock at present level.
Bias: Neutral.

UK growth is getting on to a sounder footing. The latest GDP figures for the fourth quarter of last year, published on 26th February, showed that, whilst overall growth was unrevised at 0.7%, it was no longer dependent on consumer spending. Fixed investment rose 1.1% over the quarter, adding a further 0.2% points to growth. Following the third quarter’s 2.0% rise, business investment jumped by 2.4% in the fourth quarter, with growth over the year now reported at 8.5%. However, the average growth rate in 2013 as a whole was revised down a smidgen, to 1.8% from 1.9%, because second quarter growth was revised down from 0.5% on the quarter to 0.4% (interestingly, this was the original ONS figure). The other piece of good news was that net trade contributed positively to growth for the first time since the first quarter of last year, contributing 0.4 percentage points to the overall GDP increase recorded in the quarter. However, the challenge will be to maintain this performance in the face of a stronger currency and still weak, albeit better, demand in Europe. On the negative side, although the rate of inventory accumulation slowed in 2013 Q4, its level remained high. Whilst this could be revised away in future releases – through a rise in final demand, say – the risk that some of this could be genuine, poses some downside risks to growth prospects over the coming quarters.

In terms of output, industrial production was modestly weaker than in the first estimate and is now shown to have risen by 0.5% in 2013 Q4 the same increase as in the third quarter. Whilst construction output is now estimated to have risen by 0.2% quarter on quarter, against 2.6% in the third quarter, the larger services sector growth estimate was left unchanged at 0.8%. Yet, services output was softer than suggested by the services Purchasing Managers Index (PMI) for the quarter and hence may not perform as strongly as the survey suggests in the coming quarters.

It is worth noting that, after the 26th February data release, UK GDP was still 1½% or so below its 2008 high. This compares to the US, where the level of GDP is some 7% to 8% above its pre-crisis peak, and Germany, where it is 5% above. Yet, they have not raised interest rates. With annual UK CPI inflation at 1.9% in January, and likely to either remain around 2% or fall further over the next few months, the case for an immediate rate rise remains thin. Wage inflation remains close to 1%, so real pay continues to decline, and the unemployment rate ticked up to 7.2% on the wider LFS basis in January. Pipeline price pressures also remain weak. Bank rate should remain on hold and the asset purchase facility (APF) be left unchanged at £375bn.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman until April 2014 is David B Smith (Beacon Economic Forecasting and University of Derby) after which Andrew Lilico (Europe Economics) will take over. Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Legatum Institute), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking and University of Derby). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, February 02, 2014
IEA's shadow MPC votes 6-3 for rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 14th January, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 6th February. Four SMPC members voted for a ½% increase, two members wanted an increase of ¼%, and three wanted to leave rates unaltered. This pattern of votes would deliver an increase of ¼% on normal Bank of England voting procedures.

There were several reasons why a majority of the IEA’s shadow committee wanted to raise rates now rather than wait until the recovery had gathered further momentum. The most important was the belief that starting interest rate normalisation immediately would avoid a damaging over-steer in the opposite direction at a later date. This argument was opposed by some SMPC members, however, who thought that less damage would be done by waiting than by raising rates prematurely.

The other main disagreement within the IEA’s shadow committee was over the margin of spare capacity that remained available. The SMPC’s ‘doves’ believed that ample spare resources remained. The ‘hawks’ thought that there had been a major reduction in aggregate supply as a result of the Global Financial Crash and the ‘big government’ policies implemented under Labour and only partially reversed by the Coalition.

Two general worries were that: firstly, irrationally onerous financial regulations would restrict banks’ ability to underwrite the recovery through new money and credit creation; and, second, that the financial markets could be de-stabilised by political events such as the European elections, the Scottish referendum and the prospect of a change of British government in May 2015.

Minutes of the meeting of 14th January 2014

Attendance: Philip Booth (IEA Observer), Roger Bootle, Tim Congdon, Anthony J Evans, Andrew Lilico, Kent Matthews (Secretary), Patrick Minford, David B Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.
Apologies: Jamie Dannhauser, John Greenwood, Graeme Leach, David H Smith (Sunday Times observer), Mike Wickens.

Chairman’s Statement

The Chairman announced that with his sixty-eighth birthday coming up in June, and having been a member of the SMPC for seventeen years and Chairman for eleven years – during which he had put out roughly one hundred and forty reports – that it was now time for him to retire as Chairman and make way for a younger successor. David B Smith had discussed the matter with the IEA representative, Philip Booth, ahead of that evening’s meeting. They had agreed that the best way to proceed was to hold a secret e-mail ballot of SMPC members. In the meanwhile, the Chairman said he would continue to put out the SMPC reports until his successor was in place. This would include the (current) February report and possibly the March one. After that, he would remain available but suspected that he would not be needed. Tim Congdon proposed a vote of thanks for David B Smith for his long and diligent service and noted the difficulties of gathering e-mails and contributions from people in demanding roles and with frequent international travel schedules. Others noted what an excellent job David B Smith had done in keeping the committee on its toes and really driving it forward during this time. Everyone present joined in the vote of thanks to appreciate all that David had done during his time as chairman.

David B Smith said that he wanted to place on record his thanks to the staff at Lombard Street Research who had been involved in publication of the printed minutes and e-mail polls since mid-2006, mentioning especially Pippa Courtney-Sutton and Tom Crew. He also thanked Rosa Gallo at Economic Perspectives for proof-reading the minutes every month. He added that the fact that SMPC reports had appeared monthly with near Bank of England standards of accuracy, despite the extremely tight schedules involved, represented a major achievement by the production teams concerned; especially as everything was done on an unpaid voluntary basis. He thanked the members of the SMPC for their regular submission of material for the monthly document, particularly as the work of the SMPC had not attracted the attention that it had earlier since Bank Rate had been frozen. He added that media interest was likely to revive once Bank Rate started moving again. The Chairman then invited Andrew Lilico to present his analysis of the economic situation.

Economic situation

Andrew Lilico began his presentation by drawing the meeting’s attention to a series of slides on the international economy. He noted the acceleration in economic growth in advanced economies combined with a mild slowing in the growth of the Chinese economy. The unemployment rate had been falling in the US and the UK; had been broadly flat in Japan and Germany but had been rising in France. The leading indicators compiled by the Organisation for Economic Co-operation and Development (OECD) were moderately positive for all major economies except China going into 2014. Using the OECD as the data source, there had been stable monetary growth in the US, and some pick up in Japan, but a worrying slowdown for the Euro area. Sovereign bond yields in the Euro-zone had been falling in the key contexts of Portugal and Ireland. They had been steady in Italy but yields in the US and France had risen.

Andrew Lilico then turned his attention to the behaviour of the UK economy. He began his comments by noting that UK economic growth had recovered strongly in 2013, exceeding the expectations that were held out by the broad consensus of commentators at the start of last year. According to the Bank of England, this stronger growth of GDP, which was of the order of 3% when expressed as an annualised rate, was expected to persist for some years. This was according to the projection based on market interest rate expectations and an unchanged level of asset purchases of £375bn. Confidence had increased markedly where both businesses and consumers in the UK were concerned with the point of inflection being around May or June of last year. There had been a pleasing fall in the rate of consumer price (CPI) inflation, which had dropped back to its target rate of 2% in December 2013. The Bank of England’s November Inflation Report expected inflation to remain close to this central point of 2% for the next two years with a slight bias towards higher inflation rather than lower inflation.

In the UK, there had been some pickup in broad money growth. M4 lending growth remained in negative growth territory, which had been the case for the last three years. However, the pace of decline in the total M4 broad money stock had reduced close to the zero line. During the past few months, there had been a pickup in the benchmark government bond yield in the UK of around 100 basis points (i.e., 1%). Sterling had gained ground since the spring of the year, more than recovering its early year losses.

The UK Purchasing Managers’ Indices (PMIs) for services, manufacturing and construction had all shown similarly strong trajectories through the second half of last year but with some faltering in the manufacturing index at the end of the 2013. However, taken together the UK PMIs were at their highest recorded level since the surveys began. The UK unemployment rate on the Labour Force Survey (LFS) measure had fallen to 7.4%; this was relatively close to the 7% threshold which had been instituted by the Bank of England Monetary Policy Committee (MPC) in August as part of the new framework of Forward Guidance.

Andrew then raised the question of who faced the burden of proof on UK interest rate normalisation. He noted that there was strong resistance in the media to the thought that UK Bank Rate should be raised. The Resolution Foundation had argued that two million families might struggle if Bank Rate was raised. Andrew posed the question regarding UK rates: “if not now, when?” In other words, if the conditions for beginning the process of normalising interest rates were not yet in place, what would need to change to bring that about? He reiterated his own position that the medium term risks of not raising rates were greater than the short term risks of raising them. His observation was that the output gap in the UK was closing rapidly and the failure to respond to the strongly growing output of the economy would be to risk a sharp rise in interest rates at a later date.

Discussion

The Chairman thanked Andrew for his excellent presentation. David B Smith then started the discussion rolling by observing that, in his experience of using output gap models to forecast inflation over the past few decades, the output gap approach was what translators called a ‘false friend’. In other words, it was easy to fit output gap models to historic data. However, these tended to give unstable results when used for forecasting purposes. In particular, output-gap models were unduly vulnerable to data revisions and even small changes in the estimated level of output could have major implications for the projected inflationary outlook. Patrick Minford stated that emergency monetary policy was clearly inappropriate in the light of the strengthening economy and abating inflation in the past year. He quoted a comment by a prominent supporter of regulation that “there has been a regulatory fiasco” because the response of banks to fears of escalating regulations were not factored into regulative calculations. Increasing bank regulation had been responsible for the disabling of bank asset growth and the stalemate in UK monetary policy. Patrick Minford advised a detox of regulation as a remedy. He was worried that regulation had been used to justify the persistence of very low interest rates and questioned whether it would be feasible to raise interest rate in the election year of 2015. Trevor Williams disagreed, saying that delaying the first rate rise till 2015 would not present a problem in terms of the election taking place in the summer of that year, because it could be presented as a sign of a recovering economy for which the government should take credit.

Roger Bootle responded to Andrew Lilico’s “if not now, when” challenge. His response was “quite simply: later”. Roger Bootle posed the question, to which he admitted that he was not able to find a good answer, of how serious were the losses associated with making a monetary policy mistake and having to raise monetary rates later? What might we learn from keeping interest rates low now? Roger Bootle believed that we would not see evidence of inflationary pressures reviving and was worried that, if rates were raised, this would result in a strong appreciation of Sterling which he considered an unhelpful development. Ideally, it would have been better for Sterling to be below its current level.

David B Smith pointed out that it was not inevitable that Sterling would end up stronger in the event of a rise in Bank Rate provided the public relations aspects were handled competently by the Bank of England and the Chancellor. He added that there was a risk that distortions would continue to build up in the economic system for as long as Bank Rate was being squished down. Peter Warburton believed that the ½% Bank Rate which had persisted for almost five years had acquired the status of a taboo which was a very unhealthy state of affairs for UK monetary policy. He added that to break the taboo, to have a Bank Rate rise and see that it did not have devastating effects on the economy, would be a very healthy development. At the moment, some media commentators were building up the consequences of even the smallest Bank Rate rise as being implausibly large.

Tim Congdon defended the output gap as an indicator of capacity but advocated using survey data to calibrate the most recent values of the output gap, rather than the admittedly dubious Office for National Statistics (ONS) data. He conceded that the surveys were suggesting that there was not a lot of spare capacity in the economy. However, he observed that if interest rates were too low, then surely there would be a rapid expansion of credit which he failed to see. So his willingness to wait and see on the path of the economy was guided in part by the lack of response of private sector credit growth. Regarding the stronger growth of broad money than bank credit, Tim Congdon noted the powerful impact of Quantitative Easing (QE) on the broad money aggregates. In the absence of QE, he wondered whether broad money growth would fall back. He believed that banks had been unduly kicked around by regulators. In his view, banks remained under severe pressure with the latest impositions of the leverage ratio implying a disproportionately tight regulatory stance that went beyond that required by Basel III, the international standard. The growth in banks’ risk assets was very low. Tim Congdon saw no great risk of prospective inflation and thought that it would be sensible to wait for another six months and watch the growth of broad money before taking action.

David B Smith discussed the supply side consequences of very low interest rates. He argued that the prevalence of very low interest rates was associated in time with a misallocation of capital that ultimately meant that the potential growth of the economy would be damaged. Current policies represented an undue state-backed comfort blanket for speculators – such as buy to let investors – and were teaching an entire generation that only mugs made long-term investments to provide for their future needs. Tim Congdon disagreed, arguing that, on his estimation, companies were now requiring higher target rates of return to undertake projects rather than lower.

Trevor Williams raised the issue of risk posed by the Euro-zone sovereign and banking crises. He did not believe that the crises had passed or that the convergence of peripheral European bond yields was a good indicator of resolution. He observed the situation where aggressive purchases of domestic sovereign debt by some Euro-zone banks had left their balance sheets in a more vulnerable condition than before. Philip Booth reminded the committee that 2% inflation was a target, not a floor; that the target has been hit for the first time in four years; that the UK retained one of the highest inflation rates in Europe. There was a risk in not beginning to return interest rates to normal under the current circumstances.

Kent Matthews posed the question: how will low interest rates solve the growth problem? He asked, “where is the productivity growth?” He said that the improvement in the economy had come about with zero growth in productivity. He was concerned that the increase in the size of the government sector, alongside the existence of so called ‘zombie’ firms, meant that the economy was unable to respond even in a very low interest rate environment. Firms that should be growing were unable to obtain credit and those that could only survive with cheap credit should be folding. The combination of these factors was worrying for the outlook for UK productivity. His judgment was that a small rise in interest rates would not do the damage that had been suggested by Roger Bootle.

Andrew Lilico raised the issue of nominal rigidities in the economy. At the moment, lower inflation was compatible with higher real GDP growth. However, if nominal rigidity persisted, then a return of inflation to higher ground would necessarily detract from the growth outlook. He expressed the view that there was a need for real wages to grow, having been held down for the past four years. Roger Bootle asked where the massive distortions that others had suggested existed were. He asked for concrete examples of distortions. He observed that consumer confidence was still depressed and that the balance sheets of many consumers and businesses were shot to pieces. He was concerned that a raise in interest rates would deliver a hammer blow to private sector confidence. Even if such an increase was reversed, the damage would have been done; there would not be a positive response to a reversal of higher interest rates.

Roger Bootle commented about the likelihood of recurrence of a Euro-zone crisis describing the attitude to the upcoming European elections as rather odd. He noted that in the UK, in France and in the Netherlands there were expectations of protest parties gaining ground – e.g., UKIP in the UK and the Nationalist movement of Marine Le Pen in France. Philip Booth countered that regardless of whether interest rates were raised and then had to be lowered again, or whether they were held at levels that were too low for too long and then had to be raised rapidly, there would be costs. It was true that raising rates prematurely had costs. However, so would the rapid rise in rates that would follow later on if they were artificially suppressed for too long. Philip Booth next asked why Lloyds Bank and other UK banks did not place their Euro-zone loans into subsidiaries in order to insulate their balance sheets from the potential impact of a recurrence of a Euro-zone crisis. Trevor Williams responded that UK banks had extricated themselves from Euro-zone exposure to a large extent and that this would not serve any useful purpose, in his opinion.

Anthony Evans joined the discussion arguing that there was a difficulty, he felt, in offering a view on interest rates without being able to accompany that with a communication strategy. His point was that to read that the SMPC supported a rise in interest rates, to read that in isolation (and in conjunction with the communication strategy of the MPC) may be thought to have a jarring impact on the economy. Nevertheless, SMPC members who wished to vote for a rise should not be constrained by the communication strategy of the MPC, and if the basis of this decision had been made over a period of time then this would not be a shock.

Trevor Williams expressed the opinion that the UK ‘natural’ rate of unemployment (NAIRU) was not 7% on the Labour Force Survey (LFS) measure but quite a bit lower, possibly 5.5% to 6%. Therefore, he did not see a risk from continuing with the policy of ½% Bank Rate because unemployment had scope to fall further before being associated with an inflationary condition. Akos Valentinyi talked about the unusual nature of the recession and the difficulty in assessing the risks on both sides of the decision. He felt there were three reasons still to raise rates: first of all that asset prices were elevated and that there was a risk of instability if interest rates were kept too low; secondly, there was an expectations argument and he spoke about the impact of US tapering on rates in the UK; thirdly, he thought another reason to raise rates was the absence of ’credit cleansing’ so far, which was one possible reason for depressed productivity growth.

Tim Congdon countered that he did not regard the existence of so called zombie companies to be a valid argument for raising interest rates. In his view, bygones were bygones and that these companies should be allowed to live, provided that the variable costs of production were being covered. Trevor Williams agreed that, in many cases, insolvent or nearly insolvent companies could be nursed back to health with the help of the specialist restructuring teams operated by the banks. Andrew Lilico said that he felt the burden of proof was still with those who did not want to raise rates to state what would be the conditions that caused them to change their minds. Tim Congdon’s response was he would like to see six months of ½% per month increases in broad money. Roger Bootle said he would like to see evidence of a pickup of wage inflation above that of price inflation.

Peter Warburton offered, as an example of the distortion that Roger Bootle had been seeking, that the concentration of corporate balance sheets towards debt had been an unwelcome development and one that was potentially damaging to the stability of companies in the future. He argued that the low interest rates available to larger companies in the capital markets had induced them to take on more debt which had been used primarily to retire equity rather than to finance capital spending or other aspects of business growth. Andrew Lilico argued that there was an opportunity cost to allowing zombie companies to continue in operation; that if their assets were liquidated then they could be redeployed in more profitable uses. Roger Bootle maintained that the instances of distortions were weak and vague. He added that Alfred Marshall had claimed that an argument was not convincing if we could not give examples of a phenomenon. Roger Bootle argued that distortions arose from the crisis as well as from the policies. He averred that the outlook for inflation was still to fall with weak pipeline pressures on producer prices, subdued intentions of producers to raise prices.

David B Smith raised the issue of the apparent discontinuity in UK private fixed capital formation. He said that he had recently completely re-estimated his Beacon Economic Forecasting (BEF) macroeconomic forecasting model using the new 2010 based national accounts data (the latest manual describing the BEF model is available on request from xxxbeaconxxx@btinternet.com). As part of this process, he had used a post 2008 Q4 ‘dummy variable’ to try and quantify the effects of the Global Financial Crash – there were now enough post-crash observations for this to be statistically reasonable. He added that in many cases, including the relationships for the volume of household consumption, real exports and stock building there had been no indication of a structural break.

However, there appeared to have been a negative post-crash break of around 28.5% in the equations for the determination of aggregate UK private investment, after allowing for all the obvious other factors at work, such as activity, real interest rates, taxes etc. He had no clear explanation for this phenomenon; but increased political risk, the need to top up company pension schemes and increased risk aversion were all possible factors. However, a sustained reduction in private capital formation would be associated with a marked slowdown in technical progress and, hence, productivity growth in a post-neoclassical endogenous growth model, and so might help explain Britain’s poor productivity performance and unexpectedly strong demand for labour in recent years.

Peter Warburton disagreed with Roger Bootle on both the UK and global inflation outlook arguing that favourable supply side factors had greatly influenced the evolution of inflation in the past two years, notably in energy prices and food prices; and that these positive influences could not be relied upon to continue.

The Chairman then moved to request that votes were taken of the meeting. He added that the IEA observer Philip Booth would not be co-opted on this occasion because ten full SMPC members had been present. Kent Matthews had been obliged to leave the meeting early, to catch a flight to Hong Kong, and had generously volunteered to abstain from the poll. If had been able to vote, Kent Matthews would have advocated a rise of ¼% in Bank Rate and had a bias to raise Bank Rate further in a series of short steps. It was his view that the Bank of England still had QE in its armoury and that this weapon could always be deployed independently of Bank Rate if the Euro-zone crisis flared up again.

Kent Matthews had added that monetary policy was only a short-term measure which could not be expected to solve the low productivity of the British economy. That would require more fundamental changes involving the size of the state sector, taxation and the reallocation of credit. For this process to begin, real interest rates needed to get back to a normal level. In accordance with normal SMPC practice, the votes taken into consideration are listed alphabetically below.

Comment by Roger Bootle
(Capital Economics Ltd)
Vote: Hold Bank Rate.
Bias: Neutral.

Roger Bootle stated that his preference – in view of what he perceived to be weak inflation pressures – was to wait and see where Bank Rate was concerned and to accept the risk that interest rates might have to rise faster later on.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate.
Bias: Neutral.

Tim Congdon commenced his remarks by stating that, as ever, his comment was motivated by the guiding principle that the equilibrium values of national income (in nominal terms) was a function of the quantity of money. By the latter, he meant a measure that embraced all money balances and was dominated by bank deposits. In more down-to-earth terms, the rate of change in the UK’s nominal GDP, and hence in its inflation rate, was closely related over the medium term to the rate of change in the M4ex money aggregate.
In the three months to November, the annualised rate of increase in M4ex was 4.9%; in the year to November M4ex rose by 4.4%. In the context of virtually zero short-term interest rates and moderating inflation, these rates of money growth had been consistent with strong asset price advances and a healthy recovery in demand in recent quarters. However, continuing QE operations until September 2013 had been vital to maintaining money growth at a 4% to 5% annual rate. The MPC had not changed its policy on QE since late 2012, but QE operations to boost the quantity of money had remained in force until quite recently. Banks in the UK were still not growing risk assets. Talk of ‘a credit boom due to low interest rates’ was bunkum. Thus, in the three months to November, the M4exL total – i.e., lending to the private sector, excluding intermediate other financial corporations, by UK banks and building societies – barely changed, with the three-month annualised rate of increase a mere 0.5%. Within this, lending to households, on the same definition, had a three-month annualised rate of increase of 1.7%.

He added that he did not agree with Mark Carney that the UK had abundant unused spare capacity at present. Tim Congdon even feared that – because of such interventions as auto-enrolment and yet more labour market regulations from the European Union – the natural rate of unemployment was above 7%. However, for the moment his main worry was that money growth would fade, because the banks remain very much under the cosh of ever-tightening regulation. This judgement might prove a mistake and he would readily admit that was the case – if we saw M4ex rising by ½% or so a month in 2014 without the crutch of the QE operations. However, for now, he would like Bank Rate to be kept at ½% and he was far from persuaded that the UK recovery had a self-sustaining momentum.

Comment by Anthony J Evans
(ESCP Europe)
Vote: Raise Bank Rate by ½%.
Bias: Neutral.

Anthony Evans said that he wanted to accompany his vote for a ½% increase in Bank Rate by emphasising the need for a clearer communications strategy on the part of the Bank of England that expressed a clearer understanding of the circumstances in which the official REPO rate would be raised.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no change to QE.
Bias: Raise Bank Rate further.

Andrew Lilico said that he could only repeat the views set out in his economic background presentation that the medium-term risks of not raising rates were greater than the short-term risks of raising them. Despite all the practical measurement problems involved, the output gap in the UK appeared to be closing rapidly. The failure to respond to the strongly growing output of the economy would be to risk a sharp rise in interest rates at a later date, in Andrew Lilico’s view, particularly as the preliminary ONS data frequently tended to understate the strength of activity in the recovery phase.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate.

Patrick Minford voted for a ½% increase in Bank Rate but added that there was scope for the Bank of England to add to its stock of purchases of assets as a means of bolstering the growth of the money supply. Patrick Minford had a bias to raise rates further and continue the process of normalisation.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ¼%; QE to be run off gradually as debt matures.
Bias: Bank Rate to be cautiously raised to 2% before pausing.

David B Smith expressed the view that Forward Guidance had turned out to be a rod for the MPC’s own back in the sense that Forward Guidance had made it more difficult to raise interest rates in response to changing circumstances. However, we were where we were and the ‘false consciousness’ created by forward guidance – i.e., that Bank Rate would not be raised for a long period of time – made it difficult to tighten monetary policy without delivering a severe psychological shock to the borrowing classes. As a consequence, he wanted to proceed carefully in tightening, possibly with pre-announced steps of ¼% increases every second month or so until a level of 2% Bank Rate was reached. He reiterated that it was wrong to regard a strong currency as an unambiguously negative factor for growth. The evidence suggested that any detriment to net exports would be more than offset by the increased living standards associated with the lower price level, in his view.

David B Smith expected CPI inflation to ease further in 2014 – probably to 1½% to 1¾% by the fourth quarter – but to pick up again moderately in 2015. He believed that the UK patient was gradually coming round from the cranial trauma caused by the Global Financial Crash – and the second sandbagging caused by Mr Osborne’s perverse 2010 tax hikes – but that there was an urgent need for supply side measures to consolidate the recovery. The fiscal background was not as healthy as it appeared, and there were looming political risks that could de-stabilise business confidence, sterling and the gilt-edged market. Not only was there the EU election, referred to by Roger Bootle, but also the Scottish Referendum in September. Furthermore, he suspected that the financial markets would begin to discount the 2015 UK general election at least a year in advance (i.e., within a very few months).

He was apprehensive that the Labour leader’s Hugo Chavez-style rhetoric meant that business people were already becoming reluctant to invest – because of the future political and regulatory risks associated with a change of government – and that neither the foreign exchange markets nor bond investors would welcome the prospect of a Labour government (or a potentially fiscally improvident Lib-Lab coalition) being formed after May 2015. The political parallels seemed closer to the period 1974 to 1976, ahead of the December 1976 International Monetary Fund (IMF) loan, than they did to the arrival of the ostentatiously, albeit only ostensibly, moderate New Labour government in 1997.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: Neutral.

Akos Valentinyi believed that there should be a slow return to more normal levels of interest rates. He also believed that keeping Bank Rate too low for too long carried the greater risk than sitting on Bank Rate for the indefinite future.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate.

Peter Warburton argued that it was already the case that interest rates should have been raised and that now a more urgent pace of increase was appropriate in view of the recovery of the mortgage credit market, the strong growth of employment and indications that wage inflation was at last responding to improved economic circumstances. While the strength of Sterling was currently acting as a break on domestic inflationary pressures, this could not be relied upon to continue.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking and University of Derby)
Vote: Hold Bank Rate.
Bias: Neutral on Bank Rate; leave the amount of QE at current level.

Trevor Williams supported a policy of gradually depleting the level of QE through redemptions. He believed the growth of money supply was still too weak to be confident about the recovery and particularly that the pace of bank lending growth was insufficient. He argued that the high level of repayment of corporate debt was due to a lack of productivity. He did not see signs of inflation pressure in the near term. He remained concerned about deflationary risks emanating from the Euro-zone. In conclusion, he believed there was plenty of time to raise UK interest rates without taking a risk with inflation. It was better to ensure that the recovery was firmly grounded first, before contemplating a rate hike.

Policy response

1. On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in February. The other three members wished to hold.

2. There was some modest disagreement amongst the rate hikers as to the precise extent to which rates should rise. Four voted for an immediate rise of ½% but two members wanted a more modest rate rise of ¼%.

3. Four of those who voted to raise rates expressed a bias to raise rates further, while five shadow committee members had a neutral bias where the months beyond February were concerned.

Date of next meeting
Tuesday 15th April 2014.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking and University of Derby). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, January 05, 2014
Shadow MPC votes 6-3 for January rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, finalised on 2nd January, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 9th January.

Four shadow committee members wanted a ½% increase and two SMPC members voted for a rise of ¼%, while three wished to leave rates unaltered. This pattern of votes would deliver an increase of ¼% on the usual Bank of England voting procedures.

Despite the split vote, there was considerable agreement amongst the SMPC members that the British economy had picked itself up off the floor at last and that growth prospects for the next year or so were reasonable. Several individuals mentioned the upwards revisions to UK national output published just before Christmas. These suggest that the economy expanded by 1.9% on average last year, rather than the 1.4% which had previously seemed likely.

However, there was also concern that the dismal third quarter balance of payments figures released alongside the GDP figures indicated that home demand was running ahead of potential supply. Nevertheless, the immediate inflation outlook seemed reasonable, with some prospect of a further easing during 2014. The essential splits between Hawks and Doves were over the margin of spare capacity still available and how far it was urgent to commence the process of normalising real interest rates.

There was also concern that forward guidance made it difficult for the Bank to act pre-emptively when the economic situation suddenly changed. Several committee members independently warned about the risks to the recovery posed by potentially over-zealous financial regulation.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate.
Bias: Hold Bank Rate for next few months, while remaining open to another round of QE if demand weakens.

The UK is enjoying a relatively benign macroeconomic situation at present, certainly compared to some of its European neighbours. 2014 will see necessary and overdue measures to curb public expenditure. Easy money conditions (i.e., a positive rate of money growth as well as zero interest rates) are therefore appropriate to ensure that, for the public and private sectors combined, demand, output and employment keep on rising. Inflation is in line with target and underlying upward pressures on labour costs are very weak.

The main features of the monetary landscape are similar to those since the start of the Great Recession in 2007, including officialdom’s obtuseness about the causes of the economic and financial malaise from which we continue to suffer. Central bankers and financial regulators still believe that an increase in banks’ capital/asset ratios contributes to the health, wealth and happiness of nations, when in fact the result of the move to higher capital/asset ratios has been an intense squeeze on bank credit to the private sector. That squeeze has in turn restrained the growth of banks’ deposit liabilities (i.e., ‘the quantity of money’, as usually understood) and so been the dominant explanation for the prolonged weakness of nominal GDP.

However, UK inflation is under better control now than for most of the period since the start of the semi-recovery in late 2009. The consumer price index rose by 2.1% in the year to November, almost bang in line with target. According to the December survey from the Confederation of British Industry (CBI), a net balance of only 11% of companies plan to raise prices in the next three months, lower than a year ago, while upward pressures on costs are much weaker than – say – three years ago. Inflation could drop beneath target in early 2014.

Monetary policy must be forward-looking. The current better news on inflation therefore does not necessarily invalidate calls for a tightening of monetary policy. The argument against monetary tightening can be presented on quite different grounds, that the rate of money growth may be about to decelerate in the main countries, including the UK. 2013 saw positive money growth in the USA, the Eurozone, Japan and the UK, but not at high rates, and in three of these jurisdictions (the USA, the UK and Japan) the main force behind the expansion of banks’ deposit liabilities was the increase in their cash reserves due to so-called Quantitative Easing (QE). This has now been halted in the UK and is being ‘tapered’ in the US. Amazingly (and foolishly), regulators in the Eurozone are about to have another go at ‘tidying-up bank balance sheets’, meaning that credit and money growth will be negligible there in early 2014.

With the possible exception of Japan (where broad money growth is now running about 1% to 2% a year higher – and only 1% to 2% a year higher – than in the Great Recession), the prospect is for a fall in the rate of money growth and perhaps even a return to money stagnation. As at the end of 2010, I favour “keeping base rates at zero at least for the next few months, while remaining open to the need for another round of quantitative easing if demand is weaker than expected”.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

As we head into 2014, the UK economy is growing solidly. The latest figures from the Office for National Statistics (ONS) left output growth in the third quarter of last year unchanged, but past data were revised up. Real GDP is now estimated to have expanded by 1.9% over the last four quarters, up from 1.5% in the previous ONS National Accounts release. Equivalent figures for non-oil output are 2.1% and 1.6% (for current and previously published data). On the demand-side, higher consumer spending explains the majority of the upwards revisions. Business investment, disappointingly, remains weak, however; although it is now thought to have increased by 3.5% in the third quarter, it is still more than 2% off its end-2012 level.

Business surveys suggest the economy heated up over the autumn. Output growth in excess of 1% in the current and coming quarter is possible, although other indicators suggest a more modest pace of growth. For instance, retail sales volumes in October and November were actually below their third quarter average. On balance, though, above-trend growth is likely to persist in the near-term.

The inflation back-drop is benign. Headline CPI inflation, at 2.1% in November, would in fact be slightly below the Bank’s 2% target were it not for the entirely artificial effect of higher university tuition fees. ‘Core’ inflation is currently around 1½%. Although the recent decline in petrol prices has played a role in capping inflation, underlying price pressures remain limited in the UK, a reflection of the spare capacity that exists primarily in the labour market but also within firms themselves.

Were this a normal cycle, a strong case could be made for a withdrawal of monetary stimulus at this point. Indeed, the exceptional monetary measures currently in place would need to be unwound quickly. However, this is not a normal cycle, either domestically or globally. The major financial imbalances that led to the 2008/9 banking crash have not been fully resolved. It could be some while before the world economy returns to solid, sustainable growth, and en-route much could still go wrong, most obviously in Britain’s main trading partner, the Euro area.

Domestically, the recovery is not assured. For the moment, it is unduly dependent on consumption – both household and government – and a rapid upswing in house prices. Business sentiment is improving, but global events could easily reverse this trend and stymie the necessary rebalancing of activity towards tradable sectors.

Most importantly, the UK economy has plenty of scope to operate at growth rates above historic norms before slack is used up. Although spare capacity within companies is less obvious than that in the labour market, it seems highly unlikely that it has disappeared entirely, as some surveys would seem to imply. Persistently sluggish demand is likely to have impinged, most probably temporarily, firms’ effective supply capacity, giving another reason for monetary policy to err on the side of doing too much. As a cross-check, moderate rates of broad money growth – and still disappointing nominal GDP growth – do not suggest that monetary activism has done its job and should be scaled back.

Comment by Anthony J Evans
(ESCP Europe)
Vote: Raise Bank Rate by ½%.
Bias: Further rises in Bank Rate
.

The UK economy continues to grow at a rate that divides commentators. Some believe that this is a long overdue recovery, whilst others are concerned that it is unsustainable. Either way, there is a case for the Bank of England to raise interest rates now. If the economy is as strong as the headline GDP figures suggest, and given the fact that inflation is above target, the case for rate rises is obvious. In fact, the main reason against is a fear of the unknown brought about by a dangerously long commitment to low interest rates. Even if the economy is unbalanced, a rate rise may be sensible. Low interest rates can inhibit growth as well as stimulate it, and generate misallocations of capital. If capital remains in underproductive uses, then rate rises are a normal part of the adjustment process. The Bank of England have provided some worrying projections about how higher rates would affect mortgage costs for typical UK households. One of the key reasons against low rates is that it incentivises borrowers to take on unserviceable debts. Undoubtedly, rate rises will cause pressure on over extended firms and households, especially if they run ahead of increases in real incomes. However, this is a reason for having a clear strategy of getting rates back to normal levels, rather than kicking the can down the road.

Forward guidance is intended to reduce uncertainty. The fact that it contains specified thresholds gives the appearance of a clear rule that binds the central bank. On the other hand, it also has the potential to increase uncertainty if it is deployed in a discretionary way. The UK growth rate continues to run at an above-expected rate, with real GDP for the third quarter being revised up from 1.5% to 1.9% (compared to the same quarter of the previous year). When the Bank of England chose 7% as the unemployment threshold that would need to be breached prior to interest rates being raised, they forecast that this would occur in 2016. In a matter of months, this has been brought forward to 2014 with some commentators predicting it to be imminent. However, instead of forward guidance being a way for markets to anticipate interest rate rises, the Bank seem more likely to simply shift the goalposts. Instead of being used to communicate the conditions under which a rate rise would be necessary, it is being used as a tool to convince markets that rates will be kept lower for longer than current expectations.

Inflation has finally returned close to target, but inflation expectations and various forecasts suggest that this will be temporary. The conditions within the economy have changed from sluggish growth and above target inflation (which, incidentally, suggests that the problems are supply side rather than a result of inadequate monetary stimulus), to quite rapid growth and declining inflation. This is another problem with forward guidance, because it was implemented and designed for different economic conditions to the present.

Broad money remains consistently above 4% growth, when compared to the previous year, and narrow money has spiked in recent months, with some measures showing a rise from a steady rate of 7% to 8% since April 2013, to 13% in October. This supports the idea that a shortfall of aggregate demand may have contributed to the 2009 recession, but is no longer a major problem. Bank rate is too low at present, and the current conditions offer an opportunity to start the process of raising rates. It would be very dangerous to leave this until it is too late.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate further and to hold QE.

We are in the midst of an interesting monetarist/creditist experiment. Broad money has been ticking along at an annual pace of around 4½% for around a year on the Bank of England’s preferred M4ex measure. This is probably around 1.5% to 2% faster than is compatible with a 2% inflation target over the medium term if the sustainable growth rate of GDP is 1.5% to 2%. Simplifying, one would expect that monetary excess initially to drive above-trend growth and then, with a lag, a rise in inflation to 3.5% to 4% on a monetarist account. In contrast, the equivalent broad measure of bank lending has been in annual contraction for the past year, having been growing modestly in 2011 and 2012. Again over-simplifying, one would expect such a contraction in lending growth to be associated with a slowdown in GDP growth or even further recession on a creditist account.

It can now be said with confidence that no material acceleration in lending growth was required for healthy UK GDP growth to return. However, that does not mean that there will not be an eventual pick-up in lending as GDP continues to grow. As bank balance sheets appear healthier, at least temporarily, with faster income and wage growth, banks will become more willing to lend. A more rapid rate of lending growth should be anticipated as a second-round effect of faster GDP growth, feeding a further phase of yet faster broad money growth. Similarly, as GDP growth becomes embedded, investment projects foregone during the extended depression will be delayed no longer – the fact that investment has not accelerated that much yet does not bode ill for future growth prospects; quite the reverse. Indeed, we can expect a second-round effect upon investment, also, as faster monetary growth creates a greater likelihood of inflation down the line, driving investors out of fixed income assets – which offer poor inflation protection – and into real assets such as shares and machines. Thus, GDP growth becomes self-feeding for a time.

It is plausible that such a self-feeding cycle could even persist in the face of significant international headwinds. Perhaps the Syrian situation will deteriorate further, putting pressure on oil prices. Perhaps Greece will default on official sector creditors and Portugal default on private sector creditors. Such scenarios remain significant possibilities. Nevertheless, the UK’s internal monetary momentum is now sufficient that, short of major further Eurozone problems, such as a material risk of Italy or Germany leaving the Euro, we should expect the internal UK scenario to play out largely independently of international events. Solid GDP growth should drive a further phase of lending and investment growth, followed by rapid wage growth, overheating, and a spike in inflation in 2015 to 2017.

The Bank of England has clearly set its face against any attempt to curtail inflation until UK GDP growth allows us comfortably to achieve escape velocity from the Great Recession. The MPC will not raise interest rates until households and banks have experienced sufficient income and wage growth for an interest rate rise not to cause the liquidation of bad debts accumulated in the years from 2000 to 2007. Survey evidence now suggests more than a million households might default with only modest interest rate rises. If six years of depression have not been sufficient for such households to correct their finances, will they ever really do so? Policy has evolved from moral hazard to fool’s errand. Clearly, policymakers are now willing to tolerate inflation rising again, and all that entails. It is already far too late. However, one can only recommend making the best of a bad lot from the present position. From where we are placed now, raising interest rates by ½%, and quite rapidly returning them to 2% before pausing to take stock, continues to be the sensible option.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To steadily raise Bank Rate; QE to be cut back at the rate of £25bn per quarter.

Credit has at last started to flow again. So far, it is just the mortgage market but confidence is likely to spread to business investment soon, which so far has been held back by uncertainty and a shortage of credit. The politics of growth has taken hold, with an election soon and a new Governor of the Bank who is a much-needed pragmatic realist. For the new banking era, we need a new philosophy of regulation that is concerned; administered by Bank experts, and harks back to an earlier age of competition and self-regulation. We have to update the vision of practical economists like Bagehot.

At present, there are still huge risks from over-regulation. The naïve politicised enthusiasm of the regulators has interacted with fears of the bankers to shrink bank balance sheets sharply. This must stop. Nevertheless it is clear from the new Governor’s statements that the ‘Taliban tendency’ has been put to flight within the Bank. The need is now for monetary policy to take over the heavy counter-cyclical regulation of credit conditions; money supply and credit growth must be paid attention to again.

Looking at the outlook against this background, it is at last possible to be reasonably optimistic. We may now start to see credit flowing to business and Small and Medium Enterprises (SMEs) in particular, as the banks respond to the greater certainty in the environment. Large businesses are flush with cash and should now start to look at investment plans for the growth ahead. Small firms may do their necessary cheeky work of snatching victory from in front of their lethargic paws. Entrepreneurial Britain may be waking up again.

With world commodity prices falling – and oil prices steady under the impact of shale oil and gas, reflecting the slowing of the emerging countries as well as new technology and discovery – the background for some growth in real disposable income is there too. It has been growing slowly; it should gather speed, as real wages start to pick up with a tightening labour market. The stage is also set for some tightening of monetary policy once credit growth picks up; interest rates should be raised and QE start to be reversed. My vote is to raise Bank Rate by ¼% in December, with a bias to raise it steadily thereafter. The existing stock of QE should also be cut back in a steady phased manner, at a rate of £25bn per quarter.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: Avoid regulatory shocks; aggressively break up state-dependent banks; raise Bank Rate to 2% to 2½%, and gradually run off QE
.

The upwards revisions to the UK GDP data released on 20th December – together with the accompanying poor balance of payments figures for 2013 Q3 – have altered substantially the accepted view of the British economic situation. In particular, UK economic activity is now known to have been stronger than was previously believed, while the £10bn deficit on net exports recorded in the third quarter – and £20.7bn overall current account deficit during the same period – suggest that home demand is running well ahead of potential supply.

None of this will surprise people who can recall previous UK boom/bust business cycles. Almost without exception, the underlying strength of activity in previous upswings became manifest in the form of upwards revisions rather than in the initial official data and excess home demand became apparent in a worsening in net trade well before its inflationary consequences appeared. However, it strengthens the argument that the Bank of England is ‘behind the curve’ where UK interest rates are concerned. The late Lord George once commented that “a stitch in time saves nine”, by which he meant a 9% Bank Rate. Nobody is anticipating such an eventuality currently. However, the principal involved, that it is better to make rate adjustments early and pre-emptively rather than late and reactively is the antithesis of the forward guidance approach. Forward guiders believe that a commitment to hold rates encourages a strong recovery. However, that begs the question of what happens when the strength of the recovery catches the authorities unaware, perhaps because it appears in the form of data revisions.

In the light of the revised GDP data, which introduced revisions back to 2012 Q1 and added 0.6 percentage points to the level of activity in the third quarter of last year – i.e., significantly narrowing the output gap, for those who believe in that concept – it now looks as if market-price UK GDP grew by 1.9% in 2013, rather than the 1.4% previously expected as the consensus figure. However, upgrading the base does not necessarily imply faster growth in future, because of the reduced scope for ‘catch up’ growth as activity closes in on its underlying trend. Furthermore, the fact that the deterioration in real net exports reduced real GDP by 1.3 percentage points between the second and third quarters suggests that the country still faces acute supply-side limitations. In addition, Britain’s small and open economy means that the growth of UK GDP moves closely with that of the Organisation for Economic Co-operation and Development (OECD) as a whole. As a consequence, it is unlikely that the UK can flourish if the outside world faces difficulties. The latest Beacon Economic Forecasting (BEF) projections, which incorporate the various pre-Christmas ONS data releases, suggest that UK growth will average 2.4% this year, before reaching a peak of 2.8% in the election year of 2015, and the decelerating into the 2% to 2.5% range from 2016 onwards (the forecast horizon terminates in 2024). The anticipated rundown of North Sea oil and gas production means that the non-oil basic price measure of UK GDP is expected to grow by 2.6% this year, 2.9% next year, and 2.5% in 2016, compared with the 2% believed to have been recorded in 2013.

These forecasts imply that the lost output (compared to previous trends) of the post-2008 ‘Great Recession’ is a bygone and will never be reclaimed. Nevertheless, the immediate prospects do not look too bad for a mature industrial economy provided that the September Scottish referendum does not produce a vote for independence and current policies are maintained after the May 2015 general election. Mr Miliband’s commitment to 1970s style interventionist policies, apparent indifference to private property rights and populist anti-business rhetoric suggest that the financial markets would not give any benefit of the doubt to a new Labour government, or a putative big-spending Lib/Lab coalition. This could prove a major problem for a government which would probably be facing twin deficits on the current account balance of payments and Public Sector Net Borrowing (PSNB) of the order of 4½% of GDP in 2015. As a result, a 1969 or 1976 style fiscal stabilisation crisis cannot be ruled out next year, even if the prospects for 2014 are more favourable than they have been for some time.

One reason for concern about the prospects after May 2015 is that Mr Osborne has done sufficient to keep the government spending juggernaut on the road but has chickened out of the bold supply-side measures and tax-reforms required to give Britain a reasonable growth of productive potential in the long run, albeit for comprehensible political reasons. Furthermore, while the Chancellor’s delivery of his December Autumn Statement represented a minor political triumph, the detailed numbers given in the Annex tables on the Office for Budget Responsibility (OBR) website suggest that the politicians’ old favourite ‘Rosy Scenario’ is back on the scene with a vengeance. Between 2013 Q4, when the OBR forecasts commence, and 2019 Q1 (when they end), the official forecasts show the volume of general government consumption – which accounts for roughly one half of total general government expenditure – falling by a total of 5.3% and its cost easing by 1.3% during a period in which the volume of tax-rich household consumption is forecast to rise by 13% and its price by 11.2%. During the same period, the volume of general government investment is expected to rise by 7.1%, according to the OBR, while real business investment is projected to rise by 50.2% and private dwellings by 59.9%. Likewise, the cost of general government investment is forecast to decline by a total of 2% between 2013 Q4 and 2019 Q1, while the price deflator for all fixed investment (including by government) is forecast to rise by 8.3%. Some of these trends, which may reflect the implementation of tighter administrative controls since 2010, are present in the latest BEF projections. However, the longer term outlook for the public finances is dependent on the compounding effects of these OBR forecasts over the next half decade. It is surprising that there has not been more questioning of the Chancellor’s Autumn Statement forecasts for public borrowing as a consequence.

However, the recovery in the external value of sterling, when combined with a reasonably benign outlook for international inflation, suggests that there is scope for the annual increase in the CPI to ease further from the 2.1% recorded in the year to November to, perhaps, 1.5% in the final quarter of this year, before picking up to 2% in late 2015 and 2.2% in late 2016. This sort of inflation performance would also be consistent with the unchanged 4.4% annual rise in M4ex broad money in the year to November. Other inflation indicators, such as ‘core’ producer output prices, which increased by 0.7% in the year to November, and average earnings (where total pay rose by 0.9% in the four quarters ending in August to October) confirm that the immediate inflation outlook remains benign. Also, there may be a self-reinforcing element. Reduced inflation in the UK means that the real interest rate gap between Britain and the rest of the world is less negative than it was. This is likely to add to the attractions of holding sterling assets and possibly strengthen the pound slightly further, which should further help the disinflation process.

Against this inflation outlook, it is reasonable to ask why a rate increase is still needed. One reason is that, in terms of the European Central Bank’s ‘second pillar’ approach, there are already signs that a monetary tightening is required to maintain longer run financial stability. One such indicator is house prices, where the ONS measure increased by 5.5% in the year to October. Another is the Divisia money measure, which rose by 8.4% in the year to November (or 9.4% excluding other financial corporations). Further reasons for wanting to raise Bank Rate include: a simple desire to normalise rates now that the immediate crisis has passed; the continued tightening in the demand for labour; the continued leakage of excess home demand into the trade deficit, and the 13.4% increase in the Financial Times All Share Index in the year to December – which acts as a longer leading indicator of activity, arguably. Finally, there is the likelihood that economic distortions will continue to build up in the real economy while current policies persist, leading to a cumulative supply-sapping misallocation of the factors of production. The main reasons for not being even more pro-active by advocating a Bank Rate hike of ½%, or more, in January are twofold. First, for the authorities to go back on forward guidance so soon might inflict a needlessly damaging blow to confidence. Second, there has been the recent strength of sterling, with the trade-weighted index standing at 85.0 (January 2005=100) on 2nd January. My vote is for Bank Rate to be raised by ¼% in January 2014 and then to be raised cautiously in a pre-announced fashion, by ¼% increases every second month or so until it is in the 2% to 2½% range, after which a pause for re-consideration might be desirable. Likewise, the appropriate approach to QE is to allow it to gradually unwind as stocks mature, through a process of partial re-placement, but not to attempt anything too aggressive.

Finally, it cannot be emphasised too often that excessively onerous financial regulation can have major adverse consequences for the monetary aggregates, the supply of bank credit and the wider economy. For the recovery to continue and mature, it is essential that it is not derailed by imperialistic regulatory officials attempting to gold-plate financial regulation to the point where the recent recovery in monetary growth is put into reverse.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ½%; rebalance QE from gilts to securitised private sector assets.
Bias: To raise Bank Rate.

Forward guidance, far from unifying policy committees, leaves them more divided. Within a short while, it has become clear that there were disagreements among members of the MPC over the choice of threshold variables (unemployment rate, inflation rate forecast and inflation expectations) and the extent to which the breaching of thresholds should be regarded as a trigger for policy change. All that remains of Bank of England monetary policy is a form of calendar guidance, whereby the MPC influences Sterling interest rate markets through its indications that Bank Rate will not be raised for some considerable period, regardless of the real GDP growth rate, the unemployment rate, the inflation rate, or measures of inflation expectations.

A succession of strong readings for UK economic activity has culminated in near-term expectations of a 4% annualised growth rate for GDP. On most definitions, this would qualify as ‘escape velocity’, and would signal to the market an unwinding of extremely easy monetary conditions. While no UK policymaker has explicitly advocated a ‘lower for longer’ interest rate strategy – unlike in the US – this is the implicit message that governor Carney has conveyed. Data-dependence is a fig leaf for ‘lower-for-longer’. However, my expectation is that the pressures on the Bank of England to tighten will soon become unbearable. It is probable that the Labour Force Survey (LFS) unemployment rate will drop to, or below, 7% by July 2014 and that the first Bank Rate rise will occur in August 2014.

This rate rise would have already occurred if the MPC had been acting responsibly in relation to its mandate. The compound annual inflation rate over the past five years has been 3%, not 2%. The recovery of monetary growth, house prices and economic activity in recent months has provided all the evidence necessary for the Bank to begin the withdrawal from ½% Bank Rate. Remarkably, a recent public opinion survey (YouGov) found a majority of respondents agreeing that their personal finances would be favoured by a rise in interest rates.

It is high time for the interest rate rise taboo to be swept away. A rise in Bank Rate would not inflict severe damage on consumer, much less business, confidence. Nor would it countermand the assistance to homebuyers that has been provided by the mortgage guarantee. The access to and cost of the best value mortgages would be undisturbed. The delay in raising rates means that my vote is to increase Bank Rate by ½% in January, with a target rate of 2% by end-2014. Regarding QE, it is time for the Bank of England to announce a schedule of gilt sales from its hoard, beginning with issues where it holds more than 40% of the total amount. Initially, the proceeds could be used to purchase private sector assets, such as securitised infrastructure or commercial property assets.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Raise Bank Rate by ½% and decrease QE to £250bn.
Bias: Start to unwind QE and slowly raise interest rates as the economy grows.

With the recovery of the UK now an accepted fact - and not just a prediction by economists supporting ‘Plan A’ - the time has come to consider the likely future path of monetary policy. Given the Bank’s recent conversion to greater transparency in its monetary policy stance, it should provide more information about how it proposes to return monetary policy closer to normal and to unwind QE. The urgency is all the greater as the US Federal Reserve has recently announced a taper to its asset purchases, and UK monetary policy tends not to be far behind that of the US.

In his evidence to the House of Lords Economic Affairs Committee in the week before Christmas, the Governor gave a glimpse of what may lie ahead for the UK. This is different from what the Fed appears to be planning. The Governor stated that before QE was unwound interest rates would be raised. Conventional economics would expect the reverse: first, start to unwind unconventional monetary policy – i.e., previous asset purchases.

Inspection of the term structure of interest rates in recent years provides valuable insight into the issue. The MPC has argued throughout the financial crisis that asset purchases, which have been almost entirely of long-dated government bonds, have stimulated the economy by flattening the yield curve. This implies a segmented bond market, or a preferred habitat in bonds. This is contrary to the standard theory of the term structure in which, risk-adjusted, the price of bonds is based on the absence of arbitrage opportunities. The simplest such theory is the expectations hypothesis of the term structure, which assumes no risk.

Data on the term structure since 2000 shows that its shape changed dramatically after the financial crisis, becoming much steeper rather than flatter as claimed by the Governor. Throughout this period the yield curve has been roughly anchored at the long end. This includes the years before and after the financial crisis. In contrast, the short end fell sharply with the cut in Bank Rate in 2008. As a result, the yield curve has sloped upwards ever since, and is not flatter. Even if the Governor was correct, and QE did flatten the yield curve, then this effect appears to be so small that it is completely swamped by the impact of a much lower Bank Rate.

This has implications for how to return monetary policy to a more normal stance. One might expect that, as purchases of long bonds had little or no effect on the term structure, selling them back on the market would also have little effect on its shape and hence would not provide a major monetary stimulus to the economy just when inflation was likely to pick up due to a higher rate of economic growth. This suggests that the Bank of England could start to unwind QE now. Raising interest rates first, as the Governor proposes, is much more likely to affect the economy. The justification for this should be solely in terms of the use of conventional monetary policy to control inflation and not as part of unwinding QE.

A possible caveat to this argument, and a possible reason why QE has had such a small effect on the yield curve, is that for much of the time asset purchases matched the government deficit, implying little net increase in bond holdings by the private sector. This suggests that, ideally, unwinding QE should coincide with cuts in the deficit.

One further observation on the transparency of current monetary policy is of interest. The MPC has tried (successfully) to persuade the public (but economists less successfully) that interest rates will not rise until late 2014 at the earliest. Yet in the latest Inflation Report the MPC states that it has based its forecasts on the forward curve which is rising. (Recall the yield curve is sloping upwards.) The MPC is therefore using a different set of interest rate assumptions from what it wants the public to believe. Clearly, transparency has its limits.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking and University of Derby)
Vote: Hold Bank Rate.
Bias: Neutral; hold QE but gilts should be eventually run off.

If the latest economic indicators are anything to go by, UK GDP growth looks set to end 2013 on a firm note. The consensus forecast is for fourth quarter GDP to rise by 0.8%, although the sharp rise in the purchasing managers’ indices and the Lloyds Bank business confidence survey raise the possibility of an even stronger outturn. If realised, this would leave calendar year growth for 2013 as a whole at 1.9%, or even 2%, compared with a revised 0.2% in 2012.

Looking ahead, it does look as if the momentum will be maintained in the early part of 2014. Rising house prices, the resilience of the labour market, a more favourable inflation outlook and the surge in confidence point to a continuation of the recovery. In response to recent developments, forecasts for GDP growth for 2014 have been increased from an average of 2.3% in the last consensus poll to 2.6%. However, while the outlook has improved, the recovery is likely to remain very unbalanced, with net external trade expected to deteriorate further.

Further out, optimism should be tempered by the substantial challenges that remain. The process of balance sheet adjustment is ongoing; the fiscal squeeze is set to intensify, while real income growth is likely to remain historically weak. As the recovery progresses, the pace of growth is likely to fade, with GDP growth in 2015 forecast to slow towards 2% or so.

In addition, inflation is falling faster than expected. Following the recent drop, CPI inflation is now expected to fall below the 2% CPI inflation target in early 2014, and to remain at or below that rate over much of 2014 and 2015. Although firms may seek to raise profit margins, inflation is likely to be constrained by the lagged impact of sterling’s strength, the weakness of global commodity prices and by the subdued growth in unit labour costs.

The more favourable inflation backdrop is likely to underscore the MPC’s desire to keep policy extremely accommodative. Although the Bank of England expects the unemployment rate to reach the 7% forward guidance threshold earlier than previously thought, ample spare capacity and the sensitivity of income gearing to higher rates argue for maintaining the status quo. Bank Rate should remain on hold until recovery is well entrenched and with real GDP at least above the 2008 high. Moreover, asset purchases should be only run-off via redemptions. In short, the UK recovery is still vulnerable, not least because the fall in global inflation is telling us that there is deficient demand and no price inflation threat.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking and University of Derby). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, December 01, 2013
Shadow MPC votes 7-2 for a rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, finalised on 25th November, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) decided by seven votes to two that Bank Rate should be raised on Thursday 5th December.

Four SMPC members voted for a ¼% increase, three members voted for a rise of ½%, and two wanted to leave rates unaltered. This pattern of votes would deliver an increase of ¼% on the usual Bank of England voting procedures.

There were two main reasons why a majority of the SMPC thought that it was now necessary to start a gradual and phased process of raising Bank Rate towards a more normal level. One reason was the feeling that the hyper-low interest rates appropriate in the ‘lender of last resort’ period some half-a-dozen years ago were no longer required. In addition, it was feared that such abnormally low rates of interest were encouraging financial and property speculation at the expense of savers and genuine wealth-creating investment and damaging potential growth in the longer term.

A second reason for wanting a rate increase was the strength shown by recent business surveys and the official growth figures. The SMPC poll was largely completed before the release of the second estimate of third quarter UK GDP on 27th November. However, this showed unrevised quarterly and annual increases of 0.8% and 1.5%, respectively. The two main reasons for wanting to hold rates were the belief that there remained ample unused capacity in the domestic economy and concern that the problems in the Eurozone had abated – but not been resolved – leaving a potential threat to UK export demand and activity.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate by ½%.
Bias: Hold QE and start to reverse.

The widespread view that monetary policy is sufficient on its own to deal with problems that stem from the real side of the economy is worrying and likely to bias the economy towards stagflation rather than healthy long-run growth. Most of the underlying problems facing the British economy are on the supply-side and cannot be tackled by monetary means. In particular, the planning system needs reforming to allow people to move from low to high productivity areas of the country.

Because the interest rate levied on private sector borrowers has become disconnected from the central bank REPO rate, this is a particularly good time to normalise rates because the knock on effects will be less marked than normal. The immediate need is to begin the process of getting back to real rates of interest of the order of 2% to 2½%. Bank Rate should be raised by ½% in December, and QE should be on hold with a bias to reverse in the longer term.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

A solid UK recovery has finally emerged. Annualised growth in real GDP of 2¾% in the second quarter was followed up by growth of 3¼% in the third. These are preliminary numbers but survey evidence is consistent with an even more robust upswing if anything. Early estimates of market sector output (= GDP minus activity in the government and non-profit sectors) which should be more closely aligned to business surveys reveal an even faster expansion. At least in the near-term, rapid growth should continue. Reported inflows of new business have so far been even stronger over the autumn than they were over the summer. Indeed, the new business sub-index in the monthly service sector Purchasing Managers Index (PMI) report hit a record high in October (the series starts in July 1996). In addition, the evidence concerning firms’ inventories highlights a growing shortfall since the second quarter. Consistent with anecdotal evidence from the business sector, the pick-up in demand appears to have taken many firms by surprise. Re-stocking through the second half of the year could be a powerful support to overall output growth.

Elevated uncertainty has previously been a major headwind to the recovery. However, now the fog of uncertainty appears to be lifting. Business confidence in a recovery is increasing. This is filtering through to investment intentions, although rapid growth is not yet indicated. Consumer confidence has also been revived: there has been an especially large decline in unemployment fears, which would be expected to foster reduced precautionary household saving. In conjunction with lower mortgage rates and slowly improving access to mortgage credit, increased consumer confidence is boosting the housing market, especially in London where prices are increasing sharply. Monetary indicators are also consistent with a continuation of the recovery through 2014, although potentially one with less vigour than we have seen recently. Annual broad money growth has been in the 4% to 5% range since last summer, which given past trends in velocity, would not be sufficient to bring about a sustained period of above-trend growth. With no real revival in lending volumes expected, it is unlikely that broad money growth will pick up from here.

However, there are reasons to believe that money velocity will diverge from the trend of the last two decades. This could be a direct effect of efforts to subsidise bank funding and support lending, such as the Funding for Lending Scheme (FLS): companies and households with better access to bank credit facilities are less likely to hoard money balances. Especially within the business sector, there is scope for existing cash balances to be ‘put to work’. Other factors, such as reduced uncertainty (e.g. about the Eurozone’s future), would have similar effects. Nominal GDP growth could therefore remain solid even if broad money growth (specifically, M4ex) was broadly unchanged. Indeed, there is already tentative evidence of this taking place. Despite little change in the relative rate of return on immediately accessible bank deposits in recent months, there has been a big portfolio shift towards such monetary assets. Household and non-financial firms’ M1 (demand deposits and cash) expanded at an annualised rate of 13% in the six months to September, a rate last seen in late 2004. A surge in ‘on-demand liquidity’ could suggest an increasing propensity to utilise already created money balances - i.e., a rise in money velocity.

The good news is welcome. Nevertheless, it is not a reason to tighten monetary policy. Indeed, we are still some way from that point. The economy is operating well below capacity. Slack is considerable in the labour market, albeit it is less evident within companies. It is highly uncertain whether the prolonged slump in productivity will be reversed in a recovery. Some of the damage will be permanent. Nevertheless, much will not be if, but only if, the UK enjoys a sustained pick-up in demand. This is only one reason for keeping exceptionally easy policy for some time. However, there are others. Domestically-generated inflation is quiescent: ‘core’ Consumer Price Index (CPI) inflation (adjusted for the entirely artificial effect of recent tuition fee hikes) is currently 1.4%; regular nominal hourly pay in the private sector was unchanged compared with a year earlier. Given the lagged effects of lower commodity prices and weak global price pressures, underlying UK inflation should be well below 2% through 2014.

Importantly also, risks to growth and inflation remain on the downside. The global economy is far from healthy. While a decent US recovery appears to be in train, the Eurozone crisis bubbles away. The Monetary Policy Committee’s (MPC’s) central expectation of annualised quarterly growth in the Euro-area of 1% in the near-term, and even faster growth beyond that, seems particularly optimistic. Since Britain is a small, open economy, the case for tighter policy at the first signs of an incipient recovery that could be knocked off course by several external shocks is weak.

Comment by Anthony J Evans
(ESCP Europe)
Vote: Raise Bank Rate by ½%.
Bias: Further rises in Bank Rate.

If the Bank of England were narrowly following their remit, the continued above target inflation combined with increasingly positive growth forecasts should imply a belated attempt to start raising interest rates. It is true that inflation has fallen to ‘just’ 2.2% but inflation expectations seem to be adjusting to previous, higher inflation rates and it would be dangerous to ignore them. In October, the inflation rate for education was 10%, down from 20% in September. That seems to have been what was driving high inflation throughout 2013. However, education inflation was only 5% throughout late 2011 and early 2012 and CPI inflation was over 3%. Even if the cause of inflation is temporary factors, if temporary factors keep appearing, they should not be ignored. In October, a ‘YouGov’ survey saw inflation expectations for the forthcoming year to be above 3%. This is likely a blip, but should not be dismissed lightly. All nine of the Bank’s own indicators of inflation expectations show that their credibility is being questioned.

The Business Activity Index and all-sector PMI are indicating that fourth quarter growth will be even higher than in the third, and this should be a cause for concern. Not only in terms of the inflationary pressure from such a sharp jump in growth, but that it is unlikely to be sustainable. The policy goal should not be to get credit flowing if this simply props up a housing bubble or encourages zombie firms to bet on future growth. The Chancellor’s own budget depends on optimistic growth forecasts but this charade should be criticised, not emulated.

In certain circumstances, it is understandable for the Bank to switch their focus from inflation, or at least tolerate above target inflation in the short run. However, this must be part of a credible communication strategy. Forward guidance has attempted to provide this but, so far, it seems to be failing. The Bank already seem to be moving away from the threshold of 7% unemployment, and are even questioning how good this measure is as a proxy for spare capacity. It is a bit like begging the barman for a lock in, having promised faithfully that you would go home after last orders. In some ways, forward guidance is like a currency band. It can reduce uncertainty provided market expectations are close to the policy target. However, it also introduces a new layer of uncertainty, relating to the commitment to the policy.

The ‘guidance about guidance’ that we see is evidence of fault lines appearing and may indicate that it introduces more uncertainty than it quells.

Uncertainty is an important issue because it provides a coherent explanation for observed reductions in investment that accompany financial crises. The Bank of England appear to be taking uncertainty seriously with the adoption of a new index that looks at the frequency of certain phrases in various newspapers. Other – and, perhaps, more methodologically well grounded – attempts to measure uncertainty will look at volatility, and in particular spreads between various assets. Both these ‘chatter’ and ‘volatility’ measures are looking for proxies and are flawed. Nevertheless, they do support the view that uncertainty matters. And the relevance here is that the introduction of uncertainty tends to be a result of policy failure. In particular, the idea that we have a balance sheet recession caused by over indebted households may be explained instead by the idea that we have an excess of money demand caused by high levels of uncertainty.

Narrow money and broad money supply measures have dropped slightly over recent months and this may be a cause for concern if they continue to do so. However, with broad money growth consistently above 4% there is no obvious problem with money being too tight. Monetary policy could be a lot looser. However, this is more likely to make things worse than improve them. Growth would be higher, and more sustainable, if interest rates were at their natural rate and this is likely to be higher than the current policy rate.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Prospects for the UK economy look better than at any time since the financial crisis. On the basis of preliminary Office for National Statistics (ONS) estimates for 2013 Q3, GDP has grown by around 1.8% this year. This is double the rate of growth seen over the entire 2011-12 period. The first signs of the upturn appeared just over a year ago, with an expansion in the growth of the M4ex broad money supply measure towards 3% year-on-year. The initial expansion was relatively weak. However, it subsequently accelerated to around 5% in yearly terms in the first half of 2013, slipping back slightly towards 4.3% over recent months. The latest detailed statistics show household broad money rising by 4.4% on an annual basis and Private Non-Financial Corporations M4 increasing by 7.9%.

This expansion is now beginning to feed through into the wider economy. Thus far in 2013, around half of the growth in GDP has come from consumer spending. Consumption is likely to continue to underpin growth, for two reasons. Firstly, faster output and productivity growth, together with higher profitability (supported by lower unit labour costs), will permit companies to grant higher pay awards, boosting real disposable income. Over recent years, inflation has been running well ahead of earnings growth. However, that story is likely to change in 2014, with a narrowing and then reversal of this gap by the end of the year. Second, stronger consumer confidence, helped by wealth effects from a strengthening housing market, will permit modest further reduction in the household savings ratio towards 4% next year. Greater demand certainty; significant cash balances, and catch-up effects from foregone investment, suggest that business investment will play a more significant role in the recovery next year. Again, however, the overall effect will be modest.

When told that Prime Minister Attlee was a modest man, Churchill replied that; “he’s a man who has much to be modest about”. So it is with this modest recovery, due to the supply-side constraints imposed by statist intervention over recent decades and banking sector weakness in the wake of the financial crisis. GDP growth may edge above 2% in 2014, but such growth is unlikely to last beyond the first half of 2015. Potential output growth in the UK is probably at 2% or below, leading to higher inflation in 2015, and a tightening in monetary policy, if the actual growth rate exceeds potential. Spare capacity and sub-3% GDP growth rate mean that any future tightening in monetary policy is likely be modest also.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate and allow QE to wind down as redemptions fall due.

The UK recovery continues apace, with recent manufacturing output and investment plans surveys looking especially strong. Unemployment is falling, though it may disappoint over the medium term as companies that hoarded labour during the recession use existing staff before taking on new workers. Nevertheless, pay rises – which were suppressed significantly during the extended period of depression – are likely to pick up markedly as workers seek to catch up and thus share in growth.

The main dark point is the Eurozone, where problems in Greece appear to be re-emerging and general monetary growth is poor. However, overall the UK monetary authorities have an opportunity to normalise policy to some small extent. They should take it.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE by £25bn per month.

This past year has been an eventful one in monetary and regulation policy. The key event has been politicians’ realisation that the regulative mania had gone too far and was stopping the flow of credit to small businesses and housing – the flow to large businesses was being reversed anyway by their unwillingness to invest in the uncertain climate and the lack of competitive rivalry from new small business entry. It was clear that the UK recovery had stalled and the lack of credit flow was a key cause. With this realisation came a series of back-door offsets to the regulative obstruction to credit: a second FLS and the Help to Buy scheme. Close on the heels of these offsets, came the new Bank of England Governor, Mark Carney, with a mission from the Chancellor to revive the UK banking system. Mr Carney has by now started to talk about his support for UK banking and the build-up of its balance sheet; as far as he is concerned, he said, he saw no reason to complain if its balance sheet reached higher multiples of GDP in coming years, as long as it was done safely and ethically. Thus has the Bank moved to restore its relations with UK banks and about time too. The Bank of England is supposed to be the banks’ friend at court, as well as the institution that casts a weather eye over their behaviour.

We are now beginning to see some fruits from this new approach to regulation. Credit is starting to flow – notably to the housing market, and not just to the ever-hot London market but all around the country. The stories are coming in of shortages of builders, bricks and so forth; mothballed sites are springing into development, and there is the start of a housing recovery. For those that see this as a ‘bubble’, it is worth reminding them that real house prices are about 30% below their peak. However, it is clear that the deregulation we are seeing is lopsided. Housing, and through it construction, is seeing the benefit of new credit, Small and Medium Enterprises (SMEs) are not. This is because, besides being subsidised by these HM Treasury schemes, mortgage finance has a low risk-weighting in the regulatory capital requirement, whereas SME loans have a high weighting. Banks are fine-tuning their credit to avoid raising more capital; especially, as this is currently very expensive for them given the poor equity rating for banks.

This suggests regulation will have to be rethought. It is penalising the very sort of credit that banks are uniquely capable of providing, viz. to SMEs. Large firms can issue equity and bonds; SMEs basically cannot. There are business angels, there is peer-to-peer lending, there are venture capital firms and private equity; but fundamentally these are quite marginal to SMEs – though if banks continue to shun them, this will be forced to change. From the viewpoint of macroeconomic welfare we should have institutions that keep the cost of credit for SMEs as close to the social cost of credit as possible. This can be defined as the safe rate of interest plus the cost of diversified investment risk (the equity risk premium). Current regulations are driving it well above this level.

Yet when we reflect on what went wrong in the pre-crisis period it seems fairly clear that: a) the world had an over-strong boom, fuelled by extremely stimulatory monetary policy through most of the 2000s; b) banks were not properly supervised in several countries where central banks had been given ‘independence’ and had had their supervisory role curtailed or removed, the UK being a prime example, and c) larger banks acquired a size and market power that was excessive. These considerations point to the need for more bank competition and smaller banks; and for central banks to resume their supervisory role. It also points to the need for new operating rules for monetary policy, including for QE – the newly revived Open Market Operations of central banks. These new operating rules should prevent future credit booms and busts; inflation targeting alone has failed to do this. I would suggest a new rule for the setting of the monetary base that explicitly targets credit/money growth and the credit premium – as important an interest rate as the one now being targeted, for government short-term bonds. With such new rules we can allow the new regulative system to ensure general safety with the minimum of intrusion into commercial decisions on loans.

Turning finally to UK monetary policy today, I believe we need to plan for ‘re-entry’ to a normal monetary environment. The UK recovery is now strong, fuelled by a fast-recovering housing market, owing to the partial pullback of regulation and the competitive drive this has created among banks. Banks have vast liquid reserves, thanks to QE. There is little to restrain them from pouring a mass of credit into this channel. The housing recovery will fan outwards into the rest of the economy, creating a typical if much delayed recovery spike, all of this in a pre-election period when politicians will be strongly against any tightening. The Bank needs to move pre-emptively to prevent money and credit getting out of control. At the same time it needs to get the regulative balance back more in favour of SMEs. So, finally, I suggest that QE be gradually reversed and that Bank Rate be increased in two-monthly steps of 0.25% over the next year, beginning at once.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: Avoid regulatory shocks; aggressively break up state-dependent banks; raise Bank Rate to 2% to 2½%, and gradually run off QE.

The Chancellor of the Exchequer will be announcing his Autumn Statement on Thursday 5th December, after the present note will have gone to press. However, it is almost certain that much of its content will be pre-released sequentially in the newspapers from Sunday 1st December onwards if the official news managers follow their normal routine. The evidence is that Mr Osborne will be in the unusual position, for him, of being able to announce that the Office for Budget Responsibility (OBR) will have revised its growth forecasts upwards and its public borrowing projections down since the March Budget. The latest independent consensus forecast compiled by HM Treasury shows a forecast for economic growth this year of 1.4%, followed by 2.3% in 2014, and a PSNB of £101.9bn in 2013-14, being followed by a deficit of £90.3bn in 2014-15. The latter will be the last full financial year figure to be reported ahead of a May 2015 general election and will be a politically sensitive figure. The medium-term forecasts published by HM Treasury, which incorporate a rather smaller sample of forecasters, suggest that economic growth will run at some 2¼% to 2½% between 2015 and 2017, while the PSNB is expected to gradually decline before reaching £76.3bn in 2017-18, assuming current policies are maintained after the general election.

The OBR creates its own independent forecasts for release alongside the Budget and the Autumn Statement. However, these are not significantly different to the consensus normally, particularly when the scale of revisions to past ONS data is borne in mind as well as the inevitable uncertainties involved in predicting the future. As it happens, the latest Beacon Economic Forecasting (BEF) projections, run using the 27th November GDP release – the consensus obviously suffers from some compilation and publication delays – are slightly above the consensus view where national output is concerned. Economic growth is expected to average 1.4% this year, and 2.6% in 2014 and 2.8% in 2015 before easing to just over 2% in 2016 and 2017. The PSNB is expected to come in at £98.4bn in the present financial year, decline to £91.9bn in 2014-15 and ease thereafter to reach just over £71bn by 2017-18.

On the surface, this looks a reasonably hopeful picture. However, borrowing is far worse than Mr Osborne intended after the 2010 general election, and all such projections tend to rely on assumptions about public spending that assume more discipline in the future than has been achieved since the coalition took office. My BEF forecasts use the March OBR forecasts for the volume of general government investment but assume that the far greater volume of general government final consumption is held flat throughout the forecast period, rather than contracting in line with the official forecasts. The ONS national accounts for the post-electoral period between 2010 Q2 and 2013 Q3 show that the volume of general government current expenditure has risen by a total of 2.2%. However, general government investment had contracted by 7.7% between 2010 Q2 and 2013 Q2, which is the latest figure available. During the post-electoral period up to the third quarter, real household consumption has expanded by 2.8% and the basic-price measure of GDP has gone up by 3.2%.

However, there are disturbing signs that spending ministers are getting itchy fingers and want to ease up on governmental spending discipline for electoral reasons. Since we are still deep in the dark woods of fiscal profligacy, any such easing has the potential to derail the painfully slow progress in righting the public accounts achieved so far. It is also worth noting that the peak period of intended retrenchment on the spending side has yet to come and may never happen. This is because Mr Osborne foolishly decided in 2010 to backload his spending cuts and frontload his tax increases. This action was perverse from the viewpoint of fiscal consolidation and may have set back the recovery by some twelve or eighteen months.

Britain has a small, open and trade-depending economy whose annual growth moves almost in lockstep with that of its Organisation for Economic Co-operation and Development (OECD) equivalent over the business cycle, and has done so for four or five decades. As a result, no British Chancellor has more than a tentative influence over economic developments. The best that any Chancellor can hope to achieve is to improve the growth gap between the UK and the OECD by pursuing fiscal discipline, low taxes and vigorous supply-side reforms. Unfortunately, the present Coalition has been too timid to take this course. The result is that the ratio of UK to OECD GDP is again showing the declining trend that was such a marked feature of the Pre-Thatcher years. This is particularly concerning given the sharp slowdown in OECD growth since 2008.

By international standards, the UK has been underperforming on growth and inflation, badly underperforming on its international trade, and has an extremely poor fiscal position. There is no scope for complacency or giving up on austerity on the public spending side. However, well-designed tax cuts would almost certainly be more than self-funding, given the massive distortions and disincentive effects created by Britain’s onerous and complex tax system and should be pursued with boldness and vigour for economic reasons, not cheap political ones.

Where does this leave UK monetary policy? First, the situation that originally justified a ½% Bank Rate and QE was clearly far worse a few years ago and the need for a super-accommodating stance has now gone. The real economy is picking up and the normal forecasting error at this point in the cycle is to underestimate growth not to overstate it. Second, UK broad money on the M4ex definition is growing at a reasonable rate (4.3% in the year to September) and also in the OECD area as a whole (5.2% in the year to the third quarter). Furthermore, Divisia money has been going through the roof, with a yearly increase of 9.3% and a rise of 9.5% excluding other financial corporations.

Third, there are also signs from confidence surveys that the vitally important international background is improving, even if this has not yet been reflected in the official statistics. The Euro-zone still looks like a badly repaired vase, held together with sticky tape, which could crack open at any moment. However, it appears to be holding together for the time being. Fourth, the drop in annual UK CPI inflation from 2.7% in September to 2.2% in October was partly a reflection of a distortion caused by the introduction of student fees a year earlier. However, it was also a reflection of an easing in the price of oil. Lower energy costs help to explain why annual CPI inflation in the US eased from 2% in July to 1% in October and from1.6% to 0.7% in the Euro-zone over the same period. Reductions in the price of oil – and also non-oil commodities where the Economist magazine’s weekly US$ based index fell by 11.7% in the year to 19th November – act as an indirect tax cut where the developed economies are concerned. That is they are both disinflationary and output expanding and any consequent easing in inflation is not a harbinger of a renewed downturn.

Unfortunately, having fallen to US$103.5 on 7th November, the price of a barrel of Brent crude has risen more recently to reach US$110.9 on 26th November. On balance, however, the above factors suggest that a move towards a more normal nominal and real short term rate of interest is now justified.

The main reason for not being super-hawkish has been the recent strength of sterling, with the trade-weighted index standing at 83.8 (January 2005=100) on 26th November. Clearly, this will put pressure on what remains of Britain’s low value-added internationally trading sector but probably not on the sale of more complex products. The sensitivity of export and import demand to price competitiveness appears to have fallen sharply since the 1960s. This is because items traded internationally have become more specialised and sophisticated, while price inelastic services have taken a growing share of UK exports. In addition, any aggregate demand loss arising from the trade account is likely to be more than offset by the expansionary consequences of lower inflation on living standards and a reduced need for precautionary savings. Nevertheless, policy makers have clearly been walking on egg shells since 2008 because confidence has been so brittle. This means that sudden and abrupt policy changes are best avoided. My vote is for Bank Rate to be raised by ¼% in December, and then to be raised cautiously in a pre-announced fashion, by ¼% increases every second month or so until it is in the 2% to 2½% range, after which a pause for breath might be desirable. Likewise, the appropriate approach to QE is to allow it to gradually unwind as stocks mature, through a process of partial re-placement, but not to attempt anything too aggressive.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; no extension of QE.
Bias: To raise Bank Rate.

It has become ever harder to find anything constructive to say about UK monetary policy. The recovery of the UK economy in 2013 should not be a surprise in the light of the FLS and the Help-to-Buy scheme, both of which were essentially HM Treasury initiatives. FLS has lowered the average variable ISA deposit rate from 2.6% in July 2012 to 1.26% currently and the average instant access deposit rate (including bonus) from 1.55% to 0.75%. These savings rate cuts have funded cheaper mortgage rates and greatly assisted the revival of mortgage lending and refinancing activity. Annual M4 growth has surged to 2.6% and annual M4 lending growth has tipped into positive territory recently. In turn, these schemes have boosted housing construction, consumer spending and consumer confidence.

The Bank of England’s decisions on Bank Rate and the size of the QE programme have been superfluous, so far as one can tell. Household interest rates for deposits and loans rose when there was increased competition in the banking sector and fell when depositors were out-bid by the FLS. Bank Rate was ½%, throughout. It is the Treasury that has changed the cost of borrowing over the past eighteen months, not the Bank. The Bank’s new conditional ‘forward guidance’ regime introduced in August is already ripe for overhaul. The unemployment rate in the Labour Force Survey jumps around violently from month to month because it is based on different samples rather than being a longitudinal study. After smoothing out the figures, it looks as if the 7% threshold for the unemployment rate will be breached (from above) around the middle of next year. However, the Bank insists that this will not be the arbiter of its rate decision. On some survey measures, UK inflation expectations have risen over the past few months and this could be interpreted as a threat to the knockout clause. However, the Bank has dismissed the rise in expectations as unreliable and to be ignored. All that remains of Bank of England monetary policy is a form of calendar guidance, whereby the Monetary Policy Committee (MPC) influences Sterling interest rate markets through its indications that Bank Rate will not be raised for some considerable period, regardless of the real GDP growth rate, the unemployment rate, the inflation rate, or measures of inflation expectations.

For the time being, gilt yields have tracked US bond yields fairly closely and gilts remain competitive internationally. Should the strong international bid for UK gilts fail for any reason, the combination of a £100bn per annum public borrowing requirement and a 4% of GDP current account deficit might present a few problems for the value of Sterling, with feedback effects on the inflation rate. While the MPC may approve of the economic score-line, they are mere spectators shouting from the touchlines. In order for the Bank to step back on to the pitch, the MPC needs to reconnect Bank Rate to the structure of market interest rates – traditionally between deposit rates (0.75%) and the standard variable mortgage rate (4.3%). A helpful innovation where QE is concerned would be to rebalance its stock of asset purchases away from gilts into some private sector assets, such as infrastructure assets or commercial property. My vote is for Bank Rate to be raised, initially by 25 basis points, towards a target of at least 1.5%.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Raise Bank Rate by ¼% and decrease QE to £250bn.
Bias: Slow monetary tightening over time.

The key feature of the UK economy for monetary policy is, as the November Inflation Report starts by saying, “recovery has finally taken hold” and the economy is “growing robustly”. Although inflation is not yet reflecting this, as it fell in October to 2.2% from 2.9% in June, the time has come to look forward and slowly start to unwind loose monetary policy. The longer term aim should be to return the monetary stance to normal levels, i.e. a bank rate of about 3.5% to 4.0% and no QE.

At present, there are several inconsistencies in the monetary stance of the MPC which may explain their inertia. First, the MPC has made a point of introducing forward guidance to try to manipulate market expectations of interest rates. Even the economists polled by Reuters expect Bank Rate to flat-line in the future. Nonetheless, in its own forecasts, the MPC has chosen to use the forward market interest rate curve, which is rising.

Second, although the economy is growing and inflation, already above the target of 2%, is likely to increase further in the near term, the MPC continues to stress that it will not raise interest rates unless unemployment has fallen to 7%. Hitherto the MPC has argued that it takes about two years for interest rates to fully affect inflation. This requires monetary policy to be forward looking. The inconsistency here is that unemployment is a lagging indicator of market tightness and hence inflation. Not only is the new framework for monetary policy by the MPC therefore inconsistent with previous policy but, more worryingly, the MPC is now likely to respond far too late to rising inflation.

Third, the main reasons for low growth have been negligible business and housing investment. Consumption is now rising strongly with the savings rate, previously over 8% in 2008, now falling steadily. This probably explains the strong pick up in housing growth which will almost certainly add to future inflation. In contrast, business investment continues to contribute negatively to growth. It should, therefore, be clear by now that recent monetary policy based on a low price of credit and a banking system awash with liquidity does not stimulate business investment when expectations are of no, or weak, growth.

Fourth, the exchange rate has always played an important role in the economy. Based on the Bank of England’s previous macro model, I estimated that, in the first year, 80% of the impact of interest rates on inflation came via the exchange rate. The recent monetary stance has kept sterling weak. Not surprisingly, therefore, a major factor in higher than target inflation has been rising import prices. Moreover, in the second quarter, imports increased by 2.9%.

These four inconsistencies all point to the need to tighten monetary policy now rather than wait until unemployment falls to 7%, which may not happen until late next year. By that time, inflation may be even further above target. Another reason for tightening monetary policy now is the need to return it to normal levels. Achieving this in an orderly and measured manner would be far better for the economy than through a sudden large tightening that disrupts markets and results in a harmful misallocation of resources.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking and University of Derby). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

The SMPC is a group of economists who have gathered quarterly at the IEA since July 1997. That it was the first such group in Britain, and that it gathers regularly to debate the issues involved, distinguishes the SMPC from the similar exercises carried out elsewhere. Because the committee casts precisely nine votes each month, it carries a pool of ‘spare’ members since it is impractical for every member to vote every time. This can lead to changes in the aggregate vote, depending on who contributed to a particular poll. As a result, the nine independent analyses should be regarded as more significant than the exact vote. The next quarterly SMPC gathering will be held on Tuesday 14th January and its minutes will be published on Sunday 2nd February. The next two SMPC e-mail polls will be released on the Sundays of 5th January and 2nd March, respectively.

Sunday, November 03, 2013
IEA's shadow MPC votes 6-3 to raise Bank rate
Posted by David Smith at 09:00 AM
Category: Independently-submitted research

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 15th October, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 7th November. Four SMPC members voted for a ½% increase, two members wanted an increase of ¼%, and three wanted to leave rates unaltered. This pattern of votes would deliver an increase of ¼% on normal Bank of England voting procedures.

There were a variety of reasons why a majority of the IEA’s shadow committee wanted to raise rates now rather than wait until the recovery had gathered momentum and was incontestably apparent. One was a desire to start the process of interest rate normalisation sooner rather than later to avoid a damaging over-steer in the opposite direction, perhaps after the likely May 2015 general election. Another reason was to warn people thinking of taking out mortgages to buy properties, which still appeared significantly over valued by historic standards, of the potential capital loss they were taking on when (or if) rates returned to normal.

Both SMPC hawks and doves agreed that the recent UK data had been stronger than was expected earlier this year, although the poll was compiled before the ‘flash’ output measure of UK GDP in the third quarter was released on 25th October, which showed quarterly and annual rises of 0.8% and 1.5%, respectively. The main disagreement between the two groups was over the margin of spare capacity still available. The doves believed that ample spare resources remained while the hawks thought that there had been a major reduction in aggregate supply as a result of the ‘big government’ policies implemented since 2000.

Minutes of the meeting of 15th October 2013

Attendance: Phillip Booth (IEA Observer), Jamie Dannhauser, Anthony J Evans, John Greenwood, Kent Matthews (Secretary), Patrick Minford, David B Smith (Chairman), Trevor Williams.
Apologies: Roger Bootle, Tim Congdon, Graeme Leach, Andrew Lilico, David H Smith (Sunday Times observer), Akos Valentinyi, Peter Warburton, Mike Wickens.

Proposal to the Committee

The meeting opened with a discussion about voting procedures at the SMPC, initiated by a proposal from Patrick Minford. No final decision was made but it was agreed to ensure that all members had an opportunity to have their say prior to making a final decision. The committee also discussed a proposal to split future discussions into two parts: a discussion of current monetary issues (and the associated voting), and a discussion of a key current issue or topic of theory in economics to be led by one of the academic members. Again, no final decision was reached. However, it was felt that other members not present should all have an opportunity to have their say.

Economic situation

John Greenwood began his presentation with a schematic diagram (below) showing how debt-to-income ratios behaved during the course of bubbles and busts. He said that he wanted to examine what happened to debt when a bubble reached a so-called ‘Minsky moment’. It was after this point that private borrowing seized up and the government stepped in with a fiscal stimulus. At first, the private sector deleveraged but, ultimately, the public sector also had to deleverage. Case histories such as Canada and Sweden showed that the running down of debt ratios typically took twice as long as the time to run them up. The stylised diagram described the phases of boom and bust of the private sector and the public sector. In the bust phase for the private sector, monetary policy was ineffective – the pushing on a string syndrome or as Keynes described it, the ‘magneto problem’. The phase description can also be used to explain why the USA had recovered faster than Europe or the UK.

Although growth in the USA had been sub-par since 2008, it had outperformed the UK and the Eurozone in part because the US was further ahead in the deleveraging process. The USA was still in the deleveraging phase (Phase 2). Bank lending was still sluggish and money supply growth had therefore been critically dependent on Quantitative Easing (QE). If the broadest money supply measure was taken to include the shadow banks (M2 plus shadow banks’ liabilities), monetary growth was weak with households likely to continue to deleverage for two to three more years.

Turning to Europe, deleveraging had occurred later and at a substantially slower rate. Negligible M3 growth would constrain an economic upswing. The Eurozone risked repeating the experience of Japan where the failure to de-leverage had spawned Zombie companies, Zombie banks and Zombie households. Even after two decades Japan’s private sector had deleveraged less than the US had done in the past five years. In the UK, the private sector was also deleveraging but at a slow pace (especially the banks). A ranking of economies in the deleveraging phase had the US ahead of the UK which was in turn ahead of the Eurozone economies.

UK GDP was showing signs of sustainable recovery. There were three reasons for this. First, monetary stimulus was beginning to work. Second, the external headwinds were diminishing. Third, the economy was being pushed forward by pent-up demand. The monetary numbers were moving in the right direction. The Funding for Lending Scheme (FLS), the relaxation of liquidity rules and Help to Buy, were coming through in an increased lending for housing. External constraints had loosened but the key difference in the global recovery was the different way in which the US had treated the banks compared with the UK. An aggressive, systemic recapitalisation of US banks through TARP had the government acquiring the preference shares of over two hundred banks, in contrast to the ad hoc programmes of recapitalisation in the UK or the Eurozone. The provisions restricting payment of dividends on ordinary equity and restrictions on staff bonuses, when combined with the obligation to pay progressively higher dividends on the government’s preference shares, created incentives for US banks to clean up their balance sheets through massive write-offs and capital-raising. The table below summarises why the US led the UK in the recovery.

However, a sustained recovery in the UK required real disposable income to show stronger growth than current figures. Real earnings had been falling and real disposable income growth remained weak. While demand led, the UK was still in the early stages of recovery.

Discussion

The Chairman then thanked John Greenwood for his excellent presentation. He said that, in keeping with tradition, he would ask the IEA Observer, Philip Booth, to make a vote as the meeting had been inquorate and added that that one further vote would be required in absentia (Editorial note: this was supplied subsequently by Andrew Lilico). David B Smith then started the discussion rolling by asking the views of the committee on the marked pick up in the annual growth rate in the Bank of England’s ‘Divisia- money’ measure. This had accelerated from a low point of minus 0.5% in February 2012 to 8.5% in August 2013, or from 2% in January 2012 to 8.9% in August 2013 if the deposits of ‘other financial corporations’ are excluded. Their former SMPC colleague, Peter Spencer, had been an advocate of Divisia money in the past. Although David B Smith had no strong views, this seemed a noteworthy development, which had coincided with the rebound in UK activity. Jamie Dannhauser said that the more rapid increase in Divisia money reflected the rise in M1 growth that had been stressed by some City economists. Both Jamie Dannhauser and the Chairman agreed that it was broad money that acted as the accelerator, albeit with long and variable lags, while the role of narrow money was more akin to that of the speedometer. However, M1 provided confirmation of the increased activity being shown by conventional output and expenditure measures.

Patrick Minford stated that the recession had been prolonged by regulatory-induced blockages in the credit channel and that credit was coming through at last, helped along by schemes such as FLS and Help to Buy, which had had a positive effect on construction. David B Smith said the ratio of house prices to permanent income was still roughly one standard deviation (or some 16½%) above its long-run mean. There was a risk that innocent young people were being sucked into the property market at over-inflated values by such schemes. Such naïve first time buyers could potentially lose a third of their capital if house prices reverted to one standard deviation below their mean ratio when (or if) interest rates were normalised. Jamie Dannhauser said that, while market sentiment had improved, the biggest danger facing the British economy remained the uncertain outlook for the Eurozone. Philip Booth said that one aspect worth emphasising in John Greenwood’s table (above, row 4) was that the government sector in the USA was so much smaller than in the UK. Big government sectors had adverse supply-side effects on the sustainable growth rate. It was dangerous to assume that most of the output shortfall compared with the trend prevailing before the Global Financial Crash (GFC) was down to inadequate demand rather than weakened potential supply.

The Chairman then called the discussion section of the meeting to a close and made a call for votes. In accordance with normal SMPC practice, these are listed alphabetically including the one vote cast in absentia.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate by ½%.
Bias: Hold QE and start to reverse.

Philip Booth said that he was worried about using monetary policy to deal with problems that stemmed from the real side of the economy. He said that the underlying problems were on the supply-side. The planning system needed reforming to allow people to move from low to high productivity areas of the country. He said that the interest rate levied by the private sector was disconnected from the central bank REPO rate. Therefore, this was a good time to normalise rates and begin the process of getting back to normal real rates of interest in the order of 2% to 2½%. He said that Bank Rate should be raised by ½%, and that QE should be on hold with a bias to reverse.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Jamie Dannhauser said that he shared John Greenwood’s view about the UK. Balance sheet repair in the UK had been only moderate. In the USA, growth of 2% to 3% was possible. However, there was little sign of improvement in Continental Europe where there had been no deleveraging. Nevertheless, it was hard to dismiss the positive signals that the UK economy was giving about the strength of the recovery. Even so, the large margin of unused potential capacity in Britain meant that it was too early to start tightening. He voted to keep interest rates on hold with no bias on QE.

Comment by Anthony Evans
(ESCP Europe)
Vote: Raise Bank Rate by ½%.
Bias: No more QE.

Anthony Evans said that the arguments for raising rates were growing and that it was dangerous to wait for overwhelming evidence. There had been significant damage done to the supply side of the economy. The Bank of England had painted itself into a corner as to when rates should rise. The conversation had shifted to the timing of the rate rise. He said that it was better to err on the side of caution by raising rates too soon rather than too late.

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

John Greenwood said that balance sheet repair was still on-going. The idea of raising rates now was premature. There was a need for growth to take root and be sustained for one or two years before monetary policy was tightened. He said that inflation would not be a problem for a couple more years, given the background of slow money growth over the past two years and the level of capacity available. He added that interest rates should stay on hold with no further QE but he reserved a neutral outlook with respect to the need for further QE.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no change to QE.
Bias: Raise Bank Rate further.

In his post-meeting vote in absentia, Andrew Lilico stated that the economy was now growing strongly and that the final justification for emergency levels of interest rates had lapsed. The real debate ought to be about how quickly we sought to get rates up to 2%. He added that there might be an argument for an immediate 1% rise. Indeed, he might well have advocated a 1% Bank Rate hike, if the general debate had been in a healthier place. However, he would be content if any early rate rise were enacted, as matters stood. The Bank of England was going to be far behind the inflationary and monetary growth curves when it finally did act. The fact that households were being encouraged to – and, even, subsidised to – borrow additional funds for mortgages whilst they dwelt under the apparent delusion that current interest rates could last was a scandal. In his view, the monetary authorities should be seeking every opportunity and every excuse to attempt to normalise rates so that the economy could revert to a sustainable equilibrium. Begin! Begin! Begin!

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate; QE neutral.

Kent Matthews said that, while he accepted much of what John Greenwood said, he came to the opposite conclusion for policy. Balance sheet repair had been weak because the economy was weak. He agreed that real disposable income needed to grow more than at current rates and that household spending would rise only if the prospects for growth improved. He said that he disagreed with what John Greenwood said about available capacity. He said that no one knew what the level of available capacity actually was but that inflation being above target for so long was not consistent with a wide output gap. If capacity existed it was that of zombie enterprises that should be allowed to fail so that credit resources could be re-allocated to the new and emerging companies that were finding credit conditions too tight. The capacity destruction that had followed the great recession needed to be rebuilt but this could only be done if credit conditions improved for new and emerging enterprises. The long period of low interest rates had resulted in a misallocation of loanable funds and that was part of the supply side problem.

Interest rates needed to be raised now so that the markets became aware that the long period of low interest rates had come to an end. The rise did not need to be large for expectations to change. Even a small rate rise would alter market sentiment that further rises will be forthcoming. Sterling would react and inflation, which had kept the UK at the top of the European inflation league, start to recede. This process would not be painless but there was little likelihood of a sustained recovery until capacity was rebuild and the supply side of the economy improved. Interest rates should rise steadily until a normal real rate of 2% to 2.5% was restored. He voted to raise interest rates by ¼% with a bias to further increases and no QE.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate.

Patrick Minford said that the FLS and Help to Buy schemes were insufficient mechanisms for countering the negative effects of bank regulation and unblocking the credit channel. He agreed that the Bank should not wait until the economy heated up to act on interest rates. Interest should rise to normal rates and QE should be reversed. The process of reversing QE meant that gilts should be actively sold and that rates at the long end should also rise.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ¼%; QE to be run off gradually through non-renewal of maturing debt.
Bias: Bank Rate to be cautiously raised to 2% before pausing and QE to be gradually unwound.

David B Smith said that the unintended side effect of the ‘big government’ policies implemented in the US and Britain since 2000 had been to sharply reduce aggregate supply. Therefore, there was a limit to what demand-management policy could do before the economy came up against supply constraints. This meant that a lax monetary policy could only produce stagflation in the British case. He added that monetary policy should be regarded as having at least three separate elements: Bank Rate setting; funding policy, and regulatory policy, and that all three needed to be pointing in the same direction for policy effectiveness. This was not the case at present when unduly low Bank Rate and an expansionary funding policy (i.e., QE) were tugging in the opposite direction to the restrictive effects of over-regulation. He added that, for completeness, foreign exchange intervention by central banks could also have a major effect on domestic monetary conditions – so that monetary policy was a four-legged chair rather than a three-legged stool. While this was not an important UK issue at present, it clearly was in China and other ‘dirty floaters’.

The meddling sentiment that permeated the UK monetary authorities – and also Coalition politicians for cheaply populist reasons – was a throwback to the pre-Thatcher period of interventionist policy. In the late 1960s, David B Smith had been misemployed as a junior Bank of England official seasonally-adjusting the balance sheets of some half a dozen individual clearing banks because the clearers had convinced the authorities that the bank lending ceilings then imposed needed to take account of the seasonal fluctuations in their loan books. We appeared to be drifting back into a similar system of crazy micro-interventionism today. The main difference was that in the 1960s intervention was employed to restrict the growth of bank lending and direct it into politically favoured sectors, such as exporters; today, it was being employed to boost credit extension and direct it into politically favoured sectors, such as housing. What we were observing was a clear cut example of socialistic controls breeding distortions that were then tackled with yet more socialistic controls in a vicious upwards spiral of interventionism.

An important reason for raising rates now was to warn house buyers in a market which remained overvalued that rates were abnormal and could not be expected to stay so low for long. Economic agents needed to be made aware that borrowing costs would inevitably revert to some long-term norm closer to 5% than their current 0.5%. He was undecided whether to vote for an increase of ¼% or ½%. However, he pointed out that the simulations on the Beacon Economic Forecasting (BEF) model presented in last month’s SMPC submission suggested that it made little discernible difference either way. In the end, he advocated raising Bank Rate by only ¼% – primarily, in order to control any damaging ‘shock’ effects – and to let QE gradually unwind by not undertaking commensurate new purchases as the Bank’s existing holdings of gilts gradually matured. David B Smith was not advocating aggressive sales of the existing £375bn stock of QE while the annual growth of M4ex broad money remained around the relatively subdued 4.3% recorded in the year to August and the sterling index remained around its present 82.5 (January 2005 =100). He would, however, be far more aggressive if monetary growth accelerated into the 7½% to 10% range or the external value of the pound fell significantly.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking and University of Derby)
Vote: Hold; no further QE.
Bias: Reversing QE naturally.

Trevor Williams said that the supply-side was important and that spare capacity might well be less than was generally thought because of the existence of zombie enterprises. However, broad money needed to grow consistently for a sustained recovery. The reduction in energy costs had made the USA more competitive. The US economy had been able to build capacity and the Federal Reserve had been helpful in unblocking the credit channel through TARP. In the UK, productivity was low and corporates were not investing. He voted to keep interest rates on hold and no further increase in QE but to allow QE to run-off through maturity.

Policy response

On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in November. The other three members wished to hold.

There was only modest disagreement amongst the rate hikers as to the precise extent to which rates should rise. Three voted for an immediate rise of ½% but two members wanted a more modest rate rise of ¼%.

All those who voted to raise rates expressed a bias to raise rates further. There was also a common view that QE should not be increased and a majority view that it should be reversed naturally through the phased non-renewal of maturing debt.

Date of next meeting
Tuesday 14th January 2014.


What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking and University of Derby). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Saturday, October 05, 2013
Shadow MPC votes 5-4 to hold rates despite stronger growth
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, finalised on 1st October, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be left unchanged on Thursday10th October. Among the dissidents, two members wanted an increase of ¼%, while two advocated a rise of ½%.

There was considerable agreement on the shadow committee that the UK economic recovery had gathered momentum in the second quarter and that the evidence from business surveys suggested that growth might have accelerated in the third quarter, for which there is almost no official data at present.

There were two main reasons why a majority of the SMPC did not want to raise Bank Rate; even if some ‘holders’ believed that a rise might be appropriate in a quarter or two’s time. One reason for holding rates was that there was still significant excess capacity available and that inflation would stay subdued until this was used up.

A second reason was concern that the economy had not achieved ‘escape velocity’ and could slow early next year, either for domestic reasons or because of adverse shocks emanating from overseas. These included the fear that the recent Eurozone crisis was dormant – but not dead – and worries over the potential adverse consequences of the fiscal standoff in the US. In contrast, the more hawkish SMPC members thought that the most common error was to underestimate the pace of the upswing at this stage in the business cycle and that recovery was likely to be maintained, unless there was another adverse shock to the money and credit creation process caused by further misguided regulatory attacks on the banking system.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Hold Bank Rate for next three months and use rate setting and QE to achieve growth in broad money of 3% to 5%.

The UK economy is recovering and now achieving above-trend growth. Survey evidence is clear-cut, with the monthly survey carried out by the Confederation of British Industry (CBI) – which is mostly of manufacturing – showing the highest balance of companies expecting to raise output since the mid-1990s. Past experience is that above-trend growth can be maintained for several quarters without provoking more inflation, as long as the revival is taking place from a depressed condition in which the level of output started well beneath trend. In fact, the September 2013 CBI balance on price-raising intentions was very low.

Money growth is satisfactory, but not particularly high. M4ex (i.e., broad money excluding balances held by intermediate ‘other financial corporations’ or quasi-banks) was 4.5% higher in July 2013 than a year earlier, but the annualized growth rate in the three months to July was only 3.3%. Reasonably strong growth rates of demand can be reconciled with these rates of money growth, which are modest by long-run standards, largely because interest rates are more or less at zero, and people and companies are finding ways of economizing on their holdings of unattractive non-interest-bearing money. In other words, the desired ratio of money to expenditure may be falling. The argument for ending Quantitative Easing (QE), which has not been in effect since the July meeting of the Monetary Policy Committee (MPC) anyway, and/or raising interest rates has more cogency than at any time in the last five years. However, analysis of data from the Bank of England shows that over the last year money growth would have been negligible in the absence of QE.

Despite the impetus that is supposed to have been given to extra bank credit by the Funding for Lending (FLS) and ‘Help to Buy’ schemes, banks are still not expanding their risk assets (i.e., their portfolios of loans to the private sector, and securities issued by companies and financial institutions) at anywhere near the rates that were normal before the onset of the Global Financial Crisis (GFC) in 2007. According to the Bank of England’s latest Money and Credit press release, “M4Lx excluding intermediate OFCs – i.e., lending by genuine banks to genuine non-banks – increased by £4.6bn in July, compared to the average monthly decrease of £0.9bn over the previous six months”. The three-month annualised and twelve-month growth rates were 0.3% and minus 0.5% respectively. So the July number was much stronger than that in other recent months, but it was far from spectacular. Before the GFC, the UK’s banks often expanded their loan assets by £15bn or £20bn a month! It cannot be overlooked that banks are still being forced to adjust to extra regulatory burdens, including the requirement that they keep their overall leverage ratio at a fairly high figure regardless of the quality of their assets.

Most of UK banks’ strategy re-appraisal from the regulatory upheavals of 2008 and 2009 now seems to be complete. With base rates only a little above zero and the pound still far below its international value before mid-2008, the UK economy is at last making a decent recovery. However, the money creation due to QE was stopped in July. With QE no longer boosting the quantity of money, a few months of extra data are needed before analysts can be confident that the UK banking system is once more in an expansionary mode. It may be that Britain’s banks can readily boost their risk assets while complying with all the new rules and regulations. Perhaps, but one has to be sceptical. The immediate inflation prospect is fine. It remains too early to advocate an increase in base rates. Nevertheless, the situation might be quite different six months from now if the banking system really is on the verge of – or already in the throes of – rapid credit expansion. (I doubt that this is likely, but have an open mind and let us watch the data.)

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Over the last month, more evidence has emerged of a strong bounce in UK output. Complete National Accounts data for the second quarter confirm that real GDP expanded by 0.7%, with growth led by housing investment and exports. First-quarter growth was revised up by 0.1 percentage points (from 0.3% to 0.4%). Market sector output, which removes the output of government and charities, the imputed rent of owner-occupiers etc. from real GDP, grew even more swiftly. Indeed, this was also true of the first quarter, when market output expanded by 0.6%.

Measurement of financial sector activity remains extremely tricky, with Office for National Statistics (ONS) data at times diverging wildly from survey-based indicators. It makes sense therefore to track non-financial market sector output as well. While this does not affect the interpretation of the first quarter data, it suggests an ever more rapid upswing in activity in the second quarter, when annualised growth in the non-financial market sector output was 5½%.

The latest GDP figures are not however uniformly positive. Revisions to the expenditure breakdown were slightly negative on balance, revealing stronger support from inventory accumulation and government spending, and on-going weakness in business investment. The continuing sluggishness of nominal spending also remains a worry. Annualised growth in private-sector home demand was less than 4% over the first half of this year, with overall Nominal GDP (NGDP) growth even weaker. Solid output growth in the first half of this year largely reflected very subdued economy-wide inflation as measured by the GDP deflator.

The weight of survey evidence supports the official ONS output data for the second quarter. Indeed, several different business surveys point to even faster growth in the current quarter. If historical relationships continue to hold, (annualised) market sector output growth in 2013 Q3 could be in excess of 5%. The latest composite Purchasing Managers Index (PMI) climbed to a sixteen-year high. The same is true of the most recent European Commission economic sentiment index as well.

There are also encouraging signs of rapidly improving risk appetite amongst Britain’s largest companies. Deloitte’s third quarter survey of UK Chief Financial Officers (CFO’s) highlighted a substantial pick-up in expected capital spending and credit demand over next twelve months. For the first time in six years, a net balance of responding CFOs saw the current environment as a good time to take on additional balance sheet risk.

The apparent revival of ‘animal spirits’ is especially welcome. Elevated uncertainty has been a major hindrance to capital spending for some while. If sustained, upside growth risks – e.g., from business capital expenditure and house-building – could materialise. Given this, and the strength of near-term growth momentum, there is no longer a need to maintain a bias towards additional monetary ease.

However, the case for a withdrawal of monetary stimulus is weak. Monetary indicators do not suggest a rapid pick-up in demand growth. While bank lending to the private sector is now growing, the more relevant indicator – broad money – is at best consistent with NGDP slightly below its long-run average. Real output may now be growing strongly, but the level of activity remains hugely depressed. The economy is operating with considerable slack, especially within the labour market, and as a result can sustain a prolonged period of robust growth. While the financial crisis has undoubtedly done permanent damage to the sustainable level of UK output, there are good reasons to believe that supply capacity will be endogenous to the pace of demand growth in the years ahead to some degree. Some of the apparent supply-side weakness that has emerged since 2007 should be reversed in a robust recovery.

Ultra-easy monetary policy is still needed in the UK. Indeed, with the Eurozone crisis far from over (witness the on-going Italian political farce, the rise of far-right parties in Austria, Holland and Greece, the bribery scandal engulfing the Spanish prime minister’s party etc.) it seems complacent to downplay external risks to the UK recovery. Domestic conditions are much improved over the last six months, but ‘escape velocity’ has not been reached.

Comment by Anthony J Evans
(ESCP Europe)
Vote: Raise Bank Rate by ½%.
Bias: Further rises in Bank Rate.

Generally speaking, the growth figures are healthy. Real GDP rose by 0.7% between the first and second quarters, and the September release of the national accounts revised up the growth between 2012 Q4 and 2013 Q1 from 0.3% to 0.4%. The growth rate for NGDP in the second quarter of 2013 was 3.5%, which is the first time it has been above 3% since 2011. Although this is below the pre-crisis trend, it is still a reasonable rate. Within these figures, there are some concerns about business investment. The growth rate of private investment (i.e., business investment plus private sector dwellings) has fallen steadily through 2011 and 2012, and is now virtually zero. A large increase in general government investment should not be treated as a sustainable solution.

In recent months, I have voted for rate rises on the grounds that moderate growth is sufficient evidence that the economy is recovering, and there appears no reason to change that now. External factors – such as the Eurozone crises or the regime uncertainty driven by the US fiscal cliff – remain muted. Broad money continues to grow above 4% on an annualised basis and the monetary stance can be considered to be accommodating. It could be argued that, had the Bank of England utilised an effective exit strategy, and began the process of interest rate normalisation in an anticipated way, there would be less fear about the impact of rate rises now. However, every month that passes prevents expectations from adjusting. It would be imperative that rate rises are accompanied by effective communication, and forward guidance is intended to do the exact opposite. Consequently the Bank of England has painted itself into a corner – they are staking their reputation on a commitment to a policy that is becoming increasingly ill-suited to the state of the economy. It would shatter confidence for the Bank to reverse course and raise rates whilst inflation and unemployment are at their current levels. However, this opens up the prospect of a battle of wills with financial markets driven by stubbornness. These are all examples of regime uncertainty that has been introduced by forward guidance.

In addition, there is an emerging concern that the UK housing market is demonstrating the same sort of exuberance that led us into the 2008 crisis, and the Bank of England’s assurances that they are able to spot, and prick, asset bubbles lacks credibility. One of the lessons from the previous boom is that they can occur under a stable consumer price level; therefore a slight fall in the rate of increase in the Consumer Price Index (CPI) figures should not be interpreted as evidence against a bubble. Furthermore, whilst shortfalls in aggregate demand are undoubtedly a key reason for the present state of the economy, this does not mean that aggregate demand is still too low. On the contrary, output figures, unemployment figures, and price figures all suggest the problems lie elsewhere.

Ed Miliband’s recent conference speech has raised the prospect of a return to 1970s style socialism. However, existing policies are causing immense damage to both the short run and long term growth rate already. The various ad hoc policies intended to improve lending to SMEs, and assist first time buyers, involve government interference in the allocation of capital. We should not be surprised that this leads to negative unintended consequences. One of the major downsides of existing QE is the public finance implications of the authorities becoming such a large buyer of government debt. But any rebalancing towards non-gilt assets would reduce further the neutrality of the central bank, and cement its role as a market participant, rather than as a market regulator.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate at ½%; maintain asset purchases at £375bn.
Bias: Use Bank Rate changes and QE to keep annualised M4ex growth at 4% to 6%.

After an increase of 0.7% quarter-on-quarter in real GDP in the second quarter, the UK economy showed numerous further signs of improvement in the July-September quarter across several sectors. This upswing in momentum can be expected to continue through the year end, though not at the same rate. Nevertheless, despite the recent upturn, the level of activity still languishes below its pre-crisis peaks, so the recovery is still in its very early stages.
The official index of manufacturing production increased by 2.0% (month-on-month) in June and 0.2% in July. Similarly the more important index of services (which accounts for close to 80% of the early, value-added GDP estimates) increased by 0.7% in May and 0.6% in June. Survey data such as the PMI’s have increased even more sharply. The manufacturing PMI increased strongly to 57.2% in August, its highest level for two years, and marking six successive months of increase. The service sector PMI has been above 50 since January, increasing moderately to April and then soaring to reach 60.2% in July and 60.5% in August.

Employment has continued to rise steadily reaching 29.836 million in June on the official definition and 32.486 million on the basis of total jobs (which includes those doing more than one part-time job), an increase in both cases of over one million since the employment trough in 2010. In addition the housing market has notably strengthened during recent months both in terms of production, prices and the availability of finance. House-building starts increased to 29,510 in the second quarter, about 65% of the pre-crisis level, while the number of new mortgages on dwellings has increased to 61,000 in June, again still only about half the pre-crisis level. Meanwhile, average national house prices increased by 3% to 6% over the preceding year in August, although prices in London and the south-east are up by as much as 8% over the same period.

For some analysts, the precise source of this recent upturn is somewhat of a puzzle. Some may claim that the Bank of England’s new ‘forward guidance’ together with the two government schemes to support bank lending – the FLS – and the initial phase of Chancellor George Osborne’s ‘Help to Buy’ scheme – have contributed to the upturn in performance. However, overall bank lending is still declining while the shift in the Bank’s policy is far too recent to have contributed. In fact, Governor Carney announced the new forward guidance strategy only in August. Under the new guidance, the Bank will not consider any rate increases until after Labour Force Survey (LFS) unemployment has declined to 7% – subject to three conditions: that inflation and inflation expectations were within suitable bounds, and that financial stability was not threatened. With unemployment at 7.7% in June, the Bank of England has forecast that its 7% unemployment goal would not be reached until 2016.

Realistically, there are three possible sources for the recent economic upturn: first the upturn in the Eurozone; second an easing of fiscal restraints; and third the delayed results of earlier monetary relaxation. The upturn in the Eurozone is not likely to have had much influence. While it is true that UK exports did increase by 3.6% quarter-on-quarter in 2013 Q2, it is domestic demand that has been strengthening more consistently, and since June sterling has been appreciating. Consequently, if exports were a source of renewed growth, this stimulus would be fading in the second half of the year. Second, fiscal easing is a more plausible contender because fiscal spending can have a rapid impact on domestic demand. Since February, government cash outlays have increased steeply, mainly due to higher spending on current goods and services plus transfers, though not on investment. But again, this appears more like a statistical fluke because the government has not changed course – at least officially – and the Coalition will be keen to show that it can maintain budgetary discipline and still generate a recovery.

The third possibility – earlier monetary relaxation – is a much more plausible explanation. Since August 2012, M4ex – i.e., the money supply held by households and mostly non-financial companies – has been growing at a fairly steady 4% to 5% per annum, which is ahead of the rate of inflation, and therefore steadily building up purchasing power in the hands of the private sector. The growth of the broader M4, which includes the money balances of financial institutions and bank-like intermediaries, has also recently turned positive on a year-on-year basis. The upturn in both series is, in turn, attributable to earlier QE or asset purchase operations by the Bank. Although wages and salaries have been falling in real terms, the rise in employment will have gone a long way to compensate for the weakness in incomes.

It therefore appears as though the seeds of a sustainable recovery have been laid thanks primarily to monetary policy. Given the high margin of unused capacity in both labour and capital markets, I would expect the recovery to be a sustained one, accompanied by low inflation for at least the next three years, possibly even longer. In this environment, the Bank should hold rates stable at ½%, but be prepared to undertake additional asset purchases if monetary growth plunges once more, or the Eurozone crisis flares up again. Rate increases at this stage would damage the prospects for economic recovery, and should be delayed until the recovery is substantially more secure.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral but use QE to keep growth in M4ex broad money at 4% to 6%.

Received wisdom tells us that the UK economic recovery is ‘in the bag’. Well, yes and no. The pick-up in broad money supply growth, as measured by M4ex, over 2012-13 is certainly being manifest in real economy and survey measures over recent months. Furthermore, there seems little doubt that the UK outlook is better than at any stage since the onset of the financial crisis. So yes, the outlook looks better, but no, there is little room for complacency. While the UK economy is likely to perform well over the next six to nine months, that does not mean it has attained ‘escape velocity’. Any acceleration in growth is unlikely to exceed potential output growth, which is probably around 2% at most.

Consequently, this recovery continues to be characterized by weakness on both the demand and supply side of the economy. In addition, the UK banking system is unlikely to deliver ‘escape velocity’ when regulatory constraints and balance sheet reduction suggest that the broad money supply will not expand sufficiently to maintain trend GDP growth, without active QE by the Bank of England.

On the supply side, the negative impact of the extent and range of the state on the incentive to work, save and invest means that potential output growth is weak. Faced with the choice between radical supply side reforms and politically expedient demand side reforms, the Government has chosen the latter.

On the demand side, the Government continues to pursue statist solutions to state created problems, with ‘Help to Buy’ the latest example. Given the steepness of the housing market supply curve, active measures to stimulate demand are more likely to be manifest in higher prices than increased output. More people may be able to get on the housing ladder, but they will pay more for the privilege as well. Government intervention on the demand side of the housing market will only push up prices. Government intervention on the supply side of the housing market, with genuine planning liberalization, would drive down house prices. Of course, the cynic might say that with less than two years to the next General Election, all that matters to the Government is the vote buying wealth effects on consumption which might ensue from an upwards spike in house prices.

House price growth may well create a limited ‘feel good’ factor and generate positive wealth effects on consumption, but significant constraints remain. Inflation continues to run ahead of earnings growth and the savings ratio rose in 2013 Q2. Rewind to the economic recoveries in the 1980s and 1990s and real income growth was much stronger, as was the potential stimulus to consumption from a rundown in the savings ratio. This is not to argue against a consumer stimulus, merely to argue that it will be more muted than in previous economic recoveries.

Thus far, all the analysis has focused on the economic outlook from a ‘Made in Britain’ perspective. Obviously the global dimension is critical also. The UK recovery could run out of steam in late 2014 of its own accord. Throw in a potential resurrection in the Euro crisis, a hard landing in China and jitters in the US bond market and the coming years appear as uncertain as the recent past.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE by £25bn per month.

A fault line is opening up between Conservative politicians keen not to bring the economy to another grinding halt and the ‘Taliban tendency’ among the regulatory establishment, to use Vince Cable’s delightful and, for once, quite accurate phrase. In particular, it had begun to dawn on the Conservatives and maybe also the Lib Dems, around a year and a half ago, that the economy’s previously glacial recovery had something to do with the lack of credit for small businesses and first-time home buyers. This in turn could be traced to the new regulatory rules, especially the burdensome capital-raising requirements. These requirements, when combined with general post-crisis nervousness, were causing the banks to shrink their balance sheets and particularly the ‘risky’ parts that carried the biggest capital-raising penalty. Longer term, these requirements raise the cost of making loans; short term they stopped them altogether. So the Coalition government came up with two ways of undoing the regulations by the back door: the FLS and ‘Help to Buy’, both in effect subsidising loans, respectively to business and first-time house buyers.
Lending to small businesses has not yet started to recover. However, and mercifully for the Coalition, lending to house buyers has done so with a vengeance and the house market is now starting to recover quite reasonably. London has been strong throughout and must be kept out of this picture – as it is a special market, dominated by an on-going influx of foreign buyers.

However, the rest of the country is now improving markedly, albeit from a low base because real house prices are still well below the pre-crisis peaks. This is true of the national average including London; and strikingly more so for the regions outside London. Our forecasts show that even the whole country average does not get back to the pre-crisis level until after 2016. It is true the housing market is now turning and it could of course move faster. However, it has a long way to go before it reaches what the usual suspects are calling ‘bubble’ levels. Indeed, all it is doing is remedying extremely depressed conditions as credit once again begins to flow.

While Mark Carney’s forward guidance is not in our view of much significance, it is good news that he and the Bank are treating these ‘bubble’ remarks with scepticism. The moral that should be drawn from these events is not that renewed credit is a bad thing but rather that the regulatory framework should be adjusted to allow it to get back to its old vigour. At this point, these various special schemes should be withdrawn. In practice, what seems most likely is that the schemes will be left in place and some lip service paid to the need to monitor developments down the road. What we can say is that the economy is at last recovering as credit starts recovering, at least in parts. A housing recovery is a particularly strong driver of the business cycle. Already construction is growing strongly again, led by housing. We can also expect consumer durable spending to pick up with new house construction. Meanwhile, real living standards are levelling off after a long decline; this is the result of steadier raw material prices, improving employment and rising tax thresholds.

Investment is picking up also, with large companies sensing that the economy’s corner has been turned and new improved capacity will be needed. While export markets in the emerging countries have cooled a bit, those in the Eurozone are at last levelling off after their long decline and in some cases improving.

The decision by the US Federal Reserve to keep monetary conditions continuously loose can be added to all these positives. The Fed warned recently that it would ‘taper off’ its programme of buying assets in the market with printed money. However this led to a big sell-off in bond and equity markets all over the world, which took the Fed aback. In the past few days, Bernanke has announced that the taper is temporarily off the table; and markets have instantly bounced back somewhat. As in the UK, the Fed’s current programme of asset-buying (the so-called QE3) is really an antidote to the new regulatory mania sweeping Washington as it has London. As this episode of ‘taper and then not to taper’ shows, it is going to be hard to withdraw this stimulant. For now, it is needed to keep some sort of credit growth going in the US, thus offsetting the headwinds from regulation. The Fed, unlike the Bank, buys assets across a wide range of classes and so to some extent competes directly with bank lending by lending directly on mortgages and corporate bonds. The Bank has found that its QE buying of UK government bonds only has had precious little, if any, effect on credit conditions; hence the need for those special schemes.

At some point in the future, the banks will be back in the full flow of business; no doubt they will eventually lobby regulators to ease back and as the economy improves their share prices will rise allowing them to acquire new capital more cheaply. Once this has happened, QE will need to be reversed rapidly to avoid excess credit and money expansion. However, the recent episode highlights the risk that this will not happen quickly enough, given the pressures withdrawal creates. For now, inflation remains muted while growth is picking up. Nobody in the Coalition is going to want to stop that combination. Meanwhile, markets are calm about longer-run inflation, somehow trusting that policy will reverse when needed. While I am not so calm, that is also my basic view.

My view remains that we now need bank regulation to be cut back; a short term agenda that moves in the same direction and seems to be having an effect is to keep the FLS and ‘Help to Buy’ on the boil, in spite of all the protests. Meanwhile, monetary policy needs to be tightened towards normality with a rise in Bank Rate of ¼%, and a bias to continue raising it; QE needs to be unwound gradually, withdrawn by £25bn a quarter; longer term I would like to see QE/the monetary base related to the growth in M4ex (versus some target growth).


Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up state-dependent banking groups before privatisation; raise Bank Rate to 2½%, and maintain QE on standby.

Last month’s SMPC contribution of necessity devoted so much space to the theoretical and conceptual issues arising from the Bank of England’s 7th August Monetary Policy Trade-offs and Forward Guidance paper that it was decided not to proceed to the next logical stage and ask what difference state contingent forward guidance made to UK economic prospects in the short and medium term. There are two ways of regarding forward guidance. One is as communications device pure and simple, which does not alter the likely course of interest rates but simply reduces the uncertainty facing private sector economic agents. The other, which the Bank has rather backed away from since August, is that it represents a commitment to hold Bank Rate lower for longer than would otherwise have been the case. The first possibility requires an ability to look inside people’s heads which is really the preserve of the psychologist or opinion pollster rather than the economist. However, the second possibility gives rise to the sort of bread-and-butter simulation on a macroeconomic forecasting model that econometricians have been carrying out for several decades. No such study has appeared since the announcement of forward guidance to the author’s knowledge. The purpose of this month’s SMPC contribution is to describe the results of such a simulation on the author’s Beacon Economic Forecasting (BEF) macroeconomic model of the international and domestic economies, which has existed in one shape or another since the early-1980s.

The BEF model differs from current official UK models because it treats the UK as a small open and trade-dependent economy with the UK sector of the model being substantially driven off a model of the international economy. In addition, more weight is given to supply-side effects and the behaviour of the broad money stock than is conventional practice nowadays. For the current exercise, three scenarios were run: 1) a base run in which the model equation for the UK short-term rate of interest was allowed to run freely from now to 2024; 2) a frozen Bank Rate run in which the three month domestic money market rate was set at 0.6% and Bank Rate itself (which has a lesser role in the model) at 0.5%, and 3) a long-run ‘neutral’ Bank Rate run in which the three month interest rate was set at 5.1% and Bank Rate at 5% throughout. Clearly, there is no limit to the number of plausible counter-factual model simulations that could be run, and it is not claimed that any of the three scenarios are realistic. Rather the intention is to get some rough and ready feel for the effect of different Bank Rate policies in a model where most of the key economic magnitudes, including the public sector accounts, the exchange rate, the broad and narrow money supplies and bond yields are all determined endogenously. This contrasts with current official UK models where many of the key variables are set by assumption, including in some cases potential output and inflation. Such ‘open systems’ can give rise to misleading policy recommendations because they do not properly allow for the second round and subsequent effects of policy changes.

In the BEF model, the key UK three-month interest rate is predicted using a statistical Error Correction Model with the long run properties that the UK interest rate equals the real ‘world’ interest rate plus the UK inflation rate. This is what one would expect in a small open economy, such as Britain possesses; one reason being that an excessive divergence of the real domestic rate of interest from the international norm is likely to generate undesirable volatility in the exchange rate and inflation. In practice, the large margin of spare capacity in the international economy means that the real world short rate is expected to only slowly adjust from the minus 1%, or so, observed in recent quarters to a smidgen over zero in the out years of the forecast. With UK inflation expected to ease over the next year to eighteen months – in part, because of the stronger external value of sterling, whose disinflationary power is probably widely underestimated – before picking up again in late 2014, the base run only includes a relatively modest upturn in Bank Rate to 1¼% late next year, just over 2% in late 2015, and some 2½% or so from 2017 onwards. This means that the difference between the base run and the frozen Bank Rate run is almost exactly 2 percentage points throughout most of the ten year simulation horizon.

Because the base run has Bank Rate sticking at ½% until the spring of next year, there is almost no discernible difference between the two simulations before the close of 2014. Even subsequently, the effects are small to start with because of the lags involved before the economy responds to higher interest rates. Thus, by the end of 2014, CPI inflation is only 0.1 percentage points higher with a frozen Bank Rate, with the same being true of real GDP. By the final quarter of 2016, the level of the CPI is 0.6 percentage points higher and the level of real GDP is raised by 0.5%. However, by the end of the simulation, in 2024, real GDP is 1.2% higher with the frozen Bank Rate but the CPI is almost 8% higher, corresponding to an increase in CPI inflation of 0.8% per annum. The balance of payments deficit is also worsened by some £24.3bn (0.3% of GDP) in the frozen rate scenario, although the PSNB is improved by some 1.3% of GDP by 2024 – the PSNB is in surplus on both runs under the base run assumption of a government current spending volume freeze – and the LFS unemployment measure is some 355,000 people lower. Gilt yields are also reduced with the frozen interest rate but the effect is more marked at the short end, as one might expect, with five year yields 0.9 percentage points lower and twenty year gilt yields down 0.6 percentage points. Finally, the M4ex broad money stock is 7.3% higher in 2024 with the ½% Bank Rate, which is not dissimilar to the extra rise in the CPI, while the ONS house-price measure ends up 19.6% up.

There is no need to consider the 5% Bank Rate scenario in the same detail, since this is a less likely outcome, at least until after the 2015 general election. The main cost of such hawkishness would be to lose 1.8% of GDP in 2024, compared with the base run, while the CPI would end up 13% lower and the balance of payments deficit would be reduced by some 0.3% of GDP. However, these gains would have to be counterbalanced against a worsened fiscal position and an extra 471,000 LFS unemployed. Overall, it is hard to avoid the conclusions that: 1) the short term effects of holding Bank Rate at ½%, say, up to the date of the 2015 general election would not be particularly significant, and 2) whether the longer term consequences are considered desirable or not depends on one’s trade-off between output and inflation. However, the fact that it takes an extra 6.7 percentage points on the price level to buy an extra 1 percentage point of GDP, suggests that the trade-off is not a particularly favourable one and that other measures – such as supply friendly tax reforms and less onerous financial regulation by the bureaucratic Taliban – would, almost certainly, deliver better output results at noticeably less cost. Also, the distributional effects of hyper cheap money polices enrich property speculators but bear down particularly hard on private sector savers who lose both an interest return and suffer exacerbated real capital losses as a result. It is also pretty galling for private savers that the central bank officials responsible for these consequences are just about the last people left in the UK to enjoy the luxury of RPI-linked pensions.

Since the wider economic background has been well covered by the other contributors to this report, there is little reason to go into the details here. The analysis above suggests that changes in Bank Rate within the relatively narrow range considered here are unlikely to have a major impact either way. It is not difficult to simulate, say, a 10% adverse regulatory shock to broad money in the BEF model and this would seem to have a more powerful effect than relatively modest changes to Bank Rate. In essence, there are three main reasons for wanting a Bank Rate increase of ½% in October, accompanied by no further increase in QE. First, British interest rates will have to be normalised at some point and it is less disruptive to start the process early, and in small steps, rather than leave it too late and then have to slam on the brakes, perhaps after a 2015 general election. Second, the evidence suggests that the recovery is gathering momentum. The normal policy error at this stage of the cycle is to underestimate the power of the upswing; one reason being that the initial ONS estimates seem to understate cyclical swings because of the way they are compiled. Third, the continued large deficit on the current account balance of payments is a prime face indicator that domestic demand is running ahead of aggregate supply, at least in a relative sense compared to our main trading partners. Finally, anyone interested in the wider monetary debate might like to know that the Fall 2013 Cato Journal (Vol. 33, no. 3) is devoted to monetary policy and includes papers by many distinguished monetary economists and former central bankers, including John B Taylor, Allan H Meltzer and Jurgen Stark (www.cato.org/cato-journal/fall-2013). Professor Taylor’s explanation of why the US Federal Reserve is misapplying his famous rule and exacerbating monetary instability is relevant to other central banks, not just the US Fed.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; no extension of QE.
Bias: To raise Bank Rate.

Various MPC members have delivered speeches in support of the new decision-making framework now that the dust has settled on the 7th August statement. Paul Tucker sums it up as follows: “the MPC’s forward guidance provides an articulated framework for a probing approach to policy, without a change in our preferences on inflation.” There are several points to be noted. First, the stance of policy is unaltered by the introduction of the new framework: it has neither a tightening nor an easing bias as a result of the change. Second, the previous dissension within the MPC over the desirability of making further asset purchases is hidden by the broad-based improvement in economic activity. This is not the same as saying it has disappeared.

Third, the August statement should be read as an articulation of existing policy preferences rather than a brand new policy. It is far from clear whether Mark Carney’s influence has moved the UK any further along the forward guidance spectrum. Presuming that each member of the MPC will have a say on each of the ‘knockout’ clauses, the governor’s opinion will be unlikely to hold sway.

Fourth, if the previous statements are accurate, then the MPC is in danger of substituting influence over interest rate expectations for influence over inflation expectations. If it is the agreed policy of the MPC to steer expectations for the first Bank Rate rise into 2016 and to present a united front on forward guidance (such that QE squabbles are left at the door), then it is unclear what purpose is served by holding monthly votes – for the MPC, the Shadow MPC or anyone else. The notion of selecting policy settings which are appropriate to achieve an inflation objective, or a path for inflation over a two-year horizon, seems obsolete.

The most significant event for British monetary policy in the past month was the decision by the US Federal Reserve not to commence tapering of its large scale asset purchases. Gilt yields at ten years have pulled back from 3% to around 2.7% since this announcement. Nevertheless, the Sterling curve is higher than it was on 7th August and Sterling itself has appreciated modestly. The MPC’s dilemma remains. Does it scream at financial markets that their interest rate forecasts are all wrong and hope to change the outcome? Or does it follow up the statement on forward guidance with an asset purchase programme designed to prise apart the short end of the UK and US curves? I am hard pressed to define the distinctive character of UK monetary policy.

In passing, it is worth noting that the UK balance of payments was in current account deficit of 4.3% of GDP in the first half of the year, up from 3.8% in 2012. While this deterioration has been driven by a loss of net income on investments, rather than an adverse movement in the visible trade balance, it is nonetheless deeply concerning that a barely recovering economy should have a sizeable external deficit.

Against a background of sluggish potential GDP growth and stagnant productivity, even a modest improvement in the growth outlook must be regarded as an invitation to begin the painful task of normalizing the short-term interest rate. The era of ½% Bank Rate should have ended in 2010; instead it lingers on. The first steps towards rate normalization – which might only be as far as 2% – should not be delayed. My vote is to raise Bank Rate by ¼% and to keep going.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking and University of Derby)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

Recent data show that the UK economy continues to recover. According to the latest Lloyds Bank business confidence Barometer, economic prospects rose to an all-time high in September, with more than two-thirds of companies indicating greater optimism than three months ago. Firms’ own trading prospects fell marginally, but the quarterly average is at the strongest level since late 2007, prior to the height of the global financial crisis. The robust levels of economic and trading prospects point to the potential for economic growth to remain strong and even accelerate in the second half of the year. Indeed, based on our survey growth could be ¾% in the third quarter and possibly the same in the fourth, giving annual average growth of 1½% this year.

Further, more than two-fifths of companies plan to increase staff levels in the coming year. The industrial sector (manufacturing and construction) and the south of the UK have the strongest economic prospects in the latest quarter, though all sectors and regions have seen prospects improve since the start of the year. Do I believe that the recovery can be sustained at this pace, no? But it does not look like it will slow appreciably until well into 2013 Q4 and that will not show up in quarterly data until the first quarter of next year, if the survey data are to be believed.

In short, this backdrop does not mean that recovery is so assured that official rates should now be increased. Unemployment is still at 7.7%; real pay is still falling by a little over 2% a year and investment spending is still declining. Recovery is based on renewed borrowing by households, which seems unsustainable at the current rate for long enough to as yet make recovery assured.

The revised and more detailed ONS national accounts for the second quarter published on 26th September included details of the household sector accounts. The good news is that the household saving ratio rose to 5.9% in 2013 Q2, from 4.4% in the first quarter (revised from 4.2%). In part, this reflected the modestly softer growth in household spending in April-June. However, the swing in the saving ratio primarily reflected a large increase in compensation of employees in 2013 Q2 after the unusual dip in the first quarter, likely reflecting a shift in the timing of payments after the reduction in some personal tax rates in the new tax year. Household sector accounts are likely to be a key measure for activity looking ahead. Future growth in household spending will be more dependent on real income growth and is thus likely to be more restrained.

Another downside risk came from the details of the current account data. It was not so much the second-quarter deficit, which came in at £13.0bn, but the upward revision to 2013 Q1 to a gap of £21.8bn (5.5% of GDP), from £14.2bn deficit (3.6% of GDP) in the previous release. This was almost completely driven by a £7bn adverse revision to the estimate of investment income to minus £9.2bn. This is by far and away the biggest shortfall in investment income on record. The ONS ascribed the scale of this revision in part to a change in the survey format in the first quarter, which contributed to a relatively low initial response. Nevertheless, the scale of the first-quarter income investment deficit now recorded is daunting (albeit it narrowed in 2013 Q2) and this asks significant questions of the UK’s ability to fund the external deficit over the coming years, if it is not further revised in subsequent quarters.

True, the third release of second-quarter GDP saw no change to the estimate of quarterly growth and did not reflect these risks. Growth was unrevised at 0.7% as expected. Within this there were modest changes to estimates of output in particular sectors, with industrial and construction output revised higher to increases of 0.8% and 1.9% respectively (from 0.6% and 1.4%). However, with estimates of service sector output left unchanged at 0.6%, this did not result in a change in the total estimate of output.

More significant, were the revisions made to the initial estimates of the expenditure components. Contributions from net trade and business investment changes were scaled back markedly, once again dashing hopes of more balanced expansion. Business investment is now estimated to have fallen by 2.7% (from a previously estimated 0.9% rise); net trade contributed nothing to GDP in 2013 Q2, reflecting adverse changes to both export and import estimates; consumer spending was revised a little lower to 0.3% from 0.4%. On an expenditure basis, GDP only remained at the previously estimated rate because inventories are now seen to have added 0.2% to GDP (initial estimate were for minus 0.2% points) – reducing some of the momentum from that source for the third quarter.

Meanwhile, price inflation is not a serious concern, especially with wage inflation of only 0.6% on an annual basis in the three months to July. CPI inflation inched lower in August to 2.7%, in line with market expectations. Inflation has averaged 2.7% over the past nine months, rarely varying from this rate. RPI inflation, by contrast, accelerated by a little more than the markets had expected, rising to 3.3% in August from 3.1% in July. The difference between RPI and CPI annual rates rose to its highest level since December 2011. This change was chiefly driven by a reduction in the compression caused by ‘weights’, which captures the different data source and population bases in the two indices. August’s producer price indices came in lower than markets expected. Input prices fell on the month. Output prices were softer than markets expected with headline factory gate inflation up 0.1% on the month.There is little here to suggest pipeline CPI inflation pressures. As for monetary growth, M4ex remains consistent with the recovery we are seeing so far but does not suggest it is accelerating. Recovery remains sensitive to unfolding events in the US and Europe, which could create serious issues for the UK in the weeks and months ahead. In this environment, I vote to leave rates on hold and QE at £375bn.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking and University of Derby). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, September 01, 2013
Shadow MPC votes 5-4 for rate hike, attacks forward guidance
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, finalised on 27th August, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 5th September.

Three members wanted an increase of ½%, while two advocated a rise of ¼%. This split vote for a rate hike would imply a rise of ¼% on normal Bank of England voting procedures. However, a substantial minority of four SMPC members believed that Bank Rate should be held at its present ½%, although most members did not wish to see an immediate addition to the stock of Quantitative Easing (QE).

The upwards revised second quarter UK growth figures, and the somewhat improved prospects for the Euro-zone, indicated that the pace of UK recovery was quickening. However, there was disagreement as to how long this could continue.

In contrast to the Monetary Policy Committee (MPC) minutes, the SMPC report contains individual and named contributions. It is significant, therefore, that several SMPC members independently expressed serious reservations about the Bank of England’s 7th August paper on forward guidance.

These ranged from fears that the Bank’s theoretical model was gravely flawed, to issues of practical implementation, including whether a lagging labour market indicator of the business cycle represented an appropriate threshold for re-considering Bank Rate. One danger of using a lagging indicator was that policy might end up doing too little too late – or too much too late – and create accelerating inflation or worsening boom-bust cycles. The final three SMPC polls of 2013 will be released on the Sundays of 6th October, 3rd November and 1st December, respectively.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Hold Bank Rate for next three months and use rate setting and QE to achieve growth in broad money of 3% to 5%.

At long last, the UK economy’s recovery from the traumatic shock of late 2008 and 2009 seems to have resumed in earnest. To remind, the recession began in the middle of 2008, and at its worst phase from 2008 Q4 to 2009 Q1 national output was falling by 2% to 2½% a quarter – i.e., at annualised rates of almost 10%. Output did recover in the year to mid-2010, but only by about a third of what had been lost in the previous year. Since then, output has on average moved forward, but the advance has been weak and intermittent compared with the steady progress of the Great Moderation, the period of roughly fifteen years from the start of 1993. According to official data, output remains well beneath its level at the previous peak in early 2008. However, the official data may be wrong and will undoubtedly be revised. Nevertheless, they have to be taken as ‘the truth’ for current purposes.

Hopes of a more sustained recovery in late 2013 and 2014 partly rest on stronger consumer spending. This may be related to stronger house prices and partly on the rehabilitation of the banking system. The world economy is also making progress. However, the Eurozone periphery remains crippled by the various dysfunctional features of the monetary union.

A critical influence in the UK background is that the growth of the quantity of money has picked up in recent quarters to the highest figures since the start of the financial crisis in late 2007. Corporate liquidity has been comfortable, enabling companies to expand by recruitment, by acquisition and by increases in capital spending. Share prices have also been buoyant. Personal sector wealth may not be back to previous peaks in 2007 and 2008, but the gains since the trough in early 2009 have been spectacular.

Because official estimates show output to be lower than at the early 2008 peak, some observers have prescribed monetary activism to boost demand, output and employment. (See, for example, James Zuccollo’s Kick-starting Growth, a report recently published by the Reform think-tank.) They are apparently confident that inflation would not ensue. A run-away inflation process does indeed seem distant. For the moment, consumer price inflation is still within the 1%-either-side-of-2% corridor which is acceptable under the inflation targeting regime, if only just. However, it is striking that survey evidence on labour shortages does not indicate an economy operating with a wide margin of spare capacity. The survey prepared by the Confederation of British Industry (CBI) shows that the number of companies where shortages of skilled labour constrain output was roughly in line with the long-run average. On this basis, an extended period of above-trend growth would reignite inflation worries. The implied conclusion – that the trend growth in the last few years has been very low, perhaps only a mere 1% a year – is depressing, but cannot be escaped.

According to its advocates, stimulatory monetary activism is justified partly by the government’s commendable determination to bring the budget deficit down and restore sustainability to the UK’s public finances. If fiscal policy cannot be used to boost the economy, monetary policy appears to have much in its favour. However, the years since 2009 have mostly been of above-target inflation (i.e., inflation above 2%) and often of above-corridor inflation (i.e., with the annual increase in the consumer price index more than 1% above the 2% target figure). Poor inflation numbers have been recorded despite the sluggish growth of demand. That, together with the survey evidence on labour shortages, argues against any deliberate attempt ‘to go for growth’.

The government obliged the Bank of England to introduce a Funding for Lending Scheme (FLS) in July 2012 and George Osborne, the Chancellor of the Exchequer, announced a Help to Buy scheme to promote house purchase in the 2013 Budget. Both schemes can be criticised as artificial and distorting. They are to be regarded as official attempts to negate the adverse effects on the economy of tighter bank regulation. It would be better simply to cancel or reverse the move to tighter bank regulation.

As already noted, the economy’s better tone owes much to a recovery in the growth rate of the quantity of money. In the year to June, the annual growth rate of M4ex was 5.0%, with the money balances of companies (i.e., ‘private non-financial corporates’) up by 8.0%. (M4ex is of course the UK’s traditional measure of broad money in the last twenty years; i.e., M4 excluding money held by ‘intermediate other financial corporations’ or quasi-banks.) It is important to understand that the money numbers, which are buoyant by post-2008 standards, are not the result of a revival in bank lending to the private sector. On the contrary, bank lending to the genuinely non-bank UK private sector (so-called ‘M4exL’ in Bank of England jargon) actually fell slightly (by 0.7%) in the year to June. The growth of the quantity of money occurred only because the Bank of England continued to conduct expansionary quantitative easing (QE) operations.

Tighter official regulation has held back the growth of banks’ risk assets since 2008. Banks have been under pressure to ‘deleverage’ (i.e., to reduce their asset totals relative to their capital) and to ‘de-risk’ their assets (i.e., to reduce the ratio of risk assets, nearly all bank lending to the private sector, to total assets). The pressure continues, with the Bank of England – like other central banks – introducing a simple leverage ratio as a constraint on banks’ balance sheets. Both Barclays and Nationwide have expressed anger about the new regulation, not least because it penalises them for having made some new loans in the last few years in response to official jawboning. Nevertheless, they must comply and have said they will to some extent reduce their assets.

So, we have two important institutions still ‘deleveraging’, more than six years after the closure of the inter-bank market to new business in August 2007. My interpretation is that bank lending to the private sector will remain sluggish in the next few months. It will remain sluggish despite the ‘forward guidance’ from Mark Carney, the new Governor of the Bank of England, that interest rates are to be kept low until the unemployment rate has dropped to 7%. However, this could be proved wrong, and the banking system and the economy may see more demand strength than is now the prevailing wisdom. This makes the debate on interest rates more complex and less clear-cut than it has been at any time since 2009, and developments in the next few months may justify the first ‘tightening’ (in terms of QE and Bank Rate) since the start of the crisis. New mortgage lending seems to be reviving, perhaps partly because of the Help to Buy scheme, although the stock of mortgage debt is not rising rapidly. For the time being, I remain in favour of continued asset purchases by the Bank of England, in order to deliver broad money growth of between, say, 3% and 5% a year, and want Bank Rate to remain at ½%. On the other hand, I am opposed to a programme of outright monetary stimulus, and believe – as always – that over the medium term the rate of growth of the quantity of money should be geared to low inflation or, better still, price-level stability.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Additional QE and a rebalancing towards non-gilt assets.

UK output growth has picked up notably since the turn of the year. Early estimates suggest real GDP expanded at an annualised rate of 2% in the first half. The expenditure breakdown suggests the acceleration is broad-based, with net trade in particular making a sizeable positive contribution. Stronger first-half growth occurred against the backdrop of marked destocking, suggesting a more robust expansion of final demand. Although real government expenditure (consumption plus investment) has surprised on the upside, the main strength has been in private sector final demand, including net exports.

Survey evidence suggests output growth may have strengthened over the summer. The July Purchasing Managers Index (PMI), for instance, implies a rate of expansion that is some way above the economy’s historical rate of growth. The latest CBI surveys also paint an optimistic growth picture in the near-future. Particularly encouraging are signs of strengthening demand for British exports. In the housing market, prices, transaction volumes and rates of house-building are all up. The latter are now at their highest level in three years. Housing investment could thus be a significant source of final demand in coming quarters.

Any withdrawal of monetary stimulus is premature, however. There remains significant slack in the labour market. It is less clear how much spare capacity firms are operating with. However, overall the UK output gap is still sizeable. A sustained period of output growth above 2½% is needed to make a dent into this slack. Indicators of underlying inflation are subdued: basic pay only grew by 1.1% in the year to 2013 Q2, while core inflation, which adjusted for last autumn’s tuition fee hike is currently 1.5%, has been below the 2% target since last December. Relevant also, is the continued weakness of nominal demand growth – private final demand in cash terms has only grown by 3.8% in the last twelve months, a rate well below historical norms.

The economy has not reached ‘escape velocity’. When it eventually does, there will still be no immediate need for tighter monetary policy. There remains plenty of scope for a period of robust growth before capacity pressures start to emerge, even if one is pessimistic about Britain’s supply potential. Broad money growth is currently consistent with a period of solid, albeit unspectacular, demand growth. It remains to be seen how far the de facto tightening of monetary policy, induced by financial markets, will impact money and credit growth in the near future. However, the substantial upward shift in expected (risk-free) interest rates seen in recent months will surely feed through to private credit growth, hence the expansion of bank deposits.

The MPC’s new forward guidance was meant to guide market rates downwards. To date, it has failed. The improving growth outlook has trumped the MPC’s (conditional) promise not to hike Bank Rate until unemployment has fallen to 7%. It is far from clear whether this upward lurch in rates is justified by the likely path of GDP growth and inflation. Although there is no need to alter the monetary stance at this meeting, the rise in market interest rates, if sustained, would be a concern. A bias towards additional asset purchases is at this stage maintained.

Comment by Anthony J Evans
(ESCAP Europe)
Vote: Raise Bank Rate by ½%.
Bias: Further rises in Bank Rate.

Despite falling in recent months, CPI inflation has been above target for so long that it is hard to treat 2.8% as anything other than alarming. Other inflation measures continue to be above target. One of the lessons from the build-up to the 2008 financial crisis is that asset bubbles can occur without runaway inflation and it is dangerous to wait until inflation spikes before trying to tighten monetary policy. The fact that house prices are rising as fast as in 2006 may just be coincidence. However, policymakers should be alert to the dangers caused by low interest rates. There is little evidence that they are any better at spotting, and stopping bubbles than they were in 2006. There is no rational reason to be reassured by Mark Carney’s claim that we can deal with such problems as and when they emerge. One would like to see how Canada’s housing market develops before according him that degree of foresight.
Generally, the economy is on a stable growth path. Most of the factors inhibiting growth are not directly affected by monetary policy; so, it is difficult for monetary policy to be seen as a source of higher growth. Low rates of GDP growth reflect a lower level of aggregate demand than prior to the crisis, but this is not necessarily bad. The economy would grow more quickly if people were able to form expectations about the future path of nominal GDP (NGDP). Unfortunately, the Bank of England allowed NGDP to contract significantly, and have no clear policy on where they are going.

The introduction of forward guidance is not a major change in monetary policy. After all, the supposed inflation target of 2% remains in place – or at least it’s not been explicitly abandoned – and the main tools with which the MPC can hit it (i.e., interest rates and QE) remain the same. That having been said, there is something new to it. However, it is concerning that the Bank has introduced a measure as politicised as unemployment into use for monetary policy purposes. Although it is not being targeted per se, it raises questions about the validity of Phillips curve type trade-offs, since it implies that policymakers are willing to permit above target inflation if unemployment is deemed too high. The main problems with the current UK jobs market include long term unemployment, which has even less to do with aggregate demand than the headline rate, and the rise of part time work or zero hours contracts – which can mask the extent to which reduced economic activity shows up in unemployment figures. The MPC say that they chose a modest threshold of 7% on the grounds that they didn’t want to be behind the curve, but then what is the point?

It is also hard to see how committed the MPC will be to adhering to such a threshold. The whole point of a credible monetary policy is that it requires the hands of policymakers to be bound. However, there are so many conceivable scenarios about what will happen to expected inflation, unemployment, etc. that it is hard to imagine that the authorities have no room to manoeuvre. Indeed, one difficulty with forward guidance is that it overstates the unity of the MPC. Although the spotlight has fallen firmly on Mark Carney, the fact that one member voted against the conditions under which forward guidance would be ignored is important. It means that right from the beginning there is uncertainty in terms of the commitment of individual members. One of the conditions is that the 7% unemployment threshold will be ignored if there is more than a 50% chance of CPI inflation rising above 2.5% in eighteen to twenty-four months’ time. Although the press implied that this was a non-arbitrary ‘knockout’, it still rests on the interpretation and judgment of individual MPC members. To some extent it, therefore, increases the amount of uncertainty that is due to the discretionary nature of monetary policy decisions.

Broad money continues to grow at around 5%, and narrow money supply measures are even faster. The economy is not booming but low interest rates are a reason why. Given that the aim should be to normalise monetary policy as soon as possible, there is not sufficient fragility to shy away from this. There is little doubt that an unexpected increase in interest rates would cause immense confusion and be destabilising to the economy. Nevertheless, in voting for an increase in rates, it also has to be assumed that this decision would be communicated effectively.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no more QE.
Bias: To raise Bank Rate further, and soon.

The past couple of years have seen a steady pickup in monetary growth. In the final three months of 2011, the Bank of England’s standard measure of broad money growth (seasonally adjusted M4ex) had an annual growth rate of well below 2%. In the latest numbers available at the time of writing (June 2013) that rate is around 5%, where it has been throughout 2013. That is still, perhaps, somewhat below the 6% to 8% one might estimate would be compatible with CPI inflation of 2% and 2.5% or so real GDP growth rate in the long run. Nevertheless, given that the sustainable growth rate for the UK economy is probably only in the 1% to1.5% region at present, 5% monetary growth is about appropriate. Recent months have also seen a distinct pick-up in the UK macroeconomic data. GDP is estimated to have grown at 0.7% in the second quarter of 2013. Since then, most survey data has suggested a further pickup. Quarterly growth numbers pushing 1% seem plausible for the second half of 2013 in a way that few commentators would have dreamed only six months ago.

The detail of the GDP growth figures implies a broad-based pick-up, including accelerations in investment and net trade, rather than just household consumption. Absent downside risk scenarios materialising (discussed in more detail below), there should be further scope for an expansion of non-oil net trade, especially if the situation in the Eurozone stabilises. Business investment may finally be responding to a combination of intrinsic pressure from long-postponed projects and the desire to shift from financial into real assets to gain greater protection from erosion by inflation – which has been endemic over recent years and likely to accelerate over the next couple.

International events in Syria, and the possibility of their spilling over into a wider conflict, constitute a threat both to international trading conditions and to oil prices. An oil price spike could have implications for inflation down the line. However, it is appropriate for monetary policymakers to await events for the time being. The more intrinsic threat of inflation for the UK comes from the likelihood of a large further acceleration in broad money growth. The danger, here, is that the large injection of monetary base via QE becomes leveraged into broad money as the economy recovers and the banks becomes less distressed. The extended nature of the 2011 and 2012 ‘double-blip’ soft patch in growth has not changed fundamentally the dynamics of the inflationary impact of QE on exit from recession, merely delayed it.

Absent further international events derailing British recovery, the underlying pressures should be expected to assert themselves, as follows. The first stage is that a huge increase in monetary base should translate into rapid broad money growth – increased capital requirements notwithstanding – and thus inflation down the line. Anticipating that inflation, investors and companies will exit from cash and financial assets into real assets in a distinct spike in business investment. Next, that spike in business investment will be associated with a rapid pick-up in GDP growth over a few quarters. Faster growth, in turn, will make the balance sheets of banks appear much improved temporarily. These stronger bank balance sheets will then facilitate a rapid pick-up in lending. Once this scenario is in play, the Bank of England will have neither the will nor the tools to control it fully. It will lack the will because the measures required to cap such rapid monetary growth will entail driving the economy back into recession; the Bank will not be willing to do that until it feels we have comprehensively escaped the previous recession. The consequence will be even higher inflation than the UK experienced in 2008 or 2011 – perhaps much higher.

When that inflation comes, workers will seek to protect their real wages by seeking rapid pay rises. When the Bank of England is, at last, willing to cap inflation, workers will not believe its promises and the consequence will be many workers stranded on excessively high wages who then become unemployed. The key problem with losing credibility on inflation is not the inflation – the inflation comes from the money growth, not the expectations. The key problem with losing credibility on inflation is the unemployment that will be the consequence.

The key near-term issue liable to derail the scenario above is, as it was in 2011, the Eurozone crisis. That is by no means resolved, though considerable political progress has been made. Eurozone policymakers are finally acknowledging that the Eurozone will only work as a transfer-union; without debt pooling but with annual payments made from richer to poorer regions of the Eurozone via a greatly expanded version of the EU’s current structural funds arrangement. A transfer union of that sort can only be delivered in combination with political union – the establishment of the EU Federation. The Euro was always going to imply the creation of a Single European State. For Britain, that EU Federation will have political and economic consequences within just a few short years but, for now, managing the great volatility likely to be associated with exit from the current recession is the priority for monetary policymakers. The Bank has missed each opportunity since 2010 for raising interest rates. It should not be missing yet another now.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE by £25bn per month.

The revised estimate of GDP growth in 2013 Q2 comes as a relief to UK economy-watchers. A quarterly increase of 0.7% is at last appreciable, if still not strong, growth. Is this a sudden onset of recovery? Not entirely, as the service sector has had growth averaging 1.6% per annum for the past two years. However, services expansion was overlaid by the weakness in manufacturing, a collapse in construction, a banking implosion and a decline in North Sea oil. Gradually those negative elements have dissipated. With North Sea oil, the government has been in talks with the major companies to give proper assurances that there will be stability in the tax regime for oil; previously, the North Sea was treated like a cash cow, with tax being used to collect ad hoc levies. Naturally, this produced a decline in new projects. In banking, there have been the two FLS schemes and, since the Budget, the Mortgage support scheme for first-time buyers. The latter has encouraged lending, especially for housing. In addition, there seems to be more awareness among ministers that bank regulation can be excessive for the good of the economy. Commercial bank profitability has risen and the Lloyds share holdings by the government are being readied for partial sale. In short, banking may be turning around.

Then we turn to the housing improvement, which has been spurred by the recent rise in house prices, apparently reflecting the mortgage subsidy scheme. This has put new life into construction prospects; and construction has at least stopped declining for now. Finally, manufacturing is picking up as the Eurozone flattens off into a slower decline and exports are being diverted elsewhere where growth is much stronger.

Looking back at the string of disappointing growth figures since the recovery began in late 2009, it seems clear that a key element has been the new regulative approach to banking. This has caused chaos in the banking sector and blocked the credit channel. It has been justified by the need to prevent future crises. However, the evidence supports the view that the crisis was brought about by much wider factors than banking, even if banking problems made it worse. After twenty-five years of breakneck world growth, there was bound to be a downturn as the world ran out of commodities. So, the new bank regulation will not prevent future such crises of capitalism. However, as we have seen, it can be lethal to growth both by attacking the UK’s key growth industry and by killing credit growth. Fortunately, now that the coalition politicians appear belatedly to have woken up to this – witness the outburst of Vince Cable about the ‘capital Taliban’ at the Bank of England – there may be more backpedalling on the new regulative miasma that has swept the British establishment in the wake of the crisis. This has over-compensated for the monetary and regulatory authorities previous failure to control the economy and banking boom of the earlier 2000s.

The trouble about the government’s approach to this backpedalling is that it is entirely ad hoc. The Mortgage support scheme has unlocked lending to housing, and mortgages are up, as are house prices. This unlocking will mean that recovery will include the housing sector, as it would have absent the credit blockage; construction of housing will pick up, as it should. Nevertheless, lending to Small and Medium Enterprises (SMEs) continues to crash, as banks are heavily penalised for lending to them because of the expensive extra capital they need to raise to back this up. Hence the two FLS schemes seem to have bombed out in respect of SME lending. How easy, after all, to ‘increase lending’ by lending you would have made anyway, so claiming the FLS subsidy, while continuing to cut back in aggregate lending to SMEs. The latest introduction by the Bank of England of the extra ‘leverage’ capital requirement is particularly clumsy and crass, coming as it does on top of the already cumbersome and damaging capital requirements related to risk-weighted loans.
What needs to be done is a severe cutting back of these new regulative capital requirements in favour of a return to a self-regulating regime. The Bank should then act as chief monitoring agent, in the same way as existed prior to the ‘Tripartite regime’ introduced mistakenly by Gordon Brown in 1997. Formulaic approaches to capital needs are crude and essentially arbitrary. Also, when risk-weighted, as in the Basel III agreement, such capital requirements penalise lending to SMEs even through collectively these are no more risky socially than lending to blue chips.

A second need is to focus monetary policy back on its old task of ‘taking away the punch bowl when the party gets merry’ (the classic, if now clichéed, description due to McChesney Martin at the US Federal Reserve). This could be achieved by reintroducing money supply or credit growth targets into the conduct of monetary policy, in addition to the long-term inflation target. The problem with inflation targeting on its own has been that inflation does not respond much in the short run to excess credit growth, because of the power of belief that it will be subject to the target. Yet as we have seen, when a credit boom takes hold, it can cause a banking problem to be super-imposed on a recession brought about by the normal forces of capitalism.

With a new Bank governor having just arrived, who has the confidence of the Chancellor, it may be that gradually policy will move in this direction and hence growth will be less restricted by the failure of the credit process. My forecasts assume that something of this sort will happen and hence I have growth staying in the 2% to 3% range from now on. So, coming finally to the monetary judgement, it is suggested that we need a gradual normalisation of monetary conditions. Contrary to the misguided forward guidance given, I would like interest rates to start being raised now, with a ¼% rise this month, with QE gradually being reversed, by £25 billion each month. At the same time, the FLS schemes need to be reformed to deal exclusively with SME lending (and for now mortgage lending; but Help to Buy will probably be enough to keep house lending unfrozen after the end of this year). Regulative targets for risk-weighted capital and leverage should be delayed for at least five years. Longer term, the regulative system needs to be rethought along the lines above.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up state-dependent banking groups before privatisation; raise Bank Rate to 2½%, and maintain QE on standby.

The emphasis placed on the Labour Force Survey (LFS) measure of unemployment as the trigger for re-considering whether a Bank Rate increase was justified in the Bank of England’s 7th August Monetary Policy Trade-offs and Forward Guidance paper appeared at first glance to represent a reversion to a static 1950s Phillips curve model of inflation in which the long-run Phillips curve did not shift vertically upwards with rising inflation expectations and there were no horizontal shifts in the ‘natural’ rate caused by institutional factors such as the replacement ratio of benefits to post-tax earnings. As such, it seemed to ‘un-learn’ all the knowledge that policymakers and economists had acquired over the past half century.

However, a more considered view is that the Bank’s economists were trying – perhaps, subconsciously – to rescue the Contemporary Theoretical Macroeconomic Model (CTMM) which originated in the US and became the accepted policy framework for the US Federal Reserve in the Greenspan era. The CTMM was pushed by American economists who wrongly wanted to take the money supply out of theoretical models. Its intellectual dominance explains why international policymakers were indifferent to the behaviour of the banking sector before the global financial crash; put crudely, if money did not matter, then neither did the behaviour of banks. A major weakness of the CTMM is that it requires a reliable measure of the Keynesian concept of the pressure of demand – i.e., the ‘output gap’ – if it is not to fall to bits. This is because the CTMM can be reduced to three equations in its simplest text book form: one for the output gap; another for the rate of inflation, and a third for the nominal rate of interest, with both the latter pair including the output gap as an important explanatory variable.

Ahead of the global financial crash, the author attacked the CTMM and its dangerous policy implications in his May 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). The full criticisms of the CTMM made therein will not be repeated here. However, it is possible to regard the Bank’s paper as an attempt to rescue the CTMM by substituting a labour-market measure of the output gap for the previous GDP-based one, which is now admitted to be un-quantifiable. One reason is uncertainty as to how far the shortfall of activity below its pre-2008 trend reflects a supply withdrawal as opposed to a demand shock. (A personal view is that it is indeed largely a supply withdrawal caused by the big government policies of the ‘Brown terror’ but that is too weighty a subject to be covered here.) Another is that the Bank’s economists now regard the GDP figures produced by the Office for National Statistics (ONS) as too unstable to be of any practical utility – a sentiment with which one totally concurs.

However, the fatal weaknesses of the CTMM are not eliminated by the Bank’s use of an unemployment threshold. First, a stationary variable such as the output gap or unemployment can only explain the rate of change of inflation not the rate of inflation for time series reasons. Second, the CTMM is a closed economy model without a government sector. However, both overseas developments and government spending and the tax burden are massively important in an open and highly socialised economy, such as Britain’s. Third, the exchange rate is only considered as a short-term source of temporary shocks. In a small open economy, such as the UK, one would expect the domestic price level to eventually equal the overseas price level less the exchange rate when expressed in logarithmic terms. This issue should have been confronted in the Bank’s paper. Finally, there does not seem to be a single mention of the money supply in the forward guidance report. This is an amazing lacuna in a central bank publication, even if one accepts that the velocity of circulation can vary significantly with the opportunity cost of holding broad money balances.

Perhaps fortunately, central bank officials can outdo Hollywood lawyers when it comes to get out clauses. The various ‘knockouts’ and other qualifications mean that the Bank of England can largely do what it likes in practice – complete discretion being the covert goal of most central bankers, almost regardless of whether they have the practical intelligence, operational competence and forecasting ability to use it wisely. Indeed, this represents a weakness of the whole forward guidance approach. It may be credible but otiose because the official forecasts are consistent with the consensus and proved broadly right after the event. Alternatively, officials may be overtaken by events so that the Bank has to give back word and further damage a credibility that has already been shredded by its consistent failure to achieve its inflation targets. There is also the problem that using a lagging indicator of the business cycle, such as unemployment, as a trigger means that rate setting is either dependent on accurate forecasting over a long-time horizon or is likely to end up ‘behind the curve’ and be de-stabilising in control-theory terms.

Furthermore, reducing the uncertainty about the future short-term rate of interest may exacerbate uncertainty about other important variables such as prices and output. This is likely to occur if the populace believes that policy is likely to end up doing too little too late – or too much too late – and risks creating accelerating inflation or worsening boom-bust cycles. The latter appears to have happened in the first decade of the twenty-first century in the US and Britain. A personal view is that it would have been better to have adopted the carefully-considered methods originally proposed for the European Central Bank by Otmar Issing and his Bundesbank colleagues ahead of European Monetary union (EMU) instead of forward guidance. In particular, the adoption of a formal monetary ‘second pillar’ would have led to more stabilising policies in both the boom and the bust of the 2000s.

As it is, the latest figures for the M4ex definition of the UK broad money stock showed a rise of 5% in the year to June, compared with 5.2% in May. The current monetary growth rate seems appropriate on a medium-term perspective given the rather subdued outlook for the growth of potential supply. One concern is that the government is crowding out the productive private sector from access to credit through the financial repression caused by excessively onerous regulations. The lending counterpart to M4ex declined by 0.7% in the year to June, for example. There is a serious risk that misguided additional regulatory shocks lead to a renewed downturn in money and credit, pulling the rug from under the nascent recovery.

Annual CPI inflation rate eased to 2.8% in July, although the old RPIX target measure was still 3.2% up on the year and the ‘headline’ RPI and the new RPIJ showed annual rises of 3.1% and 2.6%, respectively. Core producer price inflation accelerated from 0.9% to 1.1% between June and July, and annual house price inflation on the ONS measure accelerated slightly from 2.9% to 3.1% between May and June. The adoption of LFS unemployment as the trigger for re-considering Bank Rate means that the labour market statistics have acquired a new importance. There is an interesting discussion on the merits of the various labour market indicators in the Bank’s paper. The LFS measure of joblessness has been largely constant at 7.8% during the five quarters ending in April-June although the claimant-count unemployment measure eased by 2,900 in July to 145,400 down on a year earlier. Nevertheless, overall wage pressures remain weak and economy-wide earnings in April/June were only 2.1% up on the corresponding three months of 2012.

There are three main reasons for wanting a Bank Rate increase of ½% in September, accompanied by no further increase in QE. First, British interest rates will have to be normalised at some point and it is less disruptive to start the process early, and in small steps, rather than leave it too late and then have to slam on the brakes. This is the late Lord George’s famous ‘stitch in time saves nine’ (i.e., a Bank Rate of 9%) criterion which contrasts markedly with Mr Carney’s approach of holding Bank Rate until well after the recovery is firmly established. Second, the upwards revision to UK GDP in the second quarter announced on 23rd August, which meant that non-oil GDP rose by 1.7% on the year and 0.7% on the quarter – which represents an annual equivalent rate of 3% – suggests that the recovery is gathering momentum. Third, the continued large deficit on the current account balance of payments, which amounted to 3.8% of market-price GDP last year and 3.6% in 2013 Q1, is a prime face indicator that domestic demand is running ahead of aggregate supply, at least in a relative sense compared to our main trading partners.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; no extension of QE.
Bias: To raise Bank Rate.

On Wednesday 7th August, the Bank of England’s MPC responded to the Chancellor’s Budget-time request to assess the merits of forward guidance. In so doing, it has made the most significant adjustment to its monetary policy framework since 2009 – pledging to keep Bank Rate and the size of the asset purchase programme at least at current levels until the UK’s unemployment rate falls to below 7%. Currently, the rate stands at 7.8%. It is evident from the Bank’s communiqué that it remains wedded to the notion that there is a high degree of slack in the economy. The assertion of unused economic capacity has been a consistent theme in Bank of England Inflation Reports over the past five years. During this time, inflation has been as high as 5% and persistently higher than the inflation target of 2%. Lacking a satisfactory measure of economic slack, it is impossible to test the assertion. Many survey measures of industrial capacity utilisation are close to regaining, or have already regained, the levels that pertained before the credit crisis of 2007 and 2008. The assertion of spare capacity presumes that the crisis damaged demand capability significantly more than supply capability. On the contrary, the evidence suggests that the potential growth rate of the economy has been reduced and the justification for further demand-side stimulus is invalid.
The LFS measure of the unemployment rate that forms the basis of the new policy framework gives only an approximate measure of the tightness of the labour market and notably fails to capture the extent of under-employment. The achievement of a 7% unemployment rate could be attained in a wide variety of economic circumstances, corresponding to different combinations of: labour participation (the proportion of the population of working age that is economically active); labour productivity (the output achieved by a unit of labour input), and labour intensity (the average length of the working week). The unemployment rate has a very loose connection to the MPC’s concept of economic slack.

Within its own paradigm – the post-Keynesian sticky price model – the new policy framework is flawed and over-complicated. For those of us that reject the paradigm, the criticisms go deeper still. It is remarkable, twenty years after the global supply chain revolution, that macroeconomists still have ‘slack’ as their central concept and domestic slack at that. Better to junk the whole concept of slack and work from the premise that domestic supply adjusts rapidly to global demand conditions. What business can afford to hoard productive capacity or excess inventory when the real cost of capital confronting it is positive? Unused capacity is under intense pressure to be scrapped or sold. The notion that businesses have mothballed commercially relevant spare capacity for four or more years is ridiculous. Supply chains and networks are managed such that supply conditions at the top of the chain are permanently tight. When demand disappoints, the pace of supply adjusts extremely quickly, since the storage capacity for inventory has also been managed lower over the years.

The Bank of England’s new framework makes a strong assumption about the supply response of the UK economy which conflicts with recent experience. Rather than a cyclical improvement in productivity, the outlook is for on-going stagnation or decline as overstated productivity gains in the pre-2007 period continue to normalise and as employment growth is concentrated in low-productivity jobs. In other words, the economy is rebalancing towards structurally lower average productivity. By implication, it may be possible to reach an unemployment rate of 7% quite quickly. As an aside, when the 2011 Census estimates of the UK population (roughly 1 million higher) are incorporated into the LFS, there could be an abrupt fall in the unemployment rate.

What starts out, within its own paradigm, as a clearly-defined framework of path-dependent interest rate and asset purchase guidance descends into confusion and chaos by the end of the statement. Three ‘knockout’ clauses are added, relating to inflation, inflation expectations and financial stability. In the case of the latter two clauses, no means of calibration are offered and hence no parameters on which market expectations can be based. Arguably, the remaining clause, which stipulates that the unemployment threshold will be scrapped if CPI inflation eighteen to twenty-four months ahead is more likely than not to be above 2.5%, is also notional. For years now, the MPC’s inflation expectations have been overly optimistic, resulting in consistent inflation overshoots. In the ten years, the MPC has not included a central expectation of inflation on a two-year horizon that breached 2.5%. This projection has been used, essentially, as a signalling device.

The coup de grâce is the admission that neither the 7% unemployment threshold nor any of the knockout clauses represent trigger points for MPC action. Far from knockout clauses they are pulled punches. The MPC retains discretion over the appropriate course of action. The whole rationale for forward guidance is that pre-commitment exerts traction over the rate curve. To the extent that pre-commitment is retractable, no traction will be exerted.
Also worthy of note, is the absence of any mention of an exit strategy. In the question and answer session that followed the statement, it was stated that a rise in Bank Rate would be the first manifestation of policy tightening rather than asset purchase tapering or asset sales. In fact, the MPC goes to great lengths to emphasise that, in contrast to the Federal Reserve, tapering of asset purchases is not on the policy agenda. Indeed, the MPCs selected economic threshold of 7% unemployment rate is not expected to be reached until after 2016 according to its central projection. This is beyond its forecast horizon. This rather pessimistic projection, especially as the UK economy gathers momentum, looks to be an overt attempt by the Committee to steer the financial markets to the timing of the first rate increase.

The announcement of the UK’s forward guidance framework has coincided with the approaching timetable of tapering of asset purchases by the US Federal Reserve. So far, it is the unwinding of leverage in the US bond market, with a concomitant rise in bond yields, which is the dominant influence on the UK yield curve also. The MPC faces a terrible dilemma. Does it scream at financial markets that their interest rate forecasts are all wrong and hope to change the outcome? Or does it follow up the statement on forward guidance with an asset purchase programme designed to prise apart the short end of the UK and US curves? It is unlikely that the MPC will wait long before tinkering further.

Against a background of sluggish potential GDP growth and stagnant productivity, even a modest improvement in the growth outlook must be regarded as an invitation to begin the painful task of normalising the short-term interest rate. The era of ½% Bank Rate should have ended in 2010; instead it lingers on. The first steps towards rate normalisation – which might only be as far as 2% – should not be delayed. My vote is to raise Bank Rate by ¼% and to keep on going.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold Bank Rate; no increase in QE.
Bias: To raise Bank Rate sooner rather than later (i.e., a rising forward curve) and winding down QE.

Mr Carney has quickly made his mark on the MPC by ushering in a change in the Bank of England’s conduct of monetary policy: the introduction of forward guidance. This raises a number of questions some, but not all, of which are addressed in the Bank’s accompanying paper Monetary Policy Trade-offs and Forward Guidance of August 2013. The main issues here are as follows. First, is this a good idea in theory? Second, how does the Bank’s proposed implementation compare with what theory suggests should be done? Third, has its implementation elsewhere improved the impact of monetary policy? Finally, is it likely to improve UK monetary policy, worsen it or make no practical difference?

In theory, forward guidance aims to influence the market’s expectations about future short rates. In other words, it aims to affect the forward yield curve and long rates and, through these, economic activity, including inflation, output and unemployment. Instead of trying to infer current and future monetary policy from past behaviour, and so making mistakes, forward guidance, by signalling future policy intentions, attempts to align the market’s views more closely to those of the Bank and so better implement monetary policy and enhance macroeconomic performance. It follows that a simple test of forward guidance is whether the forward yield curve accords with interest rate announcements.
Such additional information is, however, only beneficial if it is correct. The danger is that policy in the future differs from the forward guidance. This could be because economic conditions have changed unexpectedly, or because the policy objective has changed, for example, by switching from strict inflation targeting to flexible inflation targeting in which output or unemployment or financial stability become additional targets.

In an attempt to minimise these problems, in the accompanying notes the Bank of England has tried to spell out the conditions under which it would change interest rates in the near future; it calls them ‘knockouts’. The two main knockouts are a fall in unemployment below 7% and an unexpected exogenous positive shock to inflation, such as imported inflation. In the future, the Bank would need to develop a new communications strategy in which it spelled out how these conditions were being changed over time, and how it was altering its policy targets.

Forward guidance was first introduced in New Zealand and Norway. Subsequently, it has been used by the US Federal Reserve. No harmful consequences have been found for New Zealand and Norway. Nevertheless, the counterfactual of whether outcomes would have been different had they not used forward guidance is difficult to assess. The initial experience of the US was that market forward rates seemed to have been little influenced by the Fed’s forward guidance, and so the experiment was dropped. More recently, it has been reintroduced, but now accompanied by QE, which makes assessing the influence of pure forward guidance more difficult. This evidence suggests that forward guidance has done little or no harm, but neither has it produced any discernible benefits.

In the UK, the forward guidance seems to be little more than a restatement of the policy being followed by the Bank, though not made explicit. Perhaps this is why MPC members known to favour the previous system have not opposed its introduction and were happy to let Mr Carney show publically his influence on monetary policy.

Nonetheless, the announcement muddies the waters of what monetary policy is trying to achieve. The Bank of England Act of 1997 and the accompanying memoranda states that the aim of monetary policy should be to keep inflation within 1 percentage point of a target value – 2% for CPI inflation – and only subject to achieving this should it aim to support the government’s other objectives in output and employment. The wiggle room for the Bank was in how quickly it aimed to bring inflation back on target once it had breached the bands. The recent recession has shown that the Bank has interpreted this as indefinitely – or as long as inflation expectations are not being affected. The announcement of forward guidance has made explicit the new ingredient it has added to its policy objectives, namely, that the rate of unemployment is also a target. In other words, the Bank has formally shifted from being a strict to a flexible inflation targeter. This is despite the clear message from economic theory, which was widely accepted – including by most senior members of the MPC – that macroeconomic welfare is higher under strict rather than flexible inflation targeting. The difference is most pronounced when higher inflation is due to supply rather than demand shocks.

Coupling inflation and the rate of unemployment has a disastrous history as witnessed by the demise of the Phillips curve which it turned out only held if monetary policy is accommodating. Even if the Bank does not take the view that targeting unemployment is in order to achieve its inflation objectives – which was how the Phillips curve was used – it is not clear whether the Bank thinks that by holding interest rates down it can reduce unemployment, or whether it intends to hold interest rates down until unemployment falls as a result of factors not under its control. The knockouts only add to the confusion as they are determined by the Bank. In effect, they give the Bank complete discretion in setting monetary policy, as in the past.

For some time, given its remit, the Bank’s conduct of monetary policy has been a puzzle and contrary to accepted theory. Commentators have had to infer from its actions what the Bank’s objectives are. The announcement of forward guidance has the merit of making these objectives more explicit. In effect, it has also given the Bank an additional policy instrument to accompany the short rate, namely, the long rate. For forward guidance to be effective it will be necessary to communicate its strategy for setting the long rate in a transparent way. To sum up, the best that can be said for forward guidance is that it makes the Bank’s departures from its remit more explicit but it does not affect the Bank’s room for discretion. As the raison d’être of forward guidance is to improve market expectations, it will be necessary either to forego the use of discretion or to communicate any change of strategy very clearly.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.


UK growth is on the up, with the revised figures showing that real GDP advanced by 0.7% in the second quarter. So far, the leading data for the third quarter – such as the PMIs for manufacturing, services and construction – suggests that growth in July/September will be similar to that recorded in the second quarter. The detail for the second quarter GDP data showed that services activity was robust, at plus 0.6% on the quarter (compared with plus 0.5% in 2013 Q1). Perhaps surprisingly, however, this was matched by strength in industrial output (plus 0.6% in 2013 Q2 compared with plus 0.3% in Q1) and outdone by construction (plus 1.4% versus minus 1.8% in Q1). The latest PMI’s suggest that, with construction at 57.0, services at a ten year high of 60.2 and manufacturing at 54.6; growth is starting the second half on a strong and sustained note. Services are benefiting from a pick-up in household activity, manufacturing from better prospects in Europe (or at least a bottoming out of the downturn) and the US recovery, and construction from the revival in demand taking place in the residential housing sector helped by FLS and the prospect of Help to Buy.

Of course, the ONS pointed out that GDP was still 3.3% below its Q1 2008 peak. And private sector investment is 34% down from its pre-crisis high. Therefore, economic growth has a long way to go before it can be called robust. On top of that, it appears that it is consumer and government spending that are leading the recovery, which is hardly consistent with net debt to income ratios for households of over 140%. If business investment does not step up soon to lead the recovery, it will surely peter out or at least face significant enough headwinds to stall. We do not know what might lead to a serious shock in consumer or business confidence, it could be a crisis in Europe or some other event that by its nature we cannot forecast. However, recovery based on renewed household debt has to be seen as potentially resting on shaky foundations.

Still, the monetary statistics are supportive of a continued recovery and price inflation is slipping back. Core CPI inflation edged down to 2.0% for June, from 2.3% in May. On average, it has been around these levels for the past year, roughly in line with the trend seen in 2009. On a three-month annualised basis, the growth in M4ex broad money was 4.7% in June, up from an upwardly revised 4.4% in May and ending a fall to a low of 2.8% in 2013. This means that the economic recovery is likely to persist. However, this will probably be at a pace that means that inflation is not a threat and that continued spare capacity in output and the labour market will last for some time. Despite financial market perceptions to the contrary, it is not clear that LFS unemployment will fall to 7% even in two years’ time. Not least is the fact that very weak productivity, which if it picks up, say based on increased company investment and higher participation rates, means that unemployment might not fall much if at all.
Higher long term interest rate might also persist – despite forward guidance – unless action is taken by the Bank of England. The improved UK economic figures; the evident recovery in the US, and hence the prospects of tapering by the US Federal Reserve, are serving to drive up longer term rates. In my view, validating the financial markets’ expectations now with a rate rise is simply inappropriate. Bank Rate should stay on hold at ½%. Indeed, if the MPC is serious about forward guidance, given the challenge from financial market moves in the opposite direction to that intended by the official rate setters since its announcement, further QE cannot be ruled out.


What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, July 28, 2013
Shadow MPC votes 6-3 for half-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 9th July, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 1st August. Five SMPC members wanted an increase of ½%, another voted for a ¼% increase, and three voted to hold Bank Rate.

This vote distribution implies a ½% increase on normal Bank of England voting procedures. Although opinions differed on many issues, there was broad agreement on the shadow committee that over-regulation of the financial sector was a clear and present danger to the UK economic recovery.

The six that wanted to raise rates cited a variety of reasons. Broadly, one was that monetary policy was ineffective with interest rates at these levels and a rise was required so that a cut to help ward off a future crisis, such as one in the euro area, would be possible. Another reason was that with inflation exceeding its target for so long, the Bank of England ran the risk of being seen to be not serious about the inflation objective.

This is linked to the point that inflation was the Bank’s target not growth, and if the latter was the target, then the policy had not worked since the recovery remained feeble. The third broad final point of those wanting a rate rise immediately was that monetary policy cannot solve the real problem of the economy, which is a supply side one. The three dissenters argued that the time was not yet right for a rate rise and the risk of triggering a further crisis was simply too high at this point. Forward guidance was seen by some as a target and not as policy, and there were doubts about how effective it would be without some supportive policy action from the Bank of England.

Minutes of the meeting of 9th July 2013

Attendance: Philip Booth, Jamie Dannhauser, Joanna Davies (Observer - Economic Perspectives), Anthony Evans, Graeme Leach, Tim LeFroy (Observer – IEA Intern), Andrew Lilico, Kent Matthews (Secretary), David B Smith, Peter Warburton, John Webster (Observer - IEA Intern), Trevor Williams.

Apologies: Roger Bootle, Tim Congdon, John Greenwood, Patrick Minford, David Henry Smith (Observer – Sunday Times), Akos Valentinyi

Chairman’s introductory comments

The Chairman said that he would be unavailable to help with the production of the Minutes as he was attending his son’s wedding in Vietnam and said that Trevor Williams would substitute for him in his absence. He also said that the revision to the national accounts announced shortly before the SMPC gathering had noticeably affected the value figures as well as the volume figures, and that the revised data went back to the start of 1997 only. The ONS has promised the revised historic database sometime after July 31 following the publication of the Blue book.

He then invited Peter Warburton to present his analysis of the global and domestic trends.

Economic situation

Peter Warburton distributed a pack of charts and tables for reference. He began by observing global private sector credit trends, noting that bank lending was undergoing a recovery – albeit insipid. Outstanding corporate sector bond debt was accelerating, while financial institutions were on the cusp of re-leveraging as growth in debt edged above nominal GDP growth for the first time since Q4 2009. Overall, he noted that there had been a gradual improvement in private sector debt growth, but it remained feeble enough – at just below 5% per annum – to keep central banks fully engaged. He observed that surging corporate credit issuance had not displaced bank lending.

Referring to the charts and tables of global monetary growth Peter Warburton observed a similar profile to that of global credit. Global broad money growth of just above 7% per annum reflected a mixture of modest acceleration in developed economy money and gradually decelerating emerging market money. The trends in broad money growth were sufficient to support a faltering recovery in the advanced economies. US bond yields had surged in the past month with implications for debt service and future fiscal policy. Recent US research shows that QE had positively impacted high net worth households but had not improved the net worth of other, less wealthy households. Global nominal GDP growth had slowed materially in the past two years but had steadied since the middle of 2012 and improved slightly in Q1.

Adoption of path-dependent QE in the US, QQE (quantitative and qualitative easing) in Japan, and with hints of forward guidance on interest rates by the ECB and Bank of England, meant policy imparted a reflationary bias to the global economy. However, there were three headwinds to consider. First, the difficulty the US Federal Reserve had encountered in the communication of its QE tapering message suggested that bond yields would announce actual monetary tightening long before the Fed does. Second, the deliberate liquidity squeeze and recent clampdown on shadow banking activities in China might spark a greater slowdown in economic growth than intended. Third, the disinflationary effects of Yen depreciation on other economies’ export pricing in the region.

In contrast to the stubbornly high rate of unemployment in the advanced economies, the unemployment rate in emerging market economies had been falling. This was primarily a reflection of the strength of domestic demand, since world export growth remained very subdued, even among emerging nations. Manufacturing Purchasing Managers Indices (PMIs) for Japan had seen an improvement but China and India were disappointing. World inflation, on a GDP-weighted basis, remained moderate at just over 2%, but on a population-weighted basis, which took greater account of high food weightings in populous emerging nations, inflation was much faster at 6.5%.

Turning to the UK, Monetary Financial Institutions (MFI) negative net lending growth indicated that the Funding for Lending Scheme was struggling to reach its desirable 5% to 9% growth band. All past attempts to boost the housing market had not succeeded but the latest policy, ‘Help to Buy’, appeared to be bearing fruit with housing transactions showing an encouraging rise, backed up by a rising UK construction PMI.

The revised figures for GDP showed a disturbing downturn in capital expenditure. However, on the plus side the manufacturing PMI had maintained its solid second quarter performance. Domestic market conditions had improved while overseas demand had strengthened. The PMI service sector had accelerated to its highest level since March 2011 and there was some improvement in consumer confidence.

The decomposition of retail price inflation revealed a stubborn underlying private sector inflationary trend. The labour market paradox remained with a rising employment rate and increasing weekly hours worked and yet very weak annual growth of the wage bill. There was a suggestion in the data that labour incomes were pushed forward into Q2 to benefit from the lowering of the top tax rate. The worsening of the UK’s current account deficit had continued and the outlook for Sterling remained unsettled ahead of Bank of England policy announcements in August.

Discussion

David B Smith thanked Peter Warburton and opened the meeting out to general discussion. Andrew Lilico began the discussion with a reference to Simon Ward’s work on the M1 narrow money/nominal income relationship and suggested that they should consider which monetary measure was the appropriate indicator in this economic climate. There followed a discussion as to whether M1 was a leading or coincident indicator. Jamie Dannhauser and David B Smith said that M1 was a coincident and not a leading indicator.

There was a discussion about the implications of forward guidance but Andrew Lilico said that the Bank had no credibility for sticking to targets and that forward guidance would have no effect on expectations. He said that any lenders that were making loans to borrowers conditional on interest rates this low had no business doing that. He added that the worry was that nominal income growth would raise the balance sheet of banks, which would lead to an increase in bank lending, and the cycle would restart with inflationary growth.
Graeme Leach discussed the sustaining of the higher than normal zombie companies on the commercial banks books. Andrew Lilico said that an upturn in nominal income growth would see zombie companies being wiped out, as typically more companies die off early in recoveries than during recessions.
Trevor Williams said that normally lending would rise with an improvement in balance sheets but with on-going delevering and the leverage ratios being imposed this might not happen to the same extent. Andrew Lilico was sceptical that the Bank of England would maintain its hard stance on leverage ratios in the upswing. David B Smith said that George Osborne was thinking in terms of the political business cycle not the wider public good.

Peter Warburton said that some supply side adjustments were occurring. He said that real wage growth had fallen and hours worked were growing. David B Smith said that the ONS was trying to do the impossible by measuring intangibles such as software in the process of development in the capital expenditure figures.

Andrew Lilico asked if the rise in bond yields were the result of withdrawal of QE or rising expectations of growth. Trevor Williams and Jamie Dannhauser said that the bond market in the UK was heavily influenced by the US bond market and the influence from QE was likely to be smaller than that from global capital flows.

David B Smith called on the committee to make their comments on monetary policy. Philip Booth said that since we would not get unanimity on a change in interest rates he asked if the committee would make a united stand on the negative effect of bank regulation on the ability of the banks to fuel the recovery. Jamie Dannhauser said there was an anti-commercial-bank culture within the Bank of England.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate ½%.
Bias: To raise, and neutral on QE.

Philip Booth said that inflation had been above target for four years. The Bank of England was given the task of targeting inflation. Growth being high or low was the result of other policies of the government that had affected the supply-side and which monetary policy could not address. The existing situation pointed to a tightening of monetary policy. Philip Booth said that the underlying problems were on the supply-side. He said that the productivity problem could not be solved by monetary policy and that Bank Rate should be raised by ½%, given the forecast for inflation, and that there should be no further QE.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: Monetary easing.

Jamie Danhauser said that he was encouraged by the recent data. The PMI surveys were pointing in the right direction and monetary growth was trending back towards reasonable rates. However, the revised indicators showed that output was even further below the pre-recession peak. There was considerable slack in the economy. He said that it was hard to believe the productivity collapse that the data was indicating. He said that he was also concerned about the hysteresis effects of the recession, and that euro issues were still around. With the global economy still weak, there was a strong case for the maintenance of the current monetary position.

Comment by Anthony Evans
(ESCP Europe)
Vote: Raise Bank Rate ½%.
Bias: To raise.

Anthony Evans said that he was concerned about the reverence given to the new Governor. He said that there was little scope at this point for monetary growth to generate real growth, and was disappointed that the Governor seems to have placed forward guidance as a more important issue than nominal GDP targets. He recognised the danger of early tightening but rates were too low and if it is a choice of rising rates too early or too late it was better to be too early. He acknowledged that the economy was fragile but believed that current policy was making it even more fragile. The squealing noises that came out following the Fed moves was all the more reason to start the process of normalisation. There was so much uncertainty about how markets would react to a rate rise that it was almost worth doing as a controlled experiment to test reaction.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and hold QE.
Bias:Neutral.

Graeme Leach said that he has been forecasting an L shaped recovery for some years but broad money growth and a wide range of other indicators now point to a recovery somewhere between L and V shaped. Growth in M4ex at around 5% suggested that GDP growth could be 1½% this year. M4ex was providing a tailwind, which suggested that economic prospects were better than at any time since the financial crisis began. However, significant headwinds remained. Firstly, from continued deleveraging in both public and private sector debt. Secondly, from balance sheet adjustment by the banks and tight regulatory capital controls. Thirdly, from the squeeze on household real income from inflation running ahead of earnings. The household consumption squeeze was being compounded by the relatively low savings ratio at this stage of the economic recovery. Fourthly, the ever-present threat of resumption in the euro crisis. Finally, the reality that any recovery will contain within it, the seeds of its own destruction, due to a potential normalisation of interest rates at both the short and long end – although the other headwinds meant that this threat was relatively benign at present.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate ½%; hold QE.
Bias: To raise rates.

Andrew Lilico said that he had no faith in the pronouncements of the Bank of England and that forward guidance was only a target forecast. Why should anyone believe that interest rates will stay at ½%? There was an intrinsic impetus to the UK economy caused by the timing of projects. Capital spending projects had been delayed and there was an opportunity for a catch-up. The euro crisis may well return, or some other euro crisis arise, so it was forlorn to hope for a “good moment” to raise rates. Mortgage lending to borrowers that depended on rates being so low should not be made.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate; ½%; hold QE.
Bias: To raise. QE to be used only when the euro crisis returns.

Kent Matthews said that in January he voted for a ½% rise largely because of microeconomic issues. These issues remained. The loanable funds market was not allowed to operate efficiently because of Bank Rate remaining low for so long. He reminded the committee of what he said at the previous physical meeting concerning the support of zombie companies. Risk was being ‘under-priced’ for the zombie ‘insiders’ whereas it was probably ‘overpriced’ for the outsiders who faced a bank credit crunch. The Schumpeterian process of ‘creative destruction’ only worked if credit markets were well functioning and exceptionally low interest rates for this length of time have generated a misallocation of resources to the low areas.

Unlike Andrew Lilico he did not think that forward guidance was ineffective because of the lack of credibility of the Bank. On top of the micro issues he said that there were considerable macroeconomic dangers from forward guidance which was meant to influence expectations. The potential for the building up of inflationary expectations and macroeconomic instability followed the analysis of Friedman’s critique of pegging the rate of interest. Sterling had already weakened on the prospect of interest rates remaining low for some time. Since nobody knew with any certainty the size of the output gap, and OECD and IMF estimates had been reducing it over time, the next thing we will observe is inflation rising and moving away from the target. Interest rates had to start rising now to help in the process of rebalancing the economy.

The inevitable return of the euro crisis would require a tractable monetary response in the form of an interest rate cut and additional QE. An interest rtate cut would have no effect at current levels.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate ½%. Hold QE.
Bias: To raise Bank Rate.

David B Smith said that the history of the 21st century had been about the wrong type of supply-side policy. Supply withdrawal was treated as a demand withdrawal. A tax-and-spend induced supply withdrawal could not be offset by monetary policy. Long-term interest rates were distorting monetary policy to allow the housing market to be sustained. Forward guidance was pointless because either the authorities would pursue the policies that they would have done in any case or they would have to break their commitments. The vogue for nominal GDP targets ignored the fact that nominal GDP can easily generate perverse policy signals. One reason was that just over 48% of GDP was in the public sector whose behaviour can be very different to that of the non-bank private sector on which monetary policy operates. Another was that imports were a negative item in the GDP identity whose cost rose if sterling fell, perhaps because of an unduly lax monetary policy.

Weaker sterling had not had the stimulatory effect that was expected by UK officials. The main effect had been to push up prices. However, the Tax and Price Index was only up 2.2% on the year in May and real earnings had not been squeezed quite as much as one might deduce from the CPI and RPI. It was increasingly difficult to use the data produced by the ONS for prediction, as it was so unstable.

He added that he was surprised that there had not been more discussion of the extent to which European politics will be influenced by the outcome of the September elections in Germany. The German population was already restless about the fiscal burden that was being asked of it. The ECB had been utterly politicised and the German taxpayer had every right to feel angry and misled. Angela Merkel was desperately trying to paper over the cracks in the short term but the celing could well come down in late September.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate ¼%; no extension of QE.
Bias: To raise rates conditional on growth.

Peter Warburton began by stating that he was doubtful of the efficacy of forward guidance in the UK in the context of rising US government bond yields. The impressive effect of calendar-based forward guidance in the US in the first half of last year was opportunistic and probably not replicable in the UK. Peter Warburton said that, in any case, there was a stronger case now for tightening as business and consumer economic confidence was rebuilt and output growth became more robust. He still preferred to begin with an increase in the rate of interest of ¼% as even a small rise would have a negative psychological effect. However, the UK private sector remained more vulnerable to inflationary pressures compared to other large European countries and the Bank of England could not afford to ignore persistent breaches of its inflation objective, much less embark on a new policy of monetary relaxation. There were compelling reasons to diversify some of the £375bn of existing QE into a portfolio of other assets, including securitised property, infrastructure and possibly even SME (small and medium-sized enterprises) assets as a means of lowering the regulatory burden of the banks that relates to these loans. The fact that the ‘Bad Bank’ debate had revived in recent weeks was a reminder of how little structural progress has been made to restore health to the UK banking system.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold.
Bias: Neutral.

Trevor Williams said that the revised data of the economy showed how risky it was to draw firm policy conclusions from recent data. The latest figures could therefore prove to be a ‘false’ positive in terms of the pace of the recovery, despite the bigger output gap indicated by revised figures. The underlying picture was of a ‘wrong’ type of growth, unsustainable at the H1 pace. Household gearing was going up again after dropping to just above 142% of annual disposable income in Q4 last year, at a time that real wage growth was negative. The expenditure mix could be wrong for a sustainable upturn in the economy, as consumer spending was driving growth at a time that household budgets were under pressure. Continued slow European growth would be a drag on UK exports in 2013. As such, the state of the real economy did not justify a rise in the rate of interest. A real risk was that a rise in the Bank Rate would increase the frequency of household defaults and corporate failures, hitting confidence, one of the bedrocks of the recovery.

Policy response

1. On a six to three split the committee voted to raise Bank Rate in August.

2. Five of the SMPC members voted to raise rates by ½% and one voted to raise it by ¼%.

3. In consequence, it was recommended that Bank Rate should be raised by ½%.

4. All six members that voted to raise interest rates indicated a bias to raise rates further.
5. There was unanimous agreement that excessively onerous financial regulation was hindering the efficient working of the banking sector.
Date of next meeting.
Tuesday 15th October 2013.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, June 30, 2013
IEA's shadow MPC votes 5-4 for quarter-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, which was finalised on 25th June, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 4th July. Four members of the shadow committee wanted an increase of ½%, while one advocated a rise of ¼%.

This split vote for a rate hike would imply a rise of ¼% on normal Bank of England voting procedures. However, four SMPC members believed that Bank Rate should be held at its present ½% for the time being. Most members of the shadow committee saw no immediate justification for adding to the stock of Quantitative Easing (QE). Nonetheless, it was felt that the international economy was not yet out of the woods and that all monetary tools needed to be kept available on a standby basis.

Most SMPC members thought that the UK economy was showing signs of a modest recovery and that growth probably accelerated in the second quarter. However, there was less agreement as to whether recovery would continue or, alternatively, peter out in the second half of this year. One reason for wanting to raise Bank Rate in July was the belief that it was less disruptive to make the necessary rate hikes early and in a number of small increments than to leave it late and then possibly be forced to make a more abrupt move.

There was a strong concern that ill-considered financial regulation was impeding money creation and credit extension to the private sector. However, current UK broad money growth was sufficient to sustain a non-inflationary recovery. The SMPC poll was completed before the 26th June Comprehensive Spending Review and a major re-working of the UK national accounts to be published on the 27th, which might introduce substantial revisions to the current data.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Hold Bank Rate for next three months and use rate setting and QE to achieve growth in broad money of 3% to 5%.

My last note for the SMPC opened with the sentence, ‘The regulatory blight on banking systems continues in all the world’s so-called “advanced” economies, which means for these purposes all nations that belong to the Bank for International Settlements.’ As I explained in the next sentence, the growth of banks’ risk assets is constrained by official demands for more capital relative to assets, for more liquid and low-risk assets in asset totals, and for less reliance on supposedly unstable funding (i.e., wholesale/inter-bank funding). The slow growth of bank assets has inevitably meant, on the other side of the balance sheet, slow growth of the bank deposits that constitute most of the quantity of money, broadly-defined. Indeed, there have even been periods of a few quarters in more than one country since 2007 in which the assets of banks, and hence the quantity of money, have contracted.

The equilibrium levels of national income and wealth are functions of the quantity of money. The regulatory blight in banking systems has therefore been the dominant cause of the sluggish growth rates of nominal gross domestic products, across the advanced-country world, that have characterised the Great Recession and the immediately subsequent years. Indeed, the five years to the end of 2012 saw the lowest increases – and in the Japanese and Italian cases actual decreases – in nominal GDP in the G-7 leading industrialised countries for any half-decade since the 1930s.

It is almost beyond imagination that – after the experience of recent years – officialdom should still be experimenting with different approaches to bank regulation and indeed contemplating an intensification of such regulation. Nevertheless, that is what is happening. The source of the trouble seems to be a paper given at the Jackson Hole conference of central bankers, in August 2012, by Andy Haldane, executive director for financial stability at the Bank of England. The paper, called The Dog and the Frisbee, argued that a simple leverage ratio (i.e., the ratio of banks’ assets to capital, without any adjustment for the different risks of different assets) had been a better pointer to bank failure than risk-weighted capital calculations of the kind blessed by the Basle rules. The suggestion is therefore that the Basle methods of calculating capital adequacy should be replaced by, or complemented by, a simple leverage ratio.

For banks that have spent the last five years increasing the ratio of safe assets to total assets, or that have always had a high proportion of safe assets to total assets, the potential introduction of a leverage ratio is infuriating. A number of banks have been told in recent weeks that they must raise yet more capital. Because it is subject to the new leverage ratio, Nationwide Building Society has been deemed to be £2 billion short of capital. That has upset its corporate plans, to say the least of the matter, and put the kibosh on significant expansion of its mortgage assets. And what does one say about George Osborne’s ‘Help to Buy’ scheme, announced with such fanfare in the last Budget and supposed to turbocharge the UK housing finance market?

The leverage ratio has been called Mervyn King’s ‘last hurrah’, since there can be little doubt that King has been the prime mover in the regulatory tightening that has hit British banking since mid-2007. He is soon to be replaced by Mark Carney, who may or may not have a different attitude. Carney has been publicly critical of Haldane and his ‘Dog and Frisbee’ paper, but that does not guarantee an early shift in the official stance. Indeed, it is striking that – of the bank’s top team under King – only Paul Tucker, generally (and correctly) regarded as more bank-friendly than King or Haldane, has announced that he is leaving the Bank once Carney has taken over.

My verdict is that the regulatory blight on UK banking is very much still at work. Further, without QE, the quantity of money would be more or less static. As before, I am in favour of no change in sterling interest rates and the continuation of QE at a sufficiently high level to ensure that broad money growth (on the M4ex measures) runs at an annual rate of between 3% and 5%. My bias – at least for the next three months – is for ‘no change’. It is plausible that I will be advocating higher interest rates in 2014. However, much depends on a realisation in official quarters that overregulation of the banks is, almost everywhere in the advanced world, the dominant explanation for the sluggishness of money supply growth and, hence, the key factor holding back a stronger recovery. Major changes in personnel may be in prospect at the Bank of England now that Mervyn King is leaving, but the Treasury – which I understand from private information will be glad to see the back of him – has failed to prevent the growth of a regulatory bureaucracy led by King appointees.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Additional QE and a rebalancing towards non-gilt assets.

The near-term outlook for UK growth has improved somewhat. The composite UK Purchasing Managers Index (PMI), based on monthly reports covering the manufacturing, construction and private service sectors, has climbed to its highest level since March 2012. Sub-indices covering new orders across the three main parts of the economy have picked up even more sharply – the composite balance is at a three-year high. Little hard data for the second quarter has yet been published but there are early signs of relatively solid growth. The momentum going into the second quarter is marked, with activity in April already some way above the first quarter average. The strong retail sales and new car registrations in May suggest that consumers continue to show some resilience, despite very sluggish wage growth. The labour market continues to firm. Robust growth in vacancies in the three months to May better represents recent developments than the flat-lining of employment volumes.

A moderate recovery in UK output is emerging. This could amount to an argument for laying the foundations for a withdrawal of monetary accommodation. The persistence of above-target inflation into 2014 supports a more hawkish stance. There are, however, several arguments for keeping the monetary stance unchanged and also maintaining a bias towards additional ease. First, the UK recovery is not assured. Private domestic demand – although growing and supported by rising house prices – will be held back for some time by several factors, including insufficient broad money growth, fiscal tightening and balance sheet repair. External threats, meanwhile, remain considerable, as evidenced by the recent shake-out in financial markets on the back of, arguably, grossly exaggerated fears about the tapering off of QE by the US Federal Reserve. Major global imbalances continue to restrain the recovery in world demand. In ‘debtor’ economies, there has been very little reduction of excessive private and government sector debts. ‘Creditor’ nations show little willingness to undertake the policies necessary to boost domestic demand. Although output in the Euro area may stabilise in the months ahead, sustained growth is a way off. A dip back into recession may still occur. More broadly, the Eurozone crisis is far from resolved.

Risks to growth are still firmly on the downside. Inflation risks are more balanced but the recent data flow has pointed to greater disinflationary pressures than previously thought, if anything. Regular wages have barely grown over the last year – with average hours worked up by around ½% over the same period, nominal hourly pay has effectively been stagnant. Near-term and medium-term household inflation expectations are now at their lowest point in a year. Even the actual inflation data themselves have surprised on the downside. Excluding the effects of the 2012 tuition fee hike, ‘core’ inflation has been below 2% since last December. Consistent with this, UK retailers’ price expectations (for the next three months) have dropped to their lowest level since November 2009.

Additional monetary stimulus at this stage would incur costs but there are good reasons to believe that it would provide a boost to demand and asset prices. The benefits of QE still outweigh the costs in my mind. There remains a case for switching towards non-gilt assets, if additional stimulus is needed. That time has not arrived. However, it may yet do so.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

For the first time in five years, the possibility of a tightening in monetary policy is being seriously mooted. This is being driven by a number of factors. First, there is the potential tapering off later in 2013 and ultimately the ending, possibly in the first half of 2014, of central bank purchases by the US Federal Reserve. Second, there is the prospect of an improved UK GDP performance, which is probably better than at any time since recovery began; this has been signalled by the recent pick up in the growth of M4ex broad money to around 4.5% to 5% year-on-year. Third, there is the combination of an improved growth outlook with above target inflation. The May Consumer Price Index (CPI) was up 2.7% on the year with the prospect of a higher figure in June. Finally, minds are turning towards the potential 'normalisation' of monetary policy and what that means for the Bank Rate and gilt yields.

This leads to two questions. Will there be a tightening in monetary policy? Should there be a tightening in monetary policy, and if so how?

With regard to the first question, the immediate prospect of a tightening appears slim. The outgoing Governor was outvoted in each of his last five meetings. However, this was a vote against a further expansion in QE, not for a reversal in policy. Moreover, with the arrival of a new Governor, inclined towards explicit forward guidance, some form of internal debate within the Bank of England is likely to ensue. Admittedly, the Governor is a member of the MPC, not the MPC, but some attempt at forward guidance is likely to occur. In addition, given that CPI inflation has exceeded the 2% target for eighty one of the past ninety-six months, the current excess is unlikely to alarm the Monetary Policy Committee (MPC).

With regard to the second question, one can remain sceptical that any immediate tightening in policy is required. The new Prudential Regulation Authority (PRA) is signalling that the banks need to raise a further £27 billion of capital, with the attendant consequences for the money supply. But possibly of greater significance is the lack of debate thus far as to exactly how any future tightening should occur. Should it start at the short or the long end? Are there circumstances in which it could involve competing effects, such as a tightening at the short end combined with further expansion in QE? At present, there is not sufficient clarity on these issues and so a neutral bias seems appropriate. Furthermore, the recovery has within it, moderating effects, due to the recent global jump in bond yields – stemming from speculation about and the prospective reality of the withdrawal of asset purchases. The jump in yields also threatens a resurrection of the Euro crisis.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To raise Bank Rate.

Things are definitely looking up for the UK economy in the short term in internal terms. Multiple surveys indicate a pick-up in growth. At the time of writing, ten-year gilt yields have risen by around 100 basis points from their early May trough, reflecting the stronger growth outlook and diminishing expectations of further rounds of QE. The government has finally got around to starting serious spending cuts – though these will have to go on for many years and more will yet need to be announced. There is an underlying back-log of private sector investment projects delayed or foregone during the Depression of recent years. A mere reduction in the risk of things getting worse should be sufficient to release some of that investment potential and spur short-term growth.

However, circumstances are still very fragile, and could easily be derailed by external events. The worsening of the credit crunch in China; escalating war in Syria; the Greek coalition collapsing and precipitating early elections and a Euro exit; the collapse of other UK banks – any or all of these could be sufficient to further retard the flowering of that investment potential. Nothing can be guaranteed. So there will not be a ‘convenient moment’ to tighten policy for many years. To wait for such a moment is to doom the economy to excessively low interest rates and chronic above-target inflation for the foreseeable future, with the consequence being a lower-than-necessary average growth rate.

As noted in the recent Bank for International Settlements annual report, all that an accommodative monetary policy can do is to buy time for households and governments to deleverage and for structural reforms to be made that protect and increase the average growth rate of the economy. Loose monetary policy itself cannot make economies grow faster over the medium term – it can only, if done to excess, make them grow slower. Nonetheless, the UK government and households have used very low interest rates as an excuse for delay, not a means to smooth transition. They still hope that ‘something will turn up’ rather than their needing to bite the bullet on serious deleveraging. Slightly higher interest rates would give households slightly less temptation to delay, encouraging slightly faster deleveraging. Let us start with a half-point rise and take it from there.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

When the history of the Great Recession comes to be written, it will be clear that it was only to a minor extent the fault of ‘greedy bankers’. Yes, of course there were plenty of those but since when have people not been greedy? ‘Greed and fear’ goes the weary summary of business and market behaviour; what is new? The fault will be seen to lie with monetary policy’s obsession with inflation targeting, to the exclusion of maintaining general monetary stability, which had been the traditional task of policy. It was the failure to keep monetary conditions stable – for which read ‘keep the money supply on a reasonable growth track’ – that allowed the great credit boom of the 2000s to take hold. Inflation targeting was so successful in stabilising inflation expectations that inflation hardly moved however much or little interest rates were moved. As a result, interest rates and bank reserve injection were given latitude to ignore monetary excesses – because inflation was so well controlled.

Out of that failure, there came the Great Regulative Backlash that followed the crisis when the credit boom crashed. This backlash produced a massive tightening of monetary conditions via the sledgehammer of excess regulation hitting the nut of weakened banks. It has proved impossible to loosen monetary conditions sufficiently to generate a proper recovery, against the contraction engineered by this regulative excess. Official interest rates have been lowered to the zero bound and QE has injected fabulous quantities of excess reserves into the banks, with no perceptible effect on credit growth and a collapse of the money multiplier.

When we have the right models to analyse these events, we will be able to simulate a counterfactual world in which monetary policy targeted money growth and a credit boom was avoided in the 2000s. Then when the slowdown occurred due to global productivity growth slowing (for this read ‘the world hitting a raw material shortage, forcing commodity prices skywards’), the banks would not have been exposed as badly as they were, nor would households have overbought houses. Yes, we would have still had a bad recession but it would have been possible to have a normal recovery, absent any regulative mania developing. Commodity prices would have fallen back, against a background of a lower cumulative level of GDP at the time of slowdown, and recovery would have been brought about by monetary loosening -– falls in interest rates accompanied by injections of bank reserves.

Ultimately, we should blame us economists not the politicians, because it is we who failed to have these models in time. As Keynes said, the policymakers are merely echoes of the researchers who taught them. We had models in which there was no money, only (official) interest rates being used to target inflation; they also contained no interest rates on credit to small businesses and households, the key channel the banks give us. The crisis has taught us now to allow for the imperfection of the monetary channel system; there are channels and they do not communicate perfectly with each other. Money growth is an indicator of what is going on in the credit channel and what is therefore happening to credit rates to small businesses (which we observe very poorly due to the mass of accompanying charges and conditions, such as arrangement fees and collateral requests) and households. We also lost sight of the damage that can be done by monetary instability.

If we add a money growth target to the inflation target, then we have two key features of the economy being ensured by the central bank: a) the long run inflation environment, and b) the stability of the monetary environment. In the process, output growth should also be stabilised, since output growth will be reflected in money supply growth. A natural pairing of instruments with targets would be for interest rates to react to inflation while the monetary base reacts to the money supply, which it directly affects.

Where does this leave ‘macro-prudential’ policy? Regulations have the effect of raising the cost of credit – and so the ‘credit frictions’ in the economy. This is damaging to economic welfare – the only rationale for enhanced regulation is that it reduces the chances of a future banking crisis. However, if monetary policy were reset as above, this need would be met in that way, at no cost to the economy: one can think of monetary stability as ensuring that the cost of credit is kept at the socially optimal level, allowing for the desired underlying credit friction. Thus, in booms it would stop the credit cost falling unnaturally low; and vice versa in slumps. In these circumstances all that regulation should do is set a ‘basic’ level of regulative constraint on grounds of social ‘bank safety’ factors – this in turn would supply the underlying desired credit friction. There is no need for regulation to vary ‘macro-prudentially’; and this basic level of regulation would be the minimal one required to offset the moral hazard created by deposit insurance. It should not discriminate against ‘risky’ lending to small businesses. Rather it should be set in relation to the whole bank portfolio’s diversified risk level; a minimum capital ratio should be set that would prevail for a band of risk around some normal level on the whole portfolio. In this way, we should get away from the cost of funds for loans to SMEs attracting a much higher cost because their individually higher risk causes extra capital to be raised.

As through a glass darkly, the coalition and their civil servants in Whitehall and Threadneedle Street have begun to realise that their regulatory actions have blocked the credit channel; so more recently we have had Funding for Lending (FLS) schemes 1 and 2, followed by the Mortgage subsidy for first time buyers. These do appear at last to be having an effect on the housing market and on lending conditions for small businesses – the ice blocking the credit channel appears to be cracking slightly. The economy appears to be picking up towards moderate growth. This has been helped by less grasping policies towards North Sea oil and gas producers, so that now we are seeing North Sea oil output bottoming out in line with banking and construction, the latter two aided by this credit channel thaw.

It is messy to have regulation combined with policies deliberately offsetting the regulation. Nevertheless, systems cannot turn on a dime and so we must be grateful for the easing we have in the regulative backlash. The implications of this regulative ‘U-turn’ for monetary policy are that we now need to worry about the return to more normal banking behaviour.

First, we have a massive overhang of bank reserves: the UK monetary base, as measured by Bank liabilities, has expanded to about eight times its level of 2007. This implies that banks have massive liquidity available for lending should they choose to use it. QE simply must be unwound as soon as practicable, although this should be done in a way that does not upset markets unduly. Thus as regulation is eased, the QE that was injected in a failed attempt to offset it needs to be unwound.

Second, what of official interest rates at the zero bound? Ronald Mackinnon in persuasive recent work has shown that if central banks swamp the banks with bank reserves at next to zero interest rates, then banks will not use the interbank market for very short term financing; rather they have all they need held with the Bank. QE at super-low rates has thus crowded out the interbank market, which indeed has fallen into relative disuse. The result has been that the banks’ ‘cost of funds’ has borne no relation to Bank Rate; banks have borrowed on deposit, including longer term deposits from other financial intermediaries, to finance their lending – besides the effect of regulation in forcing expensive extra capital into the funding mix, now being offset by the new FLS and Mortgage subsidy schemes.

Thus, as QE is unwound, Bank Rate should be raised to restore the interbank market and reinsert it into the funding mix. This will not tighten monetary conditions as measured by the cost of funds; it will substitute interbank borrowing for bankers’ balances at the Bank. It will restore a normal banking market and drain off bank liquidity that is now dangerously excessive.

These are transitional measures needed to bring monetary policy back on track as the effects of regulation on the credit channel are eased off. In the longer term, we need to get credit and money growth back on track; once that is achieved interest rates will be back at normal and QE unwound so that the monetary base too is back at a normal level of bank reserves. We must hope too that regulation has been cut back to a much less intrusive level. To conclude, the action needed today is to unwind QE and to move Bank Rate up in small steps, initially by ½%.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up and fully privatise state-dependent banking groups; raise Bank Rate to 2½%, and maintain QE on standby.

Britain’s small open and trade-dependent economy means that it generally behaves like a small boat bobbing around on the turbulent seas of international economic developments. This can be easily verified from charts comparing British growth, inflation and real interest rates with their equivalents in the Organisation of Economic Co-operation and Development (OECD) area as a whole over the past five decades. This makes it impossible for the domestic authorities to fine tune the course of the UK economy, as politicians like to pretend and media commentary tends to assume. The government can improve Britain’s long-term growth performance relative to the rest of the world if it maintains fiscal discipline – which probably means a share of total government expenditure in national output of no more than 35% to 40% – and refrains from ill-considered interventions in the markets for labour, products and finance. However, the global business cycle still tends to pre-dominate in the short term and apparently has been doing so for far longer than is recognised generally.

Likewise, the Bank of England can improve Britain’s relative inflation performance by pursuing policies that pull up the exchange rate and vice versa. However, international inflation is the main influence on the domestic rate of price increase in the short run, not the domestic output gap. In its rate setting, also, the Bank has tended to import the foreign real rate of interest much of the time. If it does not, then sterling tends to adjust to a possibly uncomfortable extent, especially as foreign exchange markets are notoriously prone to speculative overshooting in the short term.

No one who has looked at UK fiscal and regulatory policies since 2000 in the light of the literature on international growth performance can be happy with the massive increase in economic socialisation and regulatory overkill that marked the tenure of the previous government. The present Coalition’s attempt to maintain so much of Gordon Brown’s gigantic state power grab – because it has lacked the moral fibre to do otherwise – means that we are back on the treadmill of relative economic decline that marked the pre-Thatcher years, even when compared to an OECD area whose growth has slowed dramatically. There has been considerable debate as to why ultra-low interest rates and £375bn of QE have not yet had more of a stimulatory effect on UK economic activity. One reason has been the weak international background. Another has been misguided and excessive financial regulation which has been applied at exactly the wrong point in the business cycle and has led to an unduly sluggish growth in real broad money balances and total bank credit. This issue remains of supreme importance but is well covered elsewhere in this document.

However, there is a third, structural, reason that has had less attention than it deserves. In theory, a lax monetary policy can only stimulate activity in the private sector of the economy, which accounted for 51.5% of UK GDP last year, according to the June 2013 OECD Economic Outlook Annexe Tables. This is because the government can always create money at will. However, the size of the private sector in regional GDP in fiscal 2009-10 varied from only around one quarter in Northern Ireland to over two thirds in London, using data for the twelve ‘NUTS1’ regions into which the UK is officially divided. If all twelve NUTS1 regions were separate political entities, London’s general government spending ratio of 31.7% would be the second lowest in the entire OECD after South Korea (30.2% in 2012), while the South East of England’s government spending ratio of 37.9% would then be the fifth lowest OECD figure after Switzerland (34.1%) and Australia (36.1%). In contrast, the North East (66.5%), Wales (71.4%) and Northern Ireland (74.8%) all have noticeably higher spending ratios than Denmark (59.5%), which tops the OECD socialisation scales. The degree of state-dependence in these UK regions approximates to that in the former Eastern European satellites of Soviet Russia and means that such areas are probably incapable of reacting to monetary stimuli as a result.

Certainly, the pattern of regional response to the Bank of England’s aggressive monetary ease have been pretty much what one would expect from the relative degree of economic freedom. London is already showing nascent signs of economic overheating, especially in its property market. However, the heavily socialised former industrial heartlands have shown a far weaker response, except where the more competitive exchange rate and foreign-management initiated structural reforms within specific trades, such as the motor industry and steel, have been unusually helpful. The conclusion is that monetary policy will not work equally across the national domain until the former East German style structural rigidities of the more heavily socialised regions are tackled through aggressive liberal-market reforms.

Incidentally, this is also one of the key issues facing the Eurozone. Germany has by-and-large maintained its general government expenditure ratio at its 2000 level but a number of peripheral economies went on Gordon Brown style spending binges after they had squeezed themselves into the fiscal corset demanded by the Maastricht convergence criteria – apart from Greece, which simply lied about meeting the criteria. The result is that a lax monetary policy at the level of the Eurozone as a whole may well prove an inflationary threat to Germany without providing a stimulus to the more highly socialised fringe members of the Eurozone. This has been pointed out by several German members of the European Central Bank, who have left the institution because they feel that it is no longer acting in the best traditions of the old Bundesbank.

The problem now is that restoring the lower government spending burdens that allowed countries such as Spain to qualify for Eurozone membership in the first place would require such a large fiscal retrenchment – which would of necessity be in the form of spending cuts because they have overshot the limits of taxable capacity – that it could cause a massive political upheaval. When discussing rate setting the tendency is to concentrate on the finer points of the latest monthly economic indicators. However, these are virtually irrelevant sometimes and the important issues are almost geo-political in nature.

As it is, the latest figures for the M4ex definition of the UK broad money stock showed a rise of 4.8% in the year to April, while broad money in the aggregate OECD area was up by 5.5% in the year to March. Current monetary growth rates might be regarded as being appropriate on a medium-term perspective to achieve low and stable inflation given the rather subdued outlook for the growth of potential supply. However, there is an interesting difference between the 7.1% growth in US broad money in the year to April reported by the OECD and the increases of 2.6% and 2.7% reported for the Eurozone and Japan, respectively, over the same period. The main concern is that governments are hogging the money creation process and lending to the productive private sector is being crowded out, largely because of the financial repression caused by excessively onerous regulations. The international financial markets strong negative response to Mr Bernanke’s suggestion that US QE will be approaching its end in the foreseeable future suggests that the UK boat could be hit by another wave of turbulence from monetary policy decisions overseas. This risk, together with the continuing uncertainties in the Eurozone, suggests that it may be hard for the UK monetary authorities to maintain a steady course under their new captain Mr Carney.

The rise in the annual CPI inflation rate from to 2.4% in April to 2.7% in May suggests that the more favourable April figure was an aberration and takes the year-on-year inflation rate back to the 2.7% to 2.8% range that has prevailed since October 2012. Core producer price inflation accelerated from 0.7% to 0.8% between the same two months, but remains well down on the CPI rate where much of the inflation appears concentrated in the service sector. Annual house price inflation on the ONS measure eased slightly from 2.7% to 2.6% between March and April. However, there are substantial differences between the various UK regions with house prices in London up 6% on the year but down 1.3% in the North East. The most recent labour market statistics have shown some signs of weakness in the very short-term comparisons. However, the employment rate was 0.7 percentage points up on the year in February-April; the labour force survey (LFS) measure of joblessness declined from 8.1% to 7.8% over the same period, and the claimant count measure of unemployment eased by 8,600 in May to a level 87,600 down on a year earlier. The reduction in the top rate of income tax at the start of the new fiscal year appears to have induced a surge in bonus payments in April. Nevertheless, overall wage pressures remain weak and economy-wide earnings in February/April were only 1.3% up on the corresponding three months of 2012. Overall, a Bank Rate increase of ½% seems appropriate at the July MPC meeting with no further increase in QE for the foreseeable future. British interest rates will have to be normalised at some point. It is less disruptive to start the process early, and in small steps, rather than leave it too late and then have to slam on the brakes.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To raise Bank Rate.

The economy of the advanced countries is still weak, five years into the Great Recession. Nonetheless, there are signs of recovery. In particular, the US is expanding at around 2% per annum at the moment, and the second quarter growth rate in the Eurozone is expected to be better than the weak first quarter. The British economy is also showing some limited signs of recovery. UK economic growth is still weak, at only 0.3% in the first quarter, which is just enough to avoid falling back into recession again. However, service industries have been growing relatively strongly. In addition, house prices are picking up, which is usually a good predictor that consumption will strengthen. Overall, the British economy remains weak but it is showing some positive signs. However, the annual increase in national output is still far away from the 2% to 2.5% annual growth, which is considered a healthy long-run average.

Monetary policy has run its course. It could do only so much towards lifting the economy. Low interest rates and QE were needed during the worst part of the financial crisis, in order to calm markets and stabilise the financial sector. The loose monetary stance also helped to avoid an even larger decline in output in the first phase of the recession. However, low policy rates do not help the economy return to a healthy 2% to 2.5% growth rate. In particular, low interest rates can buy time for adjustment during a financial crisis, but they can also create perverse incentives if kept low for too long. Firms that borrowed prior to the crises have adjusted more slowly than desirable because of the low interest rates. At the same time, banks are reluctant to lend to new firms until their existing loan portfolio improves. As a consequence, the recovery is slow. To escape from this trap, the central bank needs to raise cautiously its policy rate.
Inflation seems to be under control and inflation expectations are well anchored in the US, the Euro area and in Britain. Expectations can change fast if the recovery speeds up. In particular, CPI inflation has been above the 2% target since November 2009. Although it fell from its 5.2% peak in September 2011 to below 3% by mid-2012, it has been hovering above 2% ever since. It is important to note that the large drop in inflation was primarily due to a drop in the rate of goods price increase, while service inflation has been fluctuating around 3.5% since mid-2010. Overall, there are signs that inflationary pressure is slowly building up in the service industries, which make up the bulk of the British economy. The need to signal the readiness of the authorities to control inflation when necessary, also calls for a rise in interest rates.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

In an unusual turn of events, the chairman of the US Federal Reserve Ben Bernanke’s clumsy interventions have amplified nervousness in the US bond market with adverse implications for the UK rate curve. The upward shift in ten-year gilt yields of 50 basis points in the past month has also dragged up short rates and brought forward the implied date of the first rate increase to mid-2015 from late-2016. The significance of this market move is twofold. First, it casts even more doubt on the desirability and efficacy of QE programmes. Second, it has reinstated scope for a UK policy of calendar-based forward guidance on interest rates, specifically Bank Rate. These issues have pertinence in the context of Mark Carney’s imminent assumption of the governorship of the Bank of England.

MPC members may also be more inclined to supplement QE (in the form of gilt purchases) after the rout in the gilt market, overturning the six to three votes that marked the final months of Lord King’s tenure. Ironically, the MPC may be ready to grant Carney a majority for more QE, if he wants it. The twist would come if Carney were willing to advocate a broadening of asset purchases to embrace securitised infrastructure, property or small and medium-sized enterprise loans.

Every shade of opinion has been expressed regarding the ability of the new governor to change course. An ex-MPC member recently confided that he thought the MPC was ‘stuck in 2009’. Mark Carney has been recruited surely with a view to dragging the MPC out of its rut and the question remains what impact he will seek to have on arrival. Market events suggest that he will push for the adoption of Fed-style forward guidance from the start.

Meanwhile, the UK economy has perked up since the end of the cold and wet spring with the possibility of a strong reading for 2013 Q2 on 25th July. After a 0.3% quarterly increase in 2013 Q1, the second quarter should see a gain of between 0.6% and 1%. The combination of the FLS and the ‘Help to Buy’ scheme has set a positive tone in the housing market and revived gross mortgage lending (up 17% from a year earlier). Retail sales and consumer confidence are both improving more than widely expected.

There have been other indications of normalisation in the banking sector as the Chancellor has committed to the return of Lloyds Bank plc. to private ownership and a final reckoning seems to have been reached in terms of additional capital requirements for other banks and building societies. The prospect of private sector credit expansion is rather more credible now than even six months ago.
M4 growth, excluding intermediate OFCs, is running close to 5% on a year earlier, although this remains inflated by a large public sector contribution to the money supply. If QE is not extended in any form, then private credit growth would need to strengthen in order to sustain M4ex growth.

However, as previously argued, Mark Carney’s most pressing task as incoming Bank governor is to unblock the credit transmission not to construct an elaborate set of conditions under which Bank Rate may one day be raised. Indeed, if there is a role for ‘forward guidance’, it is to reassure markets of the Bank’s determination to take rates back to the region of 2% to 2½% over the next two years. An immediate move to ¾% is my preference with no early commitment to additional QE.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

At the time of writing, financial markets are currently in the process of pricing for the end of asset purchases under the QE programme in the US. For background, the Federal Reserve buys $85 billion of bonds a month, comprised of $45 billion of treasury bills and $40 billion of mortgage backed securities (MBS). The result has been a rise in the ten-year Treasury yield to 2.60% from a low of 1.63% in early May. UK ten-year gilt yields have responded to this by rising from 1.62% to 2.56% in the same period. This is without anything economically fundamental changing in the UK and, as such, seems overdone. It might not of course be overdone for the US economy, where growth is clearly moving towards its trend rate – albeit not above and maybe not at the rate that the financial markets are expecting. Even there though, it could be argued that the move seems excessive, as the Fed was careful in its recent press conference to point out that any tapering was data dependent and that that the Fed fund short term rate would not be raised for a considerable time after QE ended.

In saying any tapering was data dependent, the Fed suggested that it was not hell bent on raising rates come what may but would only do so if the economy continued on its current trajectory. Moreover, the messages were clear that QEIII would end only when unemployment hit 7% and rates would only rise if it hit 6.5%. On this basis, the data are not 100% clear about the timing of the tapering move (or the amount), unemployment edged up 0.1% to 7.6% in May, and inflation fell back, with wage pressure and core inflation very low. On top of that, Bernanke might not be around when QE ends next year, if he leaves as Fed Chairman when his current term terminates in February 2014.

As for the MPC view of the UK economy, it remained divided in June but voted to maintain the status quo 6:3. It was the fifth consecutive month the committee was divided on the need for further stimulus, with the departing Governor, Fisher and Miles arguing for a further £25bn of QE, and the fifth month that Lord King was outvoted (and at his last meeting). The tone of the minutes was broadly unchanged to slightly more upbeat than last month's. While the committee acknowledged the economic data had shown a ‘moderate’ improvement, the recovery was evolving broadly in line with the projections outlined in the May Inflation Report. As such, there was no pressing need for members to change their positions.

MPC concern remained fixated on the debate about the case for further stimulus and continued to centre on the potential damage that weak demand could inflict on the supply base of the economy versus the potential risk to inflation of keeping policy too loose for too long. For the majority of members, the persistent overshoot of inflation, ‘moderate’ signs of economic recovery, and the effect of the previous rounds of QE and the FLS argued for no change. By contrast, the dissenters maintained that the high degree of spare capacity, the importance of rebalancing growth and the substantial risks still posed by the Euro area justified further stimulus.

Positions on further QE are now firmly entrenched, for some the recent correction in asset prices had highlighted the role further QE could play in helping to address financial market volatility and to help shape future policy expectations. Given the extent to which market expectations of UK interest rates have increased over the past month, this suggests some members could vote in favour of QE as a means of managing down bond yields and interest rate expectations if required. However, there must be a big question mark over whether that would work now, given the rise in global yields triggered by the words from the Fed. That said, it is likely that the MPC will adopt some form of conditional forward guidance, possibly after the report into its efficacy for the UK in August.

With regards to recent data releases, the PMIs continue to suggest that growth in the second quarter will be close to ½%. However, the pace in the second half of 2013 will depend on Europe, the US and the rest of the world. On that score, the pace of growth in the rest of the world seems to have slowed, the US economy has exhibited some easing in its progress towards trend growth and Europe seems to be stabilising and no longer declining as quickly (though not yet in recovery mode).

On inflation, annual UK CPI inflation rose to 2.7% in May, unwinding some of the previous month’s decline. May’s price increases saw acceleration in both goods and services inflation. Goods inflation accelerated to 2.0% at an annual rate from 1.7% to reach the top end of the range seen over the last year. Service sector inflation also accelerated to 3.6% year on year in May. Although this rate remains more subdued than recorded over the last six months, service sector inflation is showing few signs of responding to the large amounts of spare capacity in the UK economy and is likely being kept elevated by relatively high unit labour costs. A further rise in June when the inflation numbers are released seems inevitable.

All in all, these figures and the volatility we are seeing argue for leaving rates where they are and QE on hold. However, if the economy firms further in the second half of the year, talk of QE will be all but banished and attention will turn to what would trigger a tighter policy stance from the Bank of England, with Mark Carney possibly using the approach adopted by the Fed.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, June 02, 2013
IEA's shadow MPC votes 5-4 to hike Bank rate by 0.25%
Posted by David Smith at 09:00 AM
Category: Independently-submitted research

In its most recent e-mail poll, which was finalised on 29th May, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 6th June. Four SMPC members wanted an immediate increase of ½%, while one advocated a rise of ¼%. Such a split vote for a rate hike would imply a rise of ¼% on normal Bank of England voting procedures. However, a substantial minority of four SMPC members believed that economic activity in Britain – and also in some of its main trading partners – remained so weak that Bank Rate should be held at its present ½% for the time being. Almost irrespective of their precise views on rates, most members of the shadow committee saw no immediate justification for adding to the existing stock of Quantitative Easing (QE). However, one wanted to start on the process of reversing it.

One reason why a narrow majority of the SMPC wanted to raise Bank Rate in June was the belief that lending costs would have to be normalised at some point. It was less disruptive to make the necessary rate hikes early and in ‘baby steps’ than to leave it too late and then have to make an abrupt upwards move; perhaps, because the financial markets had lost faith in the resolve of the British authorities. There remained widespread concern that excessive financial regulation was impeding credit creation to the private sector. Nevertheless, UK broad money growth had now recovered sufficiently to sustain a non-inflationary recovery, given the slow growth of productive potential. The economic situation was unusually opaque at present because a major re-working of the UK national accounts would be published on 27th June. This could lead to substantial revisions to current growth figures.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Hold Bank Rate for next three months and use rate setting and QE to achieve growth in broad money of 3% to 5%.

The regulatory blight on banking systems continues in all of the world’s so-called ‘advanced’ economies, which means for these purposes all nations that belong to the Bank for International Settlements (BIS). The growth of commercial banks’ risk assets is constrained by official demands for more capital relative to assets, for more liquid and low-risk assets in asset totals, and for less reliance on supposedly unstable funding (i.e., wholesale/inter-bank funding). If nothing else were happening, the contraction of asset totals and the rise in the proportion of capital to total liabilities would result in falls in the quantity of money, broadly-defined, which would in turn imply falls in the equilibrium levels of national income and wealth. In some of the Eurozone’s Club Med countries, and even to some degree in France and Italy, these processes of money contraction are still very much at work, and macroeconomic outcomes are weak and disappointing. Indeed, for the Eurozone as a whole output is flat and unemployment is rising.

In virtually all the advanced economies the ratio of safe assets (i.e., cash and government securities) to banks’ total assets is rising. The importance of new credit extension to banks’ business activities has declined, despite constant laments in the media about the absence of new bank lending to such allegedly deserving causes as small business and first-time home buyers. Senior policy-makers seem not to understand the connection between the regulatory zeal ‘to tidy up bank balance sheets’ and the marked reluctance of banks to grow their businesses. In the UK, this has led to obvious, indeed ludicrous policy inconsistencies. It was the same Chancellor of the Exchequer (George Osborne) who endorsed the regulatory excesses of the Vickers Report in 2011 that announced the Help-to-Buy initiative to boost mortgage lending in the 2013 Budget. The Chancellor’s “left hand taketh away and the right hand giveth back”. Both the taking-away and the giving-back occurred at the same time and were blessed by the same government.

The situation is redeemed to some extent by the widespread adoption of so-called QE, which can be regarded as the deliberate creation of money by the state. (A multiplicity of definitions is possible, because the subject is intellectually a total mess.) Because the banks’ safe assets are growing as a result of QE, the quantity of money is in fact rising slightly – typically at annual rates in the low single digits – in most of the leading countries, including the UK. In association with virtually zero interest rates, low but positive money growth has been accompanied over the last year by asset price buoyancy, with rising stock markets, very low bond yields, and steady markets in residential and commercial property. While the global upturn is being led by the USA, macroeconomic conditions in the UK have been satisfactory. Better growth is also being seen in Japan where an aggressive monetary stimulus is currently intended by the new Abe government. It is only in the Eurozone, where QE operations are hampered by the multi-government, hydra-headed monster that is the single currency area, where monetary conditions remain persistently hostile to growth.

In the UK the M4ex measure of money increased by 4.5% in the year to March, while the stock of M4ex lending (i.e., bank lending to the non-bank private sector, excluding that to intermediate other financial corporations) fell by 0.1% while the stock of M4 lending as a whole was down by 1.9%. In other words, money growth has been positive only because other forces have offset the contractive effect of reduction in bank claims on the private sector. QE has undoubtedly been the dominant such force.

Although recovery is certainly under way in the UK, it is wholly inappropriate for commentators to start worrying about overheating in labour and product markets. In fact, the latest figures for consumer price index (CPI) inflation were better than expected and almost back down to the 2% official target. The news from the labour market varies from month to month, but the most recent numbers – which may be erratic – have indicated rising unemployment. I am in favour of no change in sterling interest rates and the continuation of QE at a sufficiently high level to ensure that broad money growth (on the M4ex measures) runs at an annual rate of between 3% and 5%. My bias – at least for the next three months – is for ‘no change’. It is plausible that I will be advocating higher interest rates in 2014. However, much depends on a realisation in official quarters that overregulation of the banks is, almost everywhere in the advanced world, the dominant explanation for the sluggishness of money supply growth and, hence, the key factor holding back a stronger recovery.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ½%.
Bias: Hold QE.

May 2013 saw a slight fall in the rate of consumer price inflation (from 2.8% to 2.4%) and, whilst it is true that the twelve-month rate for CPI has been reasonably stable, it is consistently high. In an inflation targeting regime, this needs to be confronted because the longer inflation remains above target the more fanciful are claims that it is temporary. The introduction of forward guidance institutionalises the Monetary Policy Committee’s (MPC’s) leeway but at the cost of instilling even greater discretion. The fact that monetary policy since 2007 has been characterised by greater discretion, rather than better rules, is a large part of why it is failing.

Current events exemplify one of the main failures of inflation targeting – the inability to distinguish between price changes caused by changes in the demand to hold money, and price changes due to changes in productive efficiency. For some time, the inflation target has served as a counterproductive anchor that has prevented monetary easing from occurring when needed. However, just because monetary easing would have produced a stronger recovery if employed sooner, does not mean that more monetary easing now can compensate. It seems increasingly clear that with real growth below trend and CPI above target that a large part of the UK’s difficulties fall on the supply side. The fact that there was a demand problem in the past does not mean that there still is one today.

The 2013 Q1 growth rate of Nominal GDP (NGDP) was 3.4% higher than the same quarter of 2012, which is more than double what it was for 2012 Q4. For most of 2012 it seemed that NGDP had fallen to a sub 2% annual growth rate but the fact that it is increasing implies monetary policy is loose. For those who treat 5% NGDP growth as the norm this remains too low, especially if the goal is to catch up to the previous trend. For those who think the previous trend was inflationary, even looser policy would be a concern.

Ad hoc schemes that intend to compensate for blockages in the credit channel bring with them real dangers. The Funding for Lending scheme (FLS) has the potential to encourage banks to lend more but it should be highly concerning when the central bank simultaneously sets wholesale funding costs, and directs the flow of credit. There is no basis to believe that officials possess the knowledge required to manage this policy in a socially desirable way. There is already a concern that zero lower bound policy has generated new bubbles, and the Bank of England should be wary of stoking new ones (or indeed perpetuating existing ones). Emphasis should be on regulatory reforms that allow banks to serve as financial intermediaries. Credit needs to flow to entrepreneurs because they are in the best place to invest in value-generating projects, not because increases in credit are good per se. Lower taxes, fewer regulations, less uncertainty etc. play a bigger role than ‘lack of credit’. If anything, the misallocated credit from the preceding boom has yet to be properly reallocated. This is a prerequisite for a healthy and sustainable economic recovery.

The annual growth of M4ex continues to run at a stable rate and the MPC should carefully balance the risks of loose monetary policy on the one hand, and tightening too quickly on the other. A modest increase in interest rates would restore some credibility to the MPC, but ideally it would be accompanied by clear guidelines on the expected path of both inflation and real output growth. The fact that NGDP growth has jumped up, together with looser policy globally (for example, in Japan) means a ½% rise could be warranted. To be clear, raising interest rates does not necessarily mean a desire for ‘tight’ money. Rather, a 1% Bank Rate would be ‘less loose’ and help us infer what level it should be in order to be neutral.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate; maintain asset purchases at £375bn.
Bias: Employ rate changes and QE to keep M4ex growth at 4% to 6%.

The slow recovery of the British economy continued in 2013 Q1, and the available data suggests this pattern extended into the second quarter. The economy is likely to remain in this gradual, but fragile, improvement mode for the remainder of the year. Progress on the domestic side is being counterbalanced by difficulties on the external side. This is well illustrated by the 1.3% growth of real domestic demand over the year to 2013 Q1, which contrasts with the growth of 0.6% in real GDP over the same period. The difference was due to net trade – mainly the weakness of UK exports to the Eurozone – where the recession shows no sign of abating.

Viewed from the production side, the steady recovery of the service sector is being offset by declines in the manufacturing and construction sectors. Since the recovery started in mid-2009, services have grown fairly consistently at 0.9% p.a. while manufacturing and construction both surged initially in 2009 and 2010, but both have been declining since 2011, reflecting mainly international factors. However, new construction orders improved in the second half of 2012, suggesting a slightly better outlook for this sector in 2013.

In order to see significant progress towards a sustainable recovery at close to historical growth rates, the economy will need to overcome three main headwinds: the continuing weakness of balance sheets in the banking and household sectors; the tendency over the past year or two for inflation to exceed personal income growth, thus eroding purchasing power in the crucial consumer sector; and the weakness of economic activity abroad, particularly in the Eurozone, our largest trading partner.
In the area of balance sheet repair, Britain is making much slower progress than the US, mainly due to the more comprehensive or systemic measures taken by the US authorities to recapitalise American banks and detoxify their loan books in the early stages of the recession. As a result, US bank lending has been growing at about 4% per annum since March 2011 while UK bank lending has yet to start growing again. Household balance sheet repair is progressing roughly at the same pace in both economies, and seems likely to require two or three more years before completion. The reason is that, unlike companies, households cannot either raise capital or easily dispose of assets in order to repay existing debt. Confirming this, survey data quoted in the Bank of England’s Inflation Report shows that the most indebted households have raised their savings rate (and cut consumption) the most.

On the inflation front, the news has recently been better, with the April CPI slowing to 2.4% year-on-year. However, with administered price increases still to feed through to the CPI and energy prices subject to further hikes, progress in bringing down inflation may be slow for the remainder of 2013. Over a longer term horizon, a combination of subdued M4ex growth and weak domestic demand imply it is likely that the inflation target will be undershot in 2014. This should create space for higher employment and steady wage growth to generate stronger growth in real spending, as well as encourage firms to increase output.

On the external side, despite the easing in financial symptoms of the Eurozone crisis, the economic performance of the Euro-area has weakened with recessions in both the periphery and the core. When added to the sub-par growth of the US economy, and the slowdowns in China, India and Brazil, it is no surprise that demand for British exports remains weak. This in turn implies a longer period will be needed to rebalance the UK economy away from consumption and housing towards exports and business investment.

In this environment, the Bank should hold rates stable at ½%, but be prepared to undertake additional asset purchases if monetary growth plunges again, or the Eurozone crisis flares up once more. Rate increases at this stage would damage the prospects for economic recovery, and should be delayed until the recovery is substantially more secure.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.


Over recent years, the UK economy has experienced an ‘L’ shaped economic recovery. The weak recovery has arisen because of four main headwinds. The first has been the need for deleveraging in both the public and private sectors. The second has been the damage done to the banking system as a result of the financial crisis and the impaired monetary transmission mechanism. Third has been the squeeze on household incomes from inflation running well ahead of earnings growth. Finally, there has been the impact on precautionary behaviour, by both companies and consumers, from the ever present Euro crisis. To a varying extent, and at different times, these headwinds have combined to hold back recovery.

However, in late 2012 and early 2013 the economy also acquired a strengthening following wind, with the pick-up in the rate of M4ex broad money supply growth to around 4% to 5% on a year on year basis in recent months. Whilst such rates of growth still imply a recovery which is more ‘L’ than ‘V’ shaped, they do nonetheless suggest that GDP growth in 2013 could be around 1.5%. The underlying rate of growth in potential output in the UK has probably slipped to under 2%, because of the growth in the total intervention index – i.e., the combined burden of public spending, taxation and red tape. Supply-side weakness suggests that any improvement in nominal GDP growth – arising from the acceleration in broad money – will be split unfavourably towards inflation as opposed to real GDP growth. Consequently, inflation may struggle to fall back towards target in 2014 despite a continued output gap.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To Raise Bank Rate.

Much is made in the media of the debate amongst economists between the majority favouring spending and deficit cuts or believing them necessary if undesirable, and a vocal minority that favour increasing the deficit at least in the short-term. What has gone largely unremarked is the important debate between the majority view that interest rates must continue at around zero – perhaps, accompanied by even more QE - and the minority view that rates should be raised. In my own case, the belief that rates should be increased rests on the propositions that follow.

First, the fundamental challenge confronting the UK economy is not just a few quarters of below-trend growth. The fundamental challenge is that the underlying sustainable growth rate of the economy has dropped from the norm of 2.5% or higher of the 1980s and 1990s to perhaps as low as 1% today. If that underlying growth rate cannot be raised, then UK households and businesses that took on high debts during the 2000s will default on those debts unless there is high inflation, bankrupting our banks. The recent problems of the Co-op bank confirm that the UK banking sector’s problems are by no means over. If the UK’s nationalised and quasi-nationalised banks become distressed again, then the UK government that stands behind them will face the choice of either allowing them to default or bailing them out. Either option will impact on the UK government’s perceived credit-worthiness. If markets lost confidence in UK government debt, bond yields might rise, reducing the value of the Bank of England’s QE-acquired bonds. This capital loss would impose large further costs on the Treasury, and also reduce the value of the UK government bonds held by UK banks, placing them into further distress. That vicious cycle can only be broken by either raising the sustainable growth rate of the economy or by a period of high inflation.

Second, the central lesson of macroeconomics of the past forty years is that loose fiscal and monetary policy cannot raise the medium-term sustainable growth rate of the economy, but can reduce it if done to excess. It is, therefore, both futile to imagine that keeping interest rates at zero and printing money can address our core sustainable growth problem, unless the intention is to deliver high inflation, and dangerous to attempt to do so – since such an attempt could reduce the sustainable growth rate further, making things worse not better. Given that the sustainable growth rate is so low, any short-term boost to output that is achieved by such loose policy can only come at the expense of inflation and fall-back into recession. We saw in 2008 and 2011 that inflation rises to 5% and upwards when the UK economy is not actually contracting.

Third, more than four years into zero interest rates and QE, monetary policy has had its go. Monetary policy can be a powerful tool for boosting growth in the short term. However, the period over which it is efficacious is from around nine months to three years. Beyond that, very loose policy will tend to damage growth and also be morally questionable, as very low rates punish the prudent in order to protect the imprudent from the consequences of their errors. We cannot indefinitely accept that those that chose not to over-extend themselves in the 2000s should suffer, just so as to spare those that did over-extend themselves from the fruits of their folly.

Fourth, very low rates and extra QE at this stage provide a negative signal – they tell the financial markets and economic agents in general that policymakers believe that the situation is dire and recovery is still far off. We are well past the point at which they were signalling that the problem was temporary and policy could and would be used to turn things around quickly (the more normal signal provided by policy loosening). Raising rates would be a sign that there is a future of normality awaiting us, and with baby steps we can get there. The first of those baby steps should be a modest rise in rates. I would start with ½%.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

Mark Carney arrives as the new Governor of the Bank at a time when policy is in disarray but at the same time all the levers of policy are in the Bank’s hands. He has a good chance to improve matters. What is the problem? The Bank is pursuing a monetary policy that is at its loosest for all time. Via QE the monetary base has expanded to nearly eight times its 2007 value. Virtually all that expansion is sitting in bank reserves, as the extra money printed was deposited and not lent; so the banking system has created no additional money, and the total (‘broad’) money supply has barely grown. Meanwhile, interest rates on government three month bonds are held down close to the Bank Rate of ½%, an all-time low that has prevailed for four years; on longer maturities the government can borrow at rates below inflation. Yet, rates on credit to small businesses remain, as far as we can measure them, stratospheric; and lending to Small and Medium-sized Enterprises (SMEs) continues to contract sharply. The economy is growing weakly at best. Equity prices have soared as investors have chased yield elsewhere than in government bonds; yet large businesses refuse to invest, preferring to wait for recovery. As for inflation, it is now sagging back towards 2%, after a long period of being driven up by soaring commodity prices, now mercifully falling back; the lack of credit and money growth has held domestic inflation down so the Bank’s credibility has not been tested.

In a nutshell, this highly and indeed dangerously expansionary monetary policy has had little or no effect on credit, real activity, the broad money supply or inflation but has driven down yields on government bonds and other assets, damaging savers at the expense of government and large borrowers. Why?

What we have been discovering the hard way is that money does not course equally vigorously through all channels, especially when regulators insert large barriers between them via their controls. Small businesses always find it hard to get credit and face a rate much higher than Bank Rate, which varies with general business conditions in a way that we do not observe very well; arrangement and other fees come and go, as do eligibility criteria and collateral requirements. Now, in addition to the usual hurdles they would face because of poor business conditions and the banks’ internal difficulties, these businesses face a new and massive regulatory obstruction: as they are ‘high risk’ they push up a bank’s risk-weighted assets and so force the bank to get expensive extra capital to satisfy the new capital ratios. The banks have reacted by refusing to expand their balance sheets by lending to these expensive firms. Instead they have clung onto their ‘low risk’ large customers and official paper, most especially reserves with the Bank. The credit channel to the dynamic part of the economy, the 50% represented by SMEs, has been blocked by regulation. So all the money printed has gone into the other channels, causing a lake of liquidity to form around governments and large corporations. The economy has flat-lined as these monopolistic elements bask in the luxury of doing nothing much except ‘cuts’.

Mr Carney should change this. As the chief regulator he should cut back these capital requirements, or at least postpone them sine die. As the banks come back to life, he can then junk the clumsy bureaucracy of the FLS and the mortgage subsidy for first time buyers. He will then need to tighten monetary policy as bank credit expands and the recovery strengthens. All those bank reserves created by QE are like dry firewood waiting for a spark; not merely must it be stopped as agreed by majority in the latest MPC minutes but it must also be removed fast. Interest rates must rise to keep credit and money growth under control. There will be difficulties in removing the existing stock of QE, as the Bank’s bond holdings will fall sharply in value with rising interest rates; also politicians will want to stop the Bank ’spoiling the recovery’. However, the Treasury will have to absorb the loss on the Bank’s assets (after all the Bank’s loss is its gain) and the politicians must be ignored.

For the longer term, people will worry that weakening bank regulation will lead to a future crisis. But regulation works against the grain of the free market economy; it would be better to control excess credit expansion by monetary policy in future. The inflation target should stay at 2% because as a society we decided to eliminate the deadly virus of unchecked and uncertain inflation. However, the monetary control mechanism could supplement the target with a money supply target which would proxy the otherwise unobservable cost of credit to SMEs. The setting of Bank Rate and the printing of money could be jointly orientated towards the control of monetary conditions. If Mr Carney can sort these things out, he will have more than earned his unprecedented Gubernatorial package.

What should be done this month? QE should start to be reversed and bank regulation eased back sharply. One interim solution would be to make any capital requirement smaller and also absolute – that is, related not to risky assets but merely to the overall size of the bank balance sheet. Then ‘excess risk’ when it eventually becomes a threat in some years’ time would be handled by making monetary conditions respond to the money supply. Meanwhile, the marginal cost penalty on bank lending to SMEs would be removed. Pending all these changes we need the FLS and the mortgage subsidy scheme to be expanded as necessary to offset the damaging effects of regulation- much as the government is now being forced to do; these actions will continue to bear down on the costs of credit to smaller borrowers. Interest rates on government paper should rise now by 0.5%, to begin the normalisation of the official paper market. Besides beginning to remove the distortion in the savings market, it would also revive the interbank market, whose operations are suppressed by the lake of QE reserves and the low rate on borrowing from the Bank. It will also take the froth off the equity market. Most importantly it will start to reduce the dangers of inflation as the economy re-enters growth.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up and fully privatise state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

Sir Mervyn King has been such a predominant influence on the Bank of England’s economic approach since he became its Chief Economist in 1991, Deputy Governor in 1997, and Governor in 2003 that the Bank’s economists must be feeling a similar sense of disorientation to that felt by the state officials of Eastern Europe after the fall of the Berlin wall. This is not intended as a suggestion that Sir Mervyn was running a totalitarian system. Indeed, the openness and transparency of UK monetary policy making – as demonstrated at the question and answer session at Sir Mervyn King’s final Inflation Report press conference, for example – is probably at the leading edge of central banking practice. However, the removal of such a powerful intellectual presence from any institution after more than two decades must inevitably give rise to a period of reflection and re-consideration. One over-arching concern about Sir Mervyn’s period in office has been the apparent closeness of the Bank’s approach to that of the US Federal Reserve, as against the traditional sound money commitment and long-term policy orientation of the pre-European Monetary Union (EMU) Bundesbank. There is a risk that, as a Canadian, the incoming Governor, Dr Mark Carney, will also adhere too closely to the excessively activist US approach to monetary policy, which led to serious over-steering and was a main cause of the Global Financial Crash. An interesting thought experiment is to ponder what would have happened to the credibility (and also the techniques) of UK monetary policy if an experienced ex-Bundesbank official (several of whom have chosen to leave the ECB in recent years) had been appointed as the new Governor by Mr Osborne.

In keeping with its commitment to transparency, the Bank of England publically released details of its new forecasting ‘platform’ on 24th May. This system has been used since the end of 2011 to generate the Inflation Report forecasts, although resource constraints at the Bank have meant that the documentation has only just been placed in the public domain. The term ‘platform’ has been used deliberately by Bank officials because there are four separate elements involved: COMPASS, which is the new central core model; MAPS, a macroeconomic modelling and projection toolkit; EASE, which is a user inter-face, and a suite of sub-models that are used to supplement and extend the projections generated in COMPASS. The new platform is consciously designed round the institutional forecasting procedures of the MPC; in particular, the important role of pure judgement on the part of MPC members. As such, it guarantees forecasting consistency in a balance sheet sense but it may be too open a system to fully incorporate the feedbacks that once would have been considered desirable in a macroeconomic forecasting model. The documentation provided by the Bank falls not far short of two hundred pages, often containing some dense mathematics, and there has not been time to digest so much material properly.

On the basis of a quick read through, a number of specific concerns are as follows. First, there is only a rudimentary representation of the government sector in COMPASS, despite the fact that general government expenditure accounted for 50.3% of UK non-oil basic price GDP last year. This means that the important feedbacks between monetary policy and the private-sector tax base, together with the independent effects of changes to individual spending items and tax rates on the targets of monetary policy, are not represented. Second, Britain is correctly modelled as an open economy. However, the UK model is not nested inside a global model, so it is difficult to represent consistently the indirect effects of, say, an oil price shock operating through international variables. Third, a relatively short data estimation period of 1992 to 2007 has been employed – the Bank explains the reasons for this choice – but it is easy to over-fit models using such short data runs, making them unreliable forecasters. A fourth concern is that the main monetary policy instrument incorporated in COMPASS is Bank Rate. Sub-models can be run in conjunction with COMPASS that allow credit shocks to be simulated, generally by increasing the wedge between borrowing costs and Bank Rate. However, it is not clear that this is enough to represent the effects of official balance sheet constraints and credit rationing on the economy, a subject that has been of major concern to the SMPC. It is also noteworthy that there is no necessity in COMPASS for the supply of money and the demand for money to be in equilibrium before the model settles down because the money supply itself does not seem to be included. This is consistent with the theoretical approach adopted by central banks in recent decades. However, central bankers have made an unholy mess of the world economy during this period – in large part, because they ignored what the ECB used to call the ‘second monetary pillar’.

The latest figures for the M4ex definition of the UK broad money stock show a rise of 4.5% in the year to March, while broad money in the aggregate Organisation for Economic Co-operation and Development (OECD) area was 5.5% up on the year in the first quarter of 2013. The post-2008 crisis period of very weak monetary growth seems to have come to an end during the course of last year. Current monetary growth rates might be regarded as being appropriate on a medium-term perspective to achieve low and stable inflation given the rather subdued outlook for the growth of potential supply both internationally and in the UK. The main concern is that governments are hogging the money creation process and that both total bank credit creation and, within it, lending to the productive private sector are being crowded out, largely because of the financial repression caused by excessively onerous regulations. The only cure is for the financial supervisors to regulate more intelligently and less aggressively and for governments to improve fiscal discipline by means of better spending control.

The drop in the annual CPI inflation rate from 2.8% in March to 2.4% in April was a pleasant surprise, which was reinforced by a drop in core producer price inflation from 1.3% to 0.8% between the same two months. However, annual house price inflation on the ONS measure picked up from 1.9% to 2.7% between February and March, possibly as a reflection of the recently higher rate of M4ex increase as well as Mr Osborne’s misguided schemes to ramp up the housing market. The ONS will be rebasing and redefining the UK national accounts on 27th June. Previous annual re-workings of the official GDP figures have sometimes introduced such radical back revisions that they have altered the tone of the entire economic debate. This means that there is probably little point in worrying too much about the finer details of the unrevised 0.3% increase in real GDP in the first quarter reported on 23rd May, which represented a 0.6% rise on 2012 Q1. The most recent labour market statistics have shown some signs of weakness, especially in annual earnings growth which was only 0.4% in the year to 2013 Q1 and zero in the private sector, and need to be watched carefully. Overall, however, a Bank Rate increase of ½% seems appropriate at the June MPC meeting – incidentally, this will be Sir Mervyn King’s last rate decision before Dr Carney takes over – with no further increase in QE for the foreseeable future. British interest rates will have to be normalised at some point. A stability orientated monetary policy maker would recognise that it is less disruptive to start the process early, and in small steps, rather than leave it too late and then have to slam on the brakes.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; no extension of QE.
Bias: To raise Bank Rate.

It is testament to the strength of regulatory pressures on the banks that the annual pace of M4 lending, excluding intermediate other financial corporations, has fallen back from 1.7% in December 2011 to -0.1% in March 2013. Blockages in private sector credit transmission remain a formidable obstacle to UK economic recovery. The M4 money stock, with the same exclusions, has picked up some momentum over the same period to register annual growth approaching 5% on average over the three months to March. Plainly, it is the underfunding of public sector borrowing that separates the outcomes.

The failure to stimulate additional lending, notwithstanding four years of ½% Bank Rate, £375bn of asset purchases and the FLS, illustrates the policy dilemma. The gold-plating of international bank regulation by the UK authorities has deprived the economy of valuable lending capacity at a time when public expenditure was in retreat, for very good reasons, and the Eurozone economies were in spasm.
Nevertheless, there are tentative signs that large companies have begun to increase their capital market borrowings. Private non-financial corporations borrowed £8.5bn in the first quarter of 2013 in the strongest showing since 2008. The pace of bank loan repayment slackened; bond issuance strengthened; net equity issuance turned positive, and even commercial paper made a modest contribution. As for SMEs, there is no evidence of volume gains, but a much larger percentage of small businesses have access to interest rates of 4% or less relative to last year. Lending spreads are very tempting for the banks, suggesting that competition will continue to weaken the cost of borrowing.

The weight of criticism of the government’s Help to Buy programme, not least by the outgoing Bank governor, can be taken as a positive sign: to attract such opprobrium suggests that few doubt its potential to have a definite impact on housing transactions and house building volumes. Much of the criticism surrounds the danger of reigniting house prices, yet a firm housing market is a necessary inducement to persuade vendors to offer their properties for sale.

Against a backcloth of a lacklustre potential GDP trend, even a modest improvement in the outlook must be regarded as an invitation to begin the painful task of normalising the short-term interest rate. The era of ½% Bank Rate should have ended in 2010; instead it lingers on. The first steps towards rate normalisation – which might only be as far as 3% – should not be delayed. My vote is to raise Bank Rate by ¼% and to keep going.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

Is the UK economy at a lower business-cycle turning point? On the surface, it appears that it is. Economic growth was confirmed at 0.3% in the first quarter. Looking at the Purchasing Managers Indices (PMIs) for services, which is further above the breakeven level of 50; manufacturing, which is edging up towards 50, and construction, which is also pushing up towards 50, growth in the second quarter could be as much as ½%. Taking the first and second quarters together (assuming the latter is that just suggested) would give 0.8% growth in the first half of 2013.

Such an increase can be compared with the forecast of 0.6% for full year growth in 2013 made by the Office of Budget Responsibility (OBR) in March, and the Consensus Forecast of 0.9%. Moreover, inflation has fallen to 2.4% in April, with producer prices slipping and suggesting that pipeline inflation pressure is easing. The world backdrop is more stable than a few months ago, with financial markets in particular on the up, indicated by equity markets hitting new multi-year highs recently (though off those in the last few days). Employment gains are still holding up well in the UK and consumer and business optimism is trending higher than they have been at any point since the second half of last year. That means UK economic growth could end 2013 above 1% for the first time in three years. What better time to start to withdraw the extraordinary stimulus of the last few years?

The problem is that the recovery narrative does not hold up that well under scrutiny. First quarter growth was down to a sharp rise in inventories; without which real GDP would have contracted slightly. Also, there is no guarantee that national output will not fall back in the second quarter for the same reason – i.e., inventories but this time as the first quarter surge unwinds. The low paid jobs created in the last few years still leave consumer spending under pressure. Lower inflation helps household real income increases to be less negative, but nominal earnings growth continues to slide. Government spending is starting to be a drag on growth – if the first quarter figures are right – as fiscal retrenchment starts to bite. Our key export markets in Europe continue to struggle, with recession likely for eight consecutive quarters. Euro-zone GDP in 2013 as a whole is likely to be down by ¾%, a quarter of one percentage point worse than last year’s decline.

However, the issue is that it is difficult to see that the real drivers for sustained recovery are yet in place. Productivity continues to fall. Labour supply growth is positive but the jobs are low paid overall, and, together with the lack of investment in plant and machinery that is required to kick start productivity gains, the recovery in the first half of 2013 looks likely to fall back to just about flat in the second half. So, all in all, it is too soon to withdraw the stimulus. I would therefore leave rates on hold and keep QE at the current level, awaiting UK developments in the second half of the year. Let us see what the new Governor of the central bank thinks of all this when he takes over at the end of June. He will find that, in May, six members wanted policy to stay on hold and three (including the outgoing Governor) wanted to ease via QE.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.


Sunday, May 05, 2013
IEA's shadow MPC votes 6-3 for half-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 16th April, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 9th May. Five SMPC members wanting an increase of ½%, another voted for a ¼% increase, and three voted to hold Bank Rate.

This vote distribution implies a ½% increase on normal Bank of England voting procedures. The recommendation of a rate rise in May represented the fourth consecutive month that a majority of the SMPC had voted in favour of higher interest rates. However, it was the first time for several years that a majority of the shadow committee had recommended an increase of ½% rather than ¼%.

While the SMPC has recommended a more hawkish stance than the official rate setters recently, there has always been a SMPC minority who wished to freeze rates until there were clear signs of recovery. The SMPC was also more hawkish than the official rate setters during the credit bubble that preceded the 2007 and 2008 financial crash. It is hard to argue, with hindsight, that the Bank of England was justified in ignoring the signs that the Heath-Barber and Lawson credit booms were being repeated in the earlier 2000s.

There appear to be three main intellectual differences between the majority view on the SMPC and the official one. These are: 1) the extent to which weak growth is a supply-side phenomenon, rather than a demand-side one; 2) how far misguided financial regulation has led to a damaging restriction in the supplies of money and credit, and 3) whether Quantitative Easing (QE) has been exhausted as a stimulus or, alternatively, should be re-directed towards private sector debt.

Minutes of the meeting of 16th April 2013

Attendance: Phillip Booth (IEA Observer), Roger Bootle, Kent Matthews (Secretary), Patrick Minford, David B Smith (Chairman), David H Smith (Sunday Times Observer), Peter Warburton, Trevor Williams.
Apologies: Tim Congdon, Jamie Dannhauser, Anthony J Evans, John Greenwood, Graeme Leach, Andrew Lilico, Akos Valentinyi, Mike Wickens.
Chairman’s introductory comments

The Chairman began the meeting by stating that he had been overseas at the time of the March Budget. However, he was not surprised that the official borrowing projections had been revised up yet again or that the official growth projections had had to be revised down. This is exactly what one would expect from the extensive international literature on fiscal consolidation. The Chancellor had consistently pursued what were known as ‘timid’ Type 2 fiscal consolidation policies – in which taxes were raised and the volume of government consumption increased, albeit through poor control rather than overt intent – and the result had been exactly what one would expect from the fiscal stabilisation literature; i.e., persistent deficit overshoots and growth way below official expectations. The interesting questions were: who on earth the Chancellor was looking to for advice, and why the Conservatives had spent their thirteen years in opposition without ever getting to grips with the intellectual issues involved? The Chairman then invited Trevor Williams to give his assessment of the global and domestic monetary situation.

Economic situation

Trevor Williams began his presentation by stating that he would start with an examination of the global monetary statistics and then work down to the Euro area and finally to the UK. He started with money supply growth in the leading three (G3) international economies and the emerging economies, which showed continued stagnation in the former and a slowing in the latter. Within the developed economies, the USA had seen some acceleration but was still below recent highs, whereas monetary growth in the UK had picked up but was still running at a very low rate. Monetary growth in Japan and the Eurozone remained flat. In Asia, monetary growth was dominated by China but here there was a slowing. Monetary growth was robust in Latin America but this looked to be an excessive growth rate if continued for too long. Brazil was, perhaps, an example of where there has been too much focus on excessive credit creation rather than supply-side reforms.

Credit growth in the developed economies was also slow and flat, with the UK still in negative territory. Surveys of bank lending conditions in the emerging markets revealed a tightening of credit standards. Furthermore, the price of credit had been rising in the USA, UK and Eurozone with adverse consequences for economic recovery. Policy rates remained low in the advanced economies and had remained stable in the emerging economies.

Global inflation had remained under control and it was also contained and falling in the developed economies. Global GDP was still heading up. However, the gap between the growth of the emerging economies and the sluggishness of the mature economies remained as large as ever. Elsewhere in the real sector, manufacturing output in Asia had risen sharply but had fallen back in the mature economies. The bottom line was that there was insufficient strength in the world economy for an inflationary danger to emerge. Inflation was not a major problem. A plot of output gap and core inflation for the major economies revealed no discernible pattern and little in the way of inflation risk. This meant that policy rates could remain low.

Trevor Williams went on to examine the statistics for the Euro area starting with ten year government bond yields. Euro area risks had reduced on the surface, owing to policy action, but underlying problems remained. While the European Central Bank (ECB) balance sheet was set to stabilise along with that of the US Federal Reserve, the Bank of Japan balance sheet was set to take-off. Despite the increase in ECB liquidity to the markets, corporate lending rates in Italy and Spain had widened against Germany and France. Euro area divergence continued with differences in manufacturing growth between Germany and the rest. In Germany, house prices had been rising gently, while those in Spain and Ireland had been declining.

In the UK, inflation was likely to remain above target but wage inflation would be weak and the economy was likely to slow in March after a good start to the year. The indicators were signalling a worsening of output, following some signs of growth at the end of 2012. The British economy had seen some improvement in money and credit conditions. However, these were insufficient to spark a strong revival in growth. Nevertheless, the latest figures for 2013 Q1 (Editorial Note: this refers to the figures released on 25th April) showed that the economy expanded by 0.3%, based on the 44% of output data available in that quarter.

This offsets the fall of 0.3% in 2012 Q4, if left unrevised. The good news was that world inflation trends remained benign. With commodity prices off lower in recent months, as the world economy slowed, inflation was set to stay low, recently in line with the weakening of global growth. The Bank of Japan had joined the QE party, and seemed prepared to go for higher inflation to revive their economy, with attendant risk for government debt.

Discussion

The Chairman then thanked Trevor Williams for his excellent presentation. He said that, in keeping with tradition, he would ask the IEA Observer, Philip Booth, to make a vote as the meeting had been inquorate. He then kicked off the discussion by expressing some unease about the manner in which the Retail Price Index (RPI) had recently become an ‘un-statistic’ as far as the Office for National Statistics (ONS) was concerned. The figures were still being published under the banner “NOT NATIONAL STATISTICS”. However, the ONS could not have it both ways. If the RPI was not a useful variable, why had the ONS persisted with its publication every month since the late 1940s? If it was worthwhile then, why had it now ceased to be useful, given that it was widely employed in private-sector contracts as well as for Index-Linked Gilts?

David B Smith’s fundamental concern was that, having failed to achieve a meaningful fiscal consolidation, the Chancellor was now planning to go even further in unleashing the inflation tax – perhaps, with the hoped-for acquiescence of Mr Carney and the Bank’s proposed more flexible inflation mandate – and was trying to disguise that decision by downgrading the RPI and its constituents. David B Smith added that some of the new measures of the price level (such as CPIH, which added housing costs to the established Consumer Price Index or CPI) were potentially useful. Unfortunately, only a relatively short back run from February 1998 onwards was available for the new measures. This was too limited a period to permit of any serious econometric modelling, something that represented a serious impediment to a forward-looking inflation targeting framework. David B Smith then added that it was not clear that the new RPI ‘Jevons’ (RPIJ) – which was named after a Victorian economist – was superior to the old RPI from a conceptual viewpoint.

That depended on the assumption that there was no loss of consumer utility when one switched from, say, apples to pears because the price of apples had gone up, even if one disliked pears. All that one could say was that retail-price inflation fell somewhere between the 2.7% shown by RPIJ and the 3.3% shown by the RPI, and not that any one measure was superior. There followed a short discussion about the proposed statistics.

The Chairman then asked Patrick Minford and Roger Bootle to make their respective comments immediately, as he knew that they both had to leave before the adjournment of the meeting. In addition, he said that he would need to call for two further votes in absentia in order to complete the magic nine. These votes were subsequently supplied by Jamie Dannhauser and Andrew Lilico. Having taken the votes of Roger Bootle and Patrick Minford, the Chairman stated that it was time to go round the table and record everybody else’s views. He said that, on this occasion, he would allow the discussion to continue into the voting round and that other people’s comments on the votes would be recorded for once. This reflected the relatively small size of the group remaining and the fact that there was still a reasonable amount of time left. The votes concerned are listed in alphabetical order below, including the two votes cast in absentia.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate by ½%.
Bias: Hold QE.

Philip Booth said that he was nervous about the mortgage guarantee scheme. He said that there was an inconsistency between the government encouraging the banks to build up capital, so that they would not fail and be a burden on the taxpayer, and at the same time for the government to guarantee loans directly. The logical policy was for the government to create a legal framework to allow banks to fail and to deal with the ‘too big to fail’ problem. In response, Kent Matthews said that he did not see an inconsistency in the government having a too-big-to-fail policy and the government absorbing the risk of bad assets of the banks through an asset guarantee scheme. It was a logical extension of a too-big-to-fail policy.

Philip Booth said that the underlying problems were on the supply-side. He said that the productivity problem could not be solved by monetary policy and that Bank Rate should be raised by ½%, given the forecast for inflation, and that there should be no further QE.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold Bank Rate.
Bias: To cut to 0.1%.

Roger Bootle said that for once he agreed with Patrick Minford (see below) in his assessment but not in his conclusion. He said that the banking system was broken. In the 1930s, the banking system had supported the recovery, as it had also done by-and-large in former recessions. He agreed that there had been regulatory overkill. Roger Bootle added that it was not clear why there was a need to tighten regulation now rather than later. He said that the popular culture of putting bankers in the stocks did not help the recovery process. This was because active bankers were needed to get the economy out of its current mess.

Roger Bootle added that the Treasury attitude of fattening up the publicly owned banks for sale was not the right structure for recovery and that the government was not addressing the problem of the banks. The economy was flat but there remained potential for improvement. The fall in commodity prices had been significant. Oil at around $100 a barrel (Brent crude) was an important milestone. He said that inflation would probably come in better than expected. If inflation fell by the end of the year, the portents for recovery were good. He said that he was only a lukewarm supporter of QE. Sterling had depreciated sufficiently already, so there was no need for further QE. He added that there should be no change to interest rates immediately. However, it may be necessary to cut rates further to 0.1%, and have negative rates imposed on bank reserves held at the Bank of England, if the economy remained moribund.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Additional QE and a rebalancing towards non-gilt assets.

In his vote in absentia, Jamie Dannhauser stated that CPI inflation remained stubbornly above the 2% target. It could go to 3% in the months ahead, in his view. However, around 1 percentage point of this could be explained by higher administered prices, suggesting a more subdued rate of underlying inflation. Absent the effect of higher university tuition fees, ‘core’ UK inflation had been below 2% since November. Indicators of price pressures in the more recent past, for instance the three-month annualised change in ‘core’ inflation, painted a picture of benign inflation. Other series, such as average wage growth or the annual change in the gross value added deflator, support the contention that the current inflation overshoot was not generalised.

Output growth continued to disappoint. The first quarter data might well show a small expansion in real GDP, but there was little momentum in the economy. External risks to growth remained sizeable given the fragility of the underlying economic position of the Euro area, even if complacent financial markets suggested otherwise. Monetary growth had picked up somewhat. There were signs that the Funding for Lending Scheme (FLS) had led to an easing of credit conditions, especially in the mortgage market. The increased availability of higher-risk loans to first-time buyers in particular could have a marked impact on house prices in the short-term and UK households’ propensity to save. Prospects for consumption had improved since the autumn.

Following news that the FLS was to be extended, there was no need to alter policy this month; it seemed advisable to wait-and-see what additional support to credit supply and broad money growth might be forthcoming. Nevertheless, with slack in the economy, particularly in the labour market, and good reasons to fear that persistently sluggish demand growth would feed through into damage to Britain’s supply capacity, monetary policy should be biased towards additional ease until such a time that there was a clear, self-sustaining momentum in broad money growth. The demands from regulators for UK banks to increase their capital buffers – by between £25bn and £50bn – by year end would be an important headwind to monetary creation in the short-run that monetary policy could attempt to offset.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate; no more QE.

In his vote in absentia submitted following the SMPC gathering, Andrew Lilico expressed the view that, with GDP growth somewhere between slightly negative and slightly positive for two years, it was understandable that policymakers were scrabbling around for some new magic bullet to boost the economy once more. Such initiatives included the FLS, the ‘help to buy’ scheme and flexible inflation targeting. What policy makers did not want to accept was that there are no painless fixes here. This was not a crossword puzzle to solve with a moment's inspiration.

On the other side, were a few defeatists who said that we must learn to live in a growth-free world. Andrew Lilico claimed that we should not accept that either. The government could do some positive things to boost medium-term growth. For example, it could: cut the size of the state; raise public sector productivity; raise the workforce size through higher retirement ages, and privatise or liquidate the nationalised banks.

Macroeconomic policy, per se, could not boost medium-term growth – as Mark Carney had acknowledged recently. Done to excess, though, macroeconomic looseness could damage growth, and had arguably been doing so for some time. Those that argued for yet more stimuli should ask themselves this question: "What would persuade me the path of stimulus was not working, if not the past three years' experience?" If the answer is: "Nothing", what you have in place is a habit, not an economic policy.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate; additional QE to be used only if the Euro crisis re-emerged.

Kent Matthews said that nothing had changed in the economy since the last physical meeting of the SMPC, held on 15th January, to make him change his mind on policy. Monetary policy had run its course and there was no sign that the economy was going to respond the low interest rates or the past policy of QE. He agreed with Phillip Booth that the problem of the economy was a supply-side one. QE and low interest rate policy had distorted the capital markets making inefficient the natural process of financial intermediation. Low interest rates were keeping enterprises that should have died in a state of ‘un-death’. This was starving new enterprises of much needed funds. Bank policy was hampering the efficient working of the capital market. While there was a need to regulate banks, he agreed that this was something for the future. Even announcing tighter regulation in the near future would influence commercial banks’ expectations and create perverse effects. Tighter regulation should be suspended until it was clear that the economy was on the road to recovery. He voted to raise Bank Rate by ½% and to hold QE which could be deployed if the Euro crisis were to flare up as it would inevitably.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate.

Patrick Minford said that the credit channel was blocked. America had managed to unblock its own credit supply through the US Federal Reserve buying sub-standard assets. However, the Bank of England had refused to buy anything other than gilts. The conservative attitude of the British Central Bank towards policy and towards the regulation of the commercial banks had blocked the credit channel. QE had distorted the capital market, which had made it cheap for the government to borrow but not companies. Distortionary monetary policy had resulted in firms being kept artificially alive while starving credit elsewhere. Funding for lending was an attempt to unblock the credit channel but with little success. He said that the capital regulations for the banks should be suspended in order to unblock the credit channel. QE should be stopped and interest rates should be pushed up. The problem was that the Treasury was focussed on fattening up the Royal Bank of Scotland group and Lloyds for sale so that the taxpayer did not incur a loss. It meant that the banks were more engaged in building up capital than in lending and reviving the economy. He said that interest rates should be raised to 1%.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up and privatise state-dependent banking groups; raise Bank Rate further, and hold QE.

David B Smith said that the economy had experienced a major – and predictable – supply withdrawal. There was a mass of empirical evidence that a rising government share in national income reduced capacity in the long term, even though there might be a short run boost from fiscal policy. His own statistical research suggested that roughly one-third of the output shortfall in the OECD area as a whole since 2008 had occurred because of the increased socialisation of the international economy since 2000, although the rest does seem to have been associated with the financial crash. In the UK, there were three things going on simultaneously. First, the increased socialisation of the economy had contributed to slightly over one half of the output shortfall since 2008, although the rest was statistically associated with the crash, if these were assumed to be independent events. Second, monetary policy had provided some transitory stimulus. However, monetary ease could not stimulate output in the long run – when the supply side was the crucial influence – and it had probably exhausted its effectiveness by now. Third, incentives and regulation had had perverse effects, especially in the case of the commercial banks.

With macro-policy exhausted, there was an overwhelming need to implement bold micro reform of the economy generally and financial institutions, specifically. For competitive reasons, as well as the too-big-to-fail issue, we needed to go back to smaller banks with regional head offices in some cases. This could be quickly brought about by breaking up the big state-owned banking groups into their historic constituents and flogging off the bits at the best price that could be achieved. He accepted that this might leave the government with a rump ‘bad bank’. However, competition and manageability should be the goals, not trying to get the taxpayers’ money back. Policy needed to address three issues. These were: first, deregulation; second, government spending, and third, the structure of the banking market. He voted to raise Bank Rate by ½% to restore monetary discipline to refocus on inflation. There was nothing further to be gained from additional QE.

Philip Booth cautioned the committee not to advocate a top-down bank restructuring because markets were not being allowed to come to a natural solution. In response, David B Smith said that he accepted Philip Booth’s argument as a general rule, when the starting point was a competitive system. However, that was not the case with the British banks, which were heavily cartelised, often as a result of officially encouraged mergers, such as those of the early 1920s and the late 1960s, which had reduced the number of clearing banks from eleven to five.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; no extension of QE.
Bias: To raise Bank Rate further.

Peter Warburton agreed with the diagnosis that blockages in private sector credit transmission were the greatest impediment to UK economic recovery. Policy innovations, such as the extended FLS and the help-to-buy initiatives were designed to “fly under the radar” of an overbearing financial regulatory regime. FLS has demonstrated beyond all reasonable doubt that it is market interest rates that matter to economic behaviour rather than the largely irrelevant Bank Rate. Paradoxically, to regain relevance, Bank Rate needs to increase in order to reconnect with the market structure of rates. With the Budget announcement of a new Bank of England remit and the invitation to further policy experimentation, it is imperative that Bank Rate is not committed to remain at ½% for an extended period. Were this to be done, its irrelevance would be ever more apparent.

However, with the addition of the massive dose of Japanese quantitative and qualitative easing, the force of global reflationary policy has increased materially. Japan has an urgent agenda for economic expansion and for policies to affirm the credibility of the 2% inflation target. It would be a surprise if the global economy did not strengthen, and also display more of an inflationary bias, in the remainder of 2013. UK’s distinctive susceptibility to imported inflation, aggravated by early-year Sterling weakness, reinforces the argument for beginning the process of Bank Rate normalisation.

There are compelling reasons to diversify some of the £375bn of existing QE into a portfolio of other assets, including securitised property, infrastructure and possibly even SME (small and medium-sized enterprises) assets as a means of lowering the regulatory burden of the banks that relates to these loans. The fact that the ‘Bad Bank’ debate has revived in recent weeks is a reminder of how little structural progress has been made to restore health to the UK banking system.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold; no further QE.
Bias: Neutral.

Trevor Williams said that Bank Rate should be held and that QE should also be on hold. In the UK, household savings had risen and government savings were not as negative as they once were. However, significant further adjustment was required before they were stable. Corporate balance sheets were robust but adjusting lower as household savings rose. In other words, corporate profit growth seemed to have slowed sharply. The wider current account balance of payments deficit last year, at 3.7% of GDP, was a sign that the savings/investment balance in the UK was still misaligned. A troubling economic environment in Europe was making it very difficult for the UK to grow through exports, although the situation was not helped by the domestic fall in productivity and the subsequent rise in unit labour costs. Nevertheless, raising interest rates was not the answer, despite the legitimate worries about the negative effects of keeping them too low for too long. Keeping rates on hold did not preclude the need for supply-side reforms to help kick start confidence and recovery. Indeed, it bought time for this to happen. An immediate increase in rates would most likely lead to higher default rates and hit already fragile consumer and business confidence, further delaying recovery rather than speeding it up. He voted to hold Bank Rates and hold QE. However, the Bank should buy non-gilts if further QE was to be exercised.

Policy response

1. On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in May. The other three members wished to hold.
2. There was only modest disagreement amongst the rate hikers as to the precise extent to which rates should rise. Six voted for an immediate rise of ½% but one member wanted a more modest rate rise of ¼%.
3. All those who voted to raise rates expressed a bias to raise rates further. There was also a common view that QE would be more effective if it was directed towards the purchase of private-sector liabilities, rather than government bonds.

Date of next meeting
Tuesday 9th July 2013.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, March 31, 2013
IEA's shadow MPC votes 5-4 to hike Bank rate
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, which was finalised on 27th March, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 4th April. Two SMPC members wanted an immediate increase of ½%, while three wanted a rise of ¼%, implying a rise of ¼% on normal Bank of England (BoE) voting procedures.

This represented the third consecutive month that a majority of shadow committee members had decided that a rate increase was justified on economic grounds, and the second month in a row that it was five to four in favour. Of the four that voted against a rise, none voted for more QE though it was held in reserve by one.

The verdict on the Budget was that it was neutral and so will do little to stimulate the economy. More broadly, some believed it was a missed opportunity: to go further in stimulating the economy via capital projects to kick start growth and more on the BoE’s remit. On the latter, the worry was generally that the changes announced and Mark Carney’s arrival suggests a period where monetary policy would be loose and could be seen to endorse inflation.

Fears about the public sector's debt position were felt by some to have been vindicated in the Budget. With more debt, for longer in the future, with not enough effort in the view of some to rein it in, prospects for recovery were damaged.

For one, lack of control of fiscal policy is as responsible for the lack of recovery as the supply side issue that the UK faces. For another, that the rating agencies were too slow to recognise the UK’s debt problem, not too fast. One worried that the focus on both fiscal and monetary policy is wrong and self defeating, their failure actively contributing to the weakness of the economy. Structural reform is key to recovery.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: To achieve low and stable growth of the quantity of money (broadly-defined).

Disappointment about the UK economy’s performance is widespread today. The government is under pressure ‘to do something’. However, its macroeconomic options are limited. Some Keynesian critics say that the government should boost its own spending, in order to stimulate aggregate demand as a whole. But the large budget deficit and associated increases in public debt prohibit such so-called ‘fiscal reflation’, while experience over many decades shows that fiscal policy does not work in the manner discussed in the textbooks. The Budget documents therefore endorse ‘monetary activism’, with the Bank of England (BoE) reported to have been given new powers to influence the economy in a positive way.

I would say that the central problem in monetary policy at present, as over all of the last five years, is that banks cannot readily grow their balance sheets while they are struggling to meet officialdom’s demands for more capital and liquidity relative to risk assets. Since equilibrium national income is a function of the quantity of money broadly-defined (i.e., of the total of bank deposits, more or less), officialdom’s demands remain a powerful deflationary force. Monetary activism in the form of ‘quantitative easing’ (QE) (i.e., the creation of new bank deposits [money] by the state) has been tried and has been vital in mitigating the officially-imposed deflation. However, various initiatives ‘to ease credit conditions’ – such as the Funding for Lending Scheme (FLS) and the granting of powers to the BoE to purchase corporate bonds (i.e., to engage in the ‘credit easing’ advocated by Ben Bernanke) – are of little importance relative to the clamp on money growth implied by the official pressure for safer bank balance sheets.

The Budget announced that public sector net borrowing is expected to be about £120 billion in the coming 2013/14 fiscal year, much as it was in 2012/13. The Office for Budget Responsibility (OBR) has correctly said that Mr Osborne’s campaign to reduce the budget deficit has ‘stalled’. As a result, public debt will rise faster than national income this year and next. Even more worrying are the medium- and long-term prospects for the UK’s public finances. In documents published with the Budget the OBR sets out a plan with assurances that, on present policies, the debt/GDP will peak in 2017. However, it had previously given assurances that the debt/GDP would peak two or three years earlier, and it was wrong. The remainder of this note discusses why the government has failed to bring the budget deficit down to lower and more sustainable levels.

The economy’s weaker-than-expected growth performance is often mentioned as the main cause of the disappointing fiscal arithmetic. Since the start of the Conservative-LibDem coalition government in 2010, growth of national output has been lower than envisaged. As tax revenues are a proportion of national output, they also have been lower than forecast. On this basis the blame for the above-target deficit outturns lies with the ‘supply side’ of the economy, which is understood as having less dynamism than in the 1980s and 1990s for all sorts of reasons that cannot be immediately remedied. Osborne has not yet been criticised because of unsatisfactory control of public expenditure. Indeed, the standard badmouthing he receives from ‘the left’ in British politics is that he has been too austere (or even ‘too austerian’, to quote Paul Krugman’s neologism in his 2011 book, End this Depression Now!). The left seems to think that Osborne has been dogmatic and uncaring in his commitment to lowering public expenditure. My argument here is that some important evidence does not support this view. On the contrary, Osborne has not reduced general government consumption at all.

As is well-known, Gordon Brown reacted to the Great Recession by so-called ‘Keynesian fiscal reflation’, so that government consumption continued to grow even as private spending and the government’s tax revenues fell. That led to the sharp widening in the budget deficit recorded between 2007 and 2010. After the change of government in 2010, the first few quarters of data appeared to suggest a move to austerity. The annual change in general government consumption was negative in each of the four quarters to the second quarter of 2011. Meanwhile, the rebound in the economy in 2010 and early 2011 boosted tax revenues, causing the budget deficit to drop significantly from 11% of GDP in 2009/10 to 8% of GDP in 2011/12. Osborne’s Plan A seemed to be in place and the UK retained its triple-A credit rating.

In the last few quarters for which data are available (i.e., up to the third quarter of 2012), general government consumption was rising faster than total expenditure in the economy. On this basis the claims of tight expenditure control under the coalition governments, and the polemics about an unjustified move to austerity, are invalid. Total expenditure in the economy is predominantly expenditure by the private sector. Whereas it has been barely growing since 2011, general government consumption has been increasing at about 2% - 3% a year.

It is therefore not true that the setbacks on the budget deficit are entirely to be attributed to weak tax revenues and the inability of the economy to expand because of supply-side constraints. The setbacks on the budget deficit are also to be explained by rising public expenditure. Osborne and his team have a more definite responsibility to control government consumption than the government’s transfer payments, the levels of which are set partly by statute and the economy’s performance (as with welfare benefits) and partly by conditions in the government debt market (as with debt interest). But an obvious link holds between control of government consumption expenditure and the budget deficit, and then between the budget deficit and the burden of debt interest. Further, the higher is the budget deficit, the greater is the increase in the national debt and – for any given average interest rate on the debt – in the debt interest that has to be paid on the debt.

The analysis in this suggests that so far Osborne’s record in curbing the budget deficit has been at best mediocre. In the last few quarters he has allowed government consumption to increase noticeably in real terms. That is one reason why the budget deficit will remain well above 5% of GDP when the present Conservative-LibDem coalition government comes to an end.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%. No change to QE.
Bias: Neutral but liquidity support available if Eurozone situation deteriorates.

Several important things came out of the March 20th budget. One is the continued implausibility of the OBR’s growth forecasts. Although the 0.6% growth forecast for 2013 is disappointing, the subsequent rates of 1.8% (for 2014), 2.3% (for 2015) and 2.7% (for 2016) are hard to believe. The OBR appear oblivious to the fact that there has been a negative supply shock, and even if potential GDP remains >2% there is little rationale for believing that the output gap will be closed. As I argued in a policy report for the Mercatus Center, the forecast reduction in government spending as a proportion of GDP can in large part be attributed to over optimistic growth forecasts. Attempting to stimulate aggregate demand in a world where potential GDP has fallen will lead to frustratingly sluggish growth and rising inflation expectations (having almost fallen to 3% in 2012, they are now approaching 4%) – exactly what we see today.

The Chancellor’s attempts to reignite a UK boom in subprime lending appear to be a muddled attempt to kick life into the housing market. It is not clear whether it will help the intended target of those priced out of the housing market, as opposed to existing homeowners using public money to cash in on another housing bubble. However, the combination of low interest rates and reduced lending standards generates adverse selection (in terms of enticing people to take on debt that they cannot afford to service) and moral hazard (incentivising mortgage holders to take on more risk). Lending standards provide an important market test and “Help to Buy” backfires if it’s help to buy an asset that you cannot ultimately afford. In a 2012 report the Financial Services Authority (FSA) pointed out that although sales of fixed-rate mortgages were increasing relative to variable rate ones, there has been a sizable shift of people already on mortgages from the former to the latter – 55% of new mortgages were fixed rate, but less than 30% of outstanding mortgages were fixed. Although it is incredibly difficult to use monetary policy to deflate specific asset bubbles, the BoE should not facilitate government efforts to maintain them. The release of data regarding the FLS should generate scepticism about the Chancellor’s efforts to widen the scope. There’s no doubt that such schemes can help at the margin but it is unlikely that they will drive banks’ decisions to extend credit.

In terms of the monetary policy remit, the announcements were underwhelming. Moving towards forward guidance ties the hands a little of those who attempt to simulate the MPC’s decisions, and inevitably turns attention away from speculating about policy decisions and towards the remit itself. Delaying the date in which the letter to the Chancellor is due constitutes an acknowledgement that inflation will continue to remain above target, without changing that target. Adding the objectives of “growth and employment” constitutes a slightly more flexible target, but is merely making a vague de facto remit, a vague de jure one. It formalises the discretion with which the MPC have already been utilising, but fails to offer a clear replacement. It is this leeway that is stymieing recovery, because it generates uncertainty. It would have been preferable to combine a nominal growth target with unambiguous expectations about its future path. Nominal GDP grew by 6.6% in Q3 2012 (relative to the previous quarter), but only 0.4% in Q4. Most would agree that going forward the optimal rate is somewhere between the two, but the stability of expectations are more important than the actual rate. In a similar way, it is the permanence of QE that determines its impact, and uncertainty about how the stock of QE will be maintained over time has limited its potential impact. Forward guidance is a fairly meek way to manage expectations relative to the types of commitment central bankers should be making.

Over the past few months, I have argued that the overriding goal of the MPC should be to get back to a neutral monetary policy, and I would still argue that rates are artificially low. Even though there is a danger of raising them too soon, the events in Cyprus also remind us that there’s a limited window of opportunity. With such disappointing growth figures it would be dangerous to raise interest rates without also have a clear communication strategy to explain why, but for the purposes of debate I vote for a moderate rate rise even without this. If events in the Eurozone begin to pose a serious risk to the UK banking system, it would be unwise to wait until an MPC meeting to act. Therefore the BoE should be prepared to offer liquidity provisions as and when needed.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Monetary growth, the housing market and survey evidence point towards a muted recovery in 2013. The Budget was fiscally neutral and won't change the short-term economic outlook. Nor should it. Fiscal policy should concentrate on deficit reduction and long-term growth, by improving the incentives to work, save and invest. The underlying budget deficit is stuck. Over the 2011-12, 2012-13 and 2013-14 period the underlying deficit is flat at close to £120 billion. Yes, it is projected to fall thereafter, but these are forecasts and the error factors are huge ¬¬- around 1 percentage point of GDP per annum for every year ahead i.e. £15 billion 1 year ahead, £30 billion 2 years, £45 billion 3 years etc. It wouldn't take much for the budget deficit to get stuck at £100 billion for as far as the eye can see.

I differ with the consensus about the short (stronger) and long term (weaker) economic outlook. Basically, I think the short-term outlook, driven by the recent pick-up in broad money growth, could be a little stronger than expected. With regard to the long-term outlook, the potential growth rate of the UK economy is probably below 2 per cent. If so, and in the absence of radical supply-side reform, fiscal policy will be under pressure throughout the current decade and as a result monetary policy could remain loose for the entire period.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise rates ½% and no more QE.
Bias: To raise Bank Rate.

Rationale: British policymaking is stuck in a rut. The Fixed Term Parliaments Act has condemned us to no General Election until 2015, when in a healthy political system we might have had two General Elections by now, since 2010. Policymakers are therefore trapped by foolish promises they made in 2008 and 2009, or even earlier, regarding their approach to fiscal and monetary control. That has meant that any concerted effort to raise the UK’s sustainable growth rate by cutting government consumption spending early or seriously increasing the efficiency of government consumption spending has been impossible. The government, having in 2011 abandoned its target of eliminating the structural deficit over a Parliament, has in the latest Budget abandoned any attempt to cut the deficit at all, being content to allow the deficit to sit at £120bn in 2011/12, 2012/13 and 2013/14. With no deficit reduction scheduled in the deficit for three years, the government’s economic policy can no longer even pretend to be a “deficit reduction programme”.

Having abandoned efforts to cut the deficit or raise the sustainable growth rate, and with events in Cyprus reminding us – if the experiences of Iceland, Ireland and Spain were not already lesson enough – that countries with as large banking sectors relative to GDP as the UK’s cannot save their major banks without bankrupting the state, the government is now clearly switching to a policy of “financial repression” to make its obligations manageable. Public service spending, benefits, tax allowances, and the deficit are all to be held in nominal terms, then inflation encouraged to accelerate fiscal drag, devalue benefits, and ease the burden of debts, whilst easing the balance sheets of bust banks by eroding the real value of their liabilities to depositors. Understandable though such a policy is, the choice of such a route constitutes surrender to events.

In the Budget a change to the monetary policy remit was announced, with George Osborne effectively informing the BoE that from now on it was fine for inflation to be as far above target as the Bank likes, for as long as it likes. That such a change in the remit was greeted with a shrug and remarks along the lines of “But that’s what policy has been for years anyway” just indicates how totally the BoE’s credibility has been eviscerated in recent years.

The new BoE framework can best be described as “not avoiding inflation”. Policymakers around the world, through the long and sad history of the monetary system of exchange, have found not avoiding inflation a tempting route. It often seems as if letting inflation go just a little higher would make everything just that little bit easier. But once inflation goes much above 5% it becomes volatile as well as difficult to keep down. The consequence will be that employers and workers will be forced to anticipate inflation in wage-setting. However, they will find it difficult always to predict inflation accurately. A number of consequences spring from this: some years employers may pay far too much, and either go bankrupt or cannot hire workers; in other years employees may be paid far too little, and therefore find themselves unable to service their own debts. High and volatile inflation thus causes unemployment and personal and corporate insolvency. Policymakers appear so set on attempting (but failing) not to repeat what they regard as the failures of the 1930s that they have forgotten the key lessons of the 1970s and 1980s and set aside the core insights of the macroeconomic theory of the past forty years.

This is the most fundamental lesson of the past few decades of macroeconomic theory and practice: neither fiscal nor monetary policy can raise the medium-term growth rate of economies, but can lower it if pursued to excess. Debates about “fiscal stimulus” and “flexible inflation targeting” thus miss the point. We do not have a short-term problem susceptible to short-term solutions. We have a deep-seated structural problem that only structural solutions can address. Monetary and fiscal stimulus measures have had their go, and achieved what they could. They have now passed the point at which they do good and reached the point at which they do harm, and the longer they are kept in place the more harm they will do.

Comment by Kent Matthews
(Cardiff Business School)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: To raise rates further.

In case anyone thought that the euro crisis looked to be coasting towards some sort of resolution based on the politician’s hope that something ‘good’ will happen if we could just hold on, the whole thing flares up again. Indeed this crisis will run and run with periodic lulls until something ‘good’ really happens as the politicians hope or the whole experiment be declared a failure with the breakup of the single currency. Whatever happens in the future, the Bank needs to have enough ammunition in its arsenal to use against the fallout from a likely breakup and the inevitable contagion of the ensuing bank crisis. QE worked to arrest a fall in the financial markets from developing into a disastrous collapse. It can be used again if the euro crisis threatens to turn into a survival phase with all the negative implications for the UK.

With this backdrop it has certainly not been a good time for Cameron’s fourth budget. Earlier, Moody had downgraded UK debt from its AAA rating and now Fitch has placed it on negative watch. The budget itself was unadventurous with only weak signals of a future supply side policy that might have positively influenced growth expectations and provided a boost to domestic investment spending. What is left of policy is a dependence on the continuation of a supposed loose monetary policy that has demonstrably failed to stimulate a moribund economy. More of the same does not sound like a good policy.

There are three reasons why the Bank should start the process of raising interest rates – two good ones, and one weak one. If the euro crisis reaches a terminal phase with the knock on effects for the UK economy, at near zero interest rates, monetary policy has no traction. A phased rise can be reversed sharply if needed to provide comfort to financial markets. The second good reason is that the current policy has led to the survival of zombie corporates (bank credit insiders) while companies that need to grow (bank credit outsiders) are faced with a credit famine and relatively high borrowing rates and tough conditions. The result is that the current policy of QE and low official bank rate has denied the economy of a Schumpeterian process of ‘creative destruction’. The third reason is that the Bank, even belatedly can try and restore some credibility to its inflation target policy. It is a weak reason because the credibility of its anti-inflation policy may well have been irreparably damaged and any rise in interest rates may fail to influence inflation expectations. However, it is worth a try!

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

While there has been criticism of the Chancellor’s decision to subsidise mortgages, for me this is a most significant step for monetary policy. As I have argued in previous SMPC submissions, excessively harsh regulation of the banks – and especially the heavy new capital requirements which are expensive to meet now when banks are unattractive to investors – have raised the costs of credit to SMEs and personal borrowers, the two sets of clients who have no effective alternative to banking. So the credit channel is blocked by regulation.

By subsidising mortgages which are widely used by both these client sets, the Treasury is directly offsetting this distortion. It remains to be seen how effective the subsidy is in practice; as so often with these bureaucratic interventions one cannot know until the detail is laid out of how it is all accessed, what side-conditions and so on. However, what is becoming clear is that the Treasury and the Bank may at last be taking action to relieve the effects of their other, regulative, actions on monetary conditions; the FLS is another one of this type that may be having a modest effect. QE, as I have argued and shown in the data, is not doing the job; it is merely reducing returns to savers; cheapening the cost of credit to government, and possibly preserving ‘zombie’ clients.

It would be better to reverse the regulations and allow the market to work freely. But with the great and the good determined to regulate, as seen in the Parliamentary Committee and the Vickers Report, the only avenue left is this sort of offset.

My view therefore is that this latest mortgage offset, together with the FLS, should be consolidated and strengthened as necessary to eradicate the distortion and get the cost of credit down to these two sets of clients. QE should be stopped and steadily reversed. Interest rates should be raised towards normal levels, starting with 0.5% this month, with a bias to continue upwards. The object should be to return general rates to normal, while eradicating the abnormal premium on SME/personal lending.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

As expected, the Treasury has revised the remit for the BoE’s MPC to allow even greater flexibility in the interpretation of the inflation objective. Although the inflation target remains unchanged at 2% “at all times”, there are three concessions to flexibility that are potentially significant in combination.

First, the MPC has been given permission “to deploy forward guidance including intermediate thresholds in order to influence expectations and thereby meet its objectives more effectively. The Government considers any use of intermediate thresholds to be a matter subject to the Committee’s operational independence in setting policy, to be considered in exceptional circumstances. The Committee is requested to provide an assessment of such approaches to setting policy alongside its August 2013 Inflation Report.”

Second, in forming and communicating its judgments the Committee should promote understanding of “the trade-offs inherent in setting monetary policy to meet a forward-looking inflation target. It should set out in its communication … the horizon over which the Committee judges it is appropriate to return inflation to the target.”

Third, when actual inflation departs from the target, in conjunction with the publication of the MPC minutes, the Committee should “communicate its strategy towards returning inflation to the target after consideration of the trade-offs.”

The disturbing aspect of these remit changes is the acquiescence of the Treasury to the Bank’s judgment and economic model. The terms of the remit allow for two distinct circumstances in which departures of inflation from target will be tolerated. The first takes for granted that there is a clearly identified short-run, and perhaps medium-run, trade-off between inflation and real economic activity. The second concerns situations where “attempts to keep inflation at the inflation target could exacerbate the development of imbalances that the Financial Policy Committee may judge to represent a potential risk to financial stability.”

Hence, the MPC is given the flexibility to “look through” inflation deviations when to tighten monetary policy would be judged to create additional output volatility and/or to jeopardise financial stability. In essence, the Bank has been given carte blanche to disregard the inflation target over an indefinite horizon.

There is an underlying premise in the Treasury document “Review of the monetary policy framework” that the sources of above-target inflation are temporary and irrelevant to the operation of monetary policy. However, since QE plays a well-documented role in driving up primary product prices, then energy and commodity price impulses cannot be considered exogenous or temporary. Similarly, the side-effects of fiscal tightening such as higher excise duties, VAT or air passenger duty, reflect the reality of ongoing fiscal normalisation. These are not exogenous or temporary, either.

The remit is crafted as if the inflation rate were drawn, as if by a gravitational force, back to 2% per annum. It does not consider the alternative: that the UK inflation rate may be in transition to a new and higher equilibrium. Our decomposition of the Retail Price Index into semi-exogenous factors (e.g., administered prices, excise duties, oil and commodity prices) and prices mainly determined in the domestic private sector is revealing. The series for private sector inflation has a clear upward drift in its inflation rate that has been in place since 2005. The Treasury makes no attempt to explain the persistence of this trend, nor its implications for the task of anchoring inflation expectations. This upward drift in private sector inflation, mirrored in consumers’ inflation expectations, is unlikely to be arrested by the adoption of a more flexible inflation mandate.

Finally, the revised remit rules out the replacement of inflation targeting with nominal GDP targeting, but holds open the door for the level of nominal GDP to play a role as an intermediate threshold, should Mark Carney wish to exercise this freedom. For further illumination on this issue we must wait until August.

However, neither the scope for larger and longer inflation departures from target nor the freedom to adopt US-style forward guidance on the level of Bank Rate addresses the fundamental blockage in the credit system. Until the Bank of England relaxes the overbearing capital and liquidity requirements on UK banks and considers the purchase of private sector assets within its asset purchase programme, then the effective growth-inflation trade-offs will remain hostile. Mark Carney’s most pressing task as incoming Bank governor is to unblock the credit transmission not to construct an elaborate set of conditions under which Bank Rate may one day be raised. Indeed, if there is a role for ‘forward guidance’, it is to reassure markets of the Bank’s determination to take rates back to the region of 2% to 2½% over the next two years. An immediate move to ¾% is my preference.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold interest rate and no increase in QE.
Bias: Hold interest rate for now.

After a broadly neutral budget that allows the debt-GDP ratio to rise to levels not seen for fifty years, the weakening of the inflation remit of the BoE, the appointment of Mark Carney and the negative-watch warning from the credit rating agency Fitch, the question that is being asked increasingly is whether the UK is positioning itself to partly inflate away its debt. Although this would be officially denied, it is becoming increasingly likely and may even shortly come to be seen by many as the only politically acceptable solution. I think that this would be the wrong way out of our debt and growth problems.

There is no convincing evidence to show that increasing government expenditure would raise private consumption expenditures, even in the short term, as assumed in Keynesian economics. If it did so in the long run, this would imply, most implausibly, that the larger the government sector, the better off would people be. Increased government investment expenditures, if well targeted, would lead to an increase in GDP and consumption. It was probably a mistake by the government to cut these, but increasing them now would only bring longer term benefits to growth. I would have preferred a budget that put more money into the hands of those most likely to spend it immediately and paid for this by cutting further wasteful government expenditures.

The changes to the BoE’s remit are still vague but strongly suggest allowing more inflation in order to increase growth, especially over the cycle. This makes sense if higher inflation is due to a negative supply shock, but not if it is due to a positive demand shock. In fact, the BoE has already adopted this policy but, perhaps due to its remit, has not formally admitted it. It is clear, however, that such a change in its responsibilities are unlikely to have made much difference to the conduct of monetary policy in the current recession, or to have increased the ability of monetary policy via interest rates to affect the real economy. The zero lower bound to interest rates has caused this. Only outright money financing of the deficit might raise GDP in the short term. Even QE and bailing out the banks is fiscal policy. In short, whatever the , monetary policy is much less effective in dealing with a recession caused by a negative supply shock as now.

In my own recent research on the UK’s credit rating (CEPR Discussion Paper 9378, March 2013) I found that the UK’s credit rating should rather have been downgraded in the second quarter of 2008. From 2010, when the government came to power, the UK’s credit rating would have started to rise, and at the present time it is even healthier. In other words, the credit rating agencies appear to have got their timing of the UK’s credit rating completely wrong. The news in Moody’s and Fitch’s down-ratings is that they are too late.

In my view the Chancellor is correct to say that one of the main reasons why the UK economy has not performed better is its export performance to the Eurozone. I would add to this the rise in the UK’s saving rate as households and banks tried to rebuild their balance sheets. Although higher inflation would probably lead to a further depreciation of sterling – as well as reduce the real value of debt – I do not recommend this as the right solution for the UK because UK imports are not that price sensitive and exports to non-euro markets are already competitive, are growing and are higher than those to the euro area. The main problem with higher inflation that lasts too long or is too high, even temporarily, is that it risks raising longer-term inflation expectations. In short, I think that we just need to stick to plan A, be patient and not adopt policies for the short term that worsen things later. It was short-termism that got us into this mess in the first place.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and hold QE in reserve.
Bias: Neutral.

As the UK Chancellor said in the opening of his Budget speech, 'this is a fiscally neutral Budget'. So it proved, with spending increases offset by spending cuts and tax increases in future years. However, as the starting point in 2013/14 was worse than forecast in the Autumn Statement in December - a PSNB of £86.5bn rather than the £80bn expected then, some £6bn higher. The cumulative effect of higher deficits in coming years means that net debt peaks at 85.6% of GDP in 2016/17 rather than the earlier 79.9% in 2015/16. That represents an increase of roughly £100bn more at the end of the five-year projection period. Gross debt peaks at 100% of GDP.

It would have been worse but for an under-spend by government departments in this financial year that has been carried forward and used to increase spending in some areas. In addition, economic growth has been revised lower by the OBR for 2013, to 0.6% from 1.2%, and next year to 1.8% from 2.0% previously. Unemployment is expected to peak at 8% by the OBR and stay there for at least two years, and CPI inflation has been raised modestly higher for this year and next. The result of these revisions is lower tax revenues relative to the previous projection in the December 2012 Autumn Statement. But these figures did not surprise financial markets and so have had little impact. Gilt yields have actually fallen back somewhat and the currency has barely moved (though likely partly down to events in Cyprus). Essentially, fiscal austerity has been maintained in the medium term with little increased borrowing in the short term.

As for the monetary policy stance, once again there was actually little change in practice. The remit has been maintained, and a study of the UK's monetary policy framework published by the Treasury concluded that the mandate should continue to focus on the primacy of price stability and the inflation target. But the BoE has been asked to look at how it could refine its operational activities - by perhaps providing conditional forward guidance and by explaining in more detail the trade offs between greater inflation flexibility and the impact on growth. Although clearly influenced by the Federal Reserve’s current practise, the changes announced were close to the bare minimum that markets expected.

The main announcements from a corporate perspective were to boost infrastructure investment, to cut the main rate of corporation tax to 20% by 2015/16, and to boost housing market activity through various measures. All in all, this was a business-like Budget that enshrined the government's tight fiscal policy stance and the loose monetary stance of that has been in place over the last few years.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, March 03, 2013
IEA's shadow MPC votes 5-4 for quarter-point rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, which was finalised on 26th February, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 7th March. Three SMPC members wanted an immediate increase of ½%, while two advocated a rise of ¼%, implying a rise of ¼% on normal Bank of England voting procedures.

This represented the second consecutive month that a majority of shadow committee members had decided that a rate increase was justified on economic grounds. However, no one expected to see an actual rate change this close to Mr Osborne’s 20th March Budget. In addition, four SMPC members believed the British economy was so weak that Bank Rate should be held, while one believed that additional Quantitative Easing (QE) would be required before the economy could recover.

The majority view was that the stock of QE should be held at its present £375bn, however. Both the SMPC’s ‘hawks’ and ‘doves’ included people who believed that QE would be more effective if the Bank bought more private-sector assets and relied less on government debt purchases. There was also disquiet about the extent of the structural fiscal weakness that might be revealed in the 20th March Budget.

This might exacerbate the downwards pressure on Sterling that was initially triggered by Sir Mervyn King’s comments at the 13th February Inflation Report launch and subsequently exacerbated by the removal of Britain’s AAA rating by Moody’s on 22nd February. The rapidly diminishing credibility of other aspects of UK policymaking made it difficult for the Bank of England to carry conviction, especially given its history of inflation overshoots, in the view of several SMPC members.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Additional QE and a rebalancing towards non-gilt assets.

Over the last month, the trade-weighted value of the pound has fallen by another 3½%. Its total decline so far in 2013 has been roughly twice as large. The implied fall in Britain’s real effective exchange rate (REER) represents an important stimulus to growth, given the economy’s need to rebalance away from domestic spending towards net exports. The extent to which this nominal depreciation translates into a sustained real depreciation is unclear; there is a possibility that it could be dissipated in a higher price level. However, given recent experience and the considerable slack in the labour market, upward pressure on unit labour costs should remain limited and a lower REER is likely to persist.

This removes some of the urgency for additional Bank of England asset purchases. Nevertheless, the case for continuing monetary aggression remains strong. Indeed, a major driver of recent sterling weakness has been the Monetary Policy Committee (MPC) itself. Its recent pronouncements suggest a greater willingness to look through above-target inflation, an expectation of additional gilt purchases – three MPC members voted for another £25bn at February’s meeting – and a desire to expand the authorities’ monetary arsenal. The minutes of the latest meeting point to a wide-ranging discussion of other tools to boost activity in the UK. While the Bank remains reluctant to undertake these unilaterally, there does appear to be some support for co-ordinated action. Importantly, there seems to be greater consensus on the MPC of the dangers for long-term supply capacity of allowing demand growth to be persistently weak. In technical jargon, the MPC’s ‘reaction function’ may include not just the output gap and the deviation of inflation from its target, but also the growth rate of output.

This is sensible monetary policy-making in today’s highly unusual environment. Even though Consumer Price Index (CPI) inflation is set to be above 2% into next year, the risks to inflation over the medium-term are limited. Powerful deflationary forces persist, including the on-going Euro crisis, the persistent failure to resolve global imbalances and widespread fiscal consolidation in the advanced world. A central bank concerned about wider financial stability and hysteresis effects on long-run supply capacity has a strong incentive to err on the side of doing too much. At the current juncture, this gives the green light for continuing monetary aggression.

However, there is also an argument for more targeted interventions. A general expansion of the stock of broad money via gilt purchases remains a powerful tool, and should continue to be used where necessary to maintain adequate bank deposit growth; but there are good reasons to consider other types of action, including co-ordinated steps with the government, that would involve the purchase of non-gilt assets. The obvious parts of the economy that could be helped via such a mechanism are: the commercial property sector, the home building industry and the energy and transport infrastructure sector.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%.
Bias: Raise Bank Rate further.

Two things suggest that the present situation of Bank Rate at ½% and a £375bn stock of QE may be about to end. On the one hand, growth remains sluggish at best, and three members of the MPC wanted to increase QE last month. On the other hand, CPI inflation continues to remain above target, and the Bank of England seems increasingly likely to publicly admit that they are happy for it to remain so. Both sides of the debate are finding compelling evidence to support their positions. One might think that the so-called ‘doves’ are the pessimists, because they’re still haunted by the (thus far, absent) threat of deflation. And the inflationary fears of the ‘hawks’ mark them as optimists, in the sense that they anticipate that past monetary easing will finally start kicking in. However, another way to view this is that by wanting to keep interest rates low indefinitely, the doves are implicitly assuming that once the present storm has passed it will be plain sailing. In other words, once the waters are calm again we can start to worry about exit policy. By contrast, the hawks may reject the idea that we are in the process of leaving the storm. Indeed, if one anticipates that there may be a deterioration in the health of the economy – whether it’s through another US fiscal cliff, a Euro-zone crisis, double digit inflation, etc. – then we might view the present as an opportunity to repair our defence mechanisms before the real storm actually arrives. In this sense, we need to fully consider the opportunity costs of keeping interest rates unchanged, and the trade-off between prompting a crisis as against having the monetary policy tools in place to respond to a future one.

As we prepare for the arrival of a new Governor, there seems to be greater attention being given to finding ways to loosen monetary policy. One of the problems with QE though is that the more successful it is the more it prevents markets from adjusting. The supposed positive impact of the Funding for Lending (FLS) scheme comes at the cost of propping up a housing market that is artificially high. In addition, interest rate guidance can backfire if the market interprets it as the central bank accepting that the recovery will be long and slow. Furthermore, it impedes the Bank of England’s desire to have a clear communication policy about their target.

Given that Nominal GDP is growing at a moderate rate, and growth in M4ex continues to rise – in December it hit 5.2% which is higher than it’s been for more than two years – the economy is in reasonable shape. One can always find reasons to wait but there’s even been good news on the fiscal front with a higher than anticipated surplus in January. The change in Governor also presents a window of opportunity to act. A moderate action would be to begin the process of raising interest rates back to their natural rate. This would make growth quicker and more sustainable, and also provide ammunition should external events cause a future deterioration. There is no reason to believe that raising rates would send a positive signal about the economy and boost confidence, but there’s also no reason not to believe that. A more ambitious action would be to get serious about replacing the regime of inflation targeting.

A Nominal GDP level target would help the Bank of England deliver monetary stability, and avoid the present challenges of trying to boost growth when inflation is above target. Most importantly, it would make future crises (caused by the central bank) less likely, because Nominal GDP is a better indicator of the monetary stance than CPI. Nominal GDP targets do not rely on timely and accurate estimates of GDP, because you can target market expectations instead. Mark Carney has indicated that a debate about monetary policy would be a good thing. One has to agree.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Maintain asset purchases at £375bn; only increase the total to offset declines in M4ex.

Why has economic growth been so much weaker in Britain than in the United States? This is not something that can be explained by a superficial comparison of the components of GDP. Keynesian economists tend to focus on the role of fiscal stimulus, yet this does not provide a satisfactory explanation of the different performance of the two economies. There has been much blame heaped on the coalition government for its strategy of austerity. However, the UK’s fiscal strategy has been less restrictive than that of the US when measured by the rate of narrowing of the budget deficit. In short, the US budget deficit has narrowed more, yet real GDP growth has been clearly superior to that in the UK. The explanation must lie elsewhere.

The evidence suggests several more fundamental factors that differentiate US and UK performance – namely the vastly greater leveraging up of Britain’s banks during the bubble, the relative failure of the British government’s measures to restore the health of the banks, and the more adverse consequences for the economy of British bank deleveraging. Ironically, the British government led the way in recapitalising the banks in the wake of the Lehman crisis, only to lose its lead to the US after the US Treasury’s Troubled Assets Relief Programme (TARP) was adjusted to focus primarily on repairing the balance sheets of the banks.

In the United States, the total debt of all domestic sectors (household, non-financial corporations, financial corporations and government) has declined from 311% of GDP in 2009 Q1 to 255% in 2012 Q3, a decline of 56 percentage points. In Britain, by contrast, total debt of all corresponding sectors has declined only about half as much. From a higher absolute peak of 561% of GDP in 2010 Q1, UK total debt has declined to 529% of GDP in 2012 Q3, a decline of 31 percentage points. Basically, this means British households and institutions are having more difficulty repairing balance sheets than their American counterparts. Is it possible to pin-point the differences?

Drilling down into the debt ratios for individual sectors shows that both the household and the non-financial corporate sectors in Britain are lagging in their balance sheet repair. However, the major problem is in the UK financial sector. This is partly on account of its larger size relative to GDP, partly on account of British banks’ high dependence on non-deposit financing (such as inter-bank borrowing and debt issues) during the credit bubble of 2003 to 2008, but also due to the adverse impact of financial sector deleveraging on the economy. Given the amount of balance sheet contraction that has been required of the banks, partly from regulatory pressure, and partly stemming from their own shareholders, creditors and customers, it was inevitable that banks should pass on the effects of deleveraging in the form of reduced lending and the imposition of tighter credit conditions to households and businesses.

Just as there was a positive feedback loop in the financial sector during the bubble which meant that rising asset prices created more collateral for banks to lend against, so in the current de-leveraging phase a negative feedback loop has operated whereby lower asset prices and tighter credit standards have reduced the amount that banks are willing to lend. Above and beyond all of this, the British government’s early measures to restore the health of the banking system were far less effective than the measures taken by the US authorities.

The process of US bank rehabilitation consisted essentially of four main elements. First there was greater attention to restoring capital levels: the US Treasury and the Federal Deposit Insurance Corporation (FDIC) required immediate recapitalisation by all banks, much of it directly from the government in the form of preference shares, but some of it from market sources. Second, this was quickly followed by a series of demanding stress tests and further rounds of capital-raising where necessary. Third, the FDIC required the banks to take substantial write-downs against toxic loans, and to take back ‘on balance sheet’ at least $400 billion of securitised loans, cleaning up their balance sheets by late 2010. Finally, the US Federal Reserve provided large amounts of additional liquidity by means of its QE operations, pushing banks’ excess reserves to $1.2 trillion by February 2010. In short, capital levels were greatly increased, loans were reduced, balance sheets were cleaned up, and liquidity enhanced. The net result was that US banks were able to embark on new lending by March 2011. Indeed, US bank lending has been growing at roughly 4% per annum since then – in marked contrast to the UK or the Eurozone where bank lending is still declining.

An additional factor that operated in the US but was not present in the UK was that the US banks were able to rely on the guarantees of the two giant nationalised housing agencies, Fannie Mae and Freddie Mac, which have served as an additional shock absorber for the mortgage portfolios of the US banking system.

In Britain, the successive shock failures of Northern Rock, then RBS and HBOS seemed to paralyse the government and the Financial Services Authority (FSA). Instead of forcefully taking them over in their entirety or insisting on some minimum level of systemic recapitalisation for all the banks, things were handled on a non-systemic, case-by-case basis. A systemic approach seemed beyond reach, either because the government had already shot its bolt with its very large current spending at the onset of the crisis, or because the amounts of capital required would have threatened the government’s AAA credit rating. In any event some banks, such as Barclays, were permitted to seek external sources of capital, while others like HSBC did not have to raise capital at all. The stress tests conducted by the European Banking Authority (EBA) in Europe and the UK were widely regarded as noticeably more lenient than those conducted in the US, and the extent of loan losses imposed was much less damaging to banks’ balance sheets. Consequently UK banks remained more leveraged and with less robust balance sheets than their US counterparts.

As an example of the consequences of this different treatment of the banks in the UK, consider the results of their reliance on non-deposit funding. At the peak of the bubble in early 2009, banks were funding an astonishing £760 billion or 55% of GDP from non-deposit sources. The subsequent withdrawal of these non-deposit sources by wholesale, domestic or foreign, lenders is inevitably forcing banks to deleverage – either by reducing their lending, or by selling their subsidiaries, whether core or non-core businesses. Based on the latest data, bank lending that is funded from non-deposit sources was still £184 billion in December, or 10.8% of GDP in 2012 Q3. This means that the British economy and the British banks, in particular, still have further to deleverage before they can start to expand again without relying on leverage.

In view of this challenging backdrop, it is appropriate for the Bank of England to keep Bank Rate at ½% and for it to continue to provide additional liquidity as necessary in the form of QE operations if, and when, money and credit threaten to become too tight in quantitative terms.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Monetary growth, the housing market and survey evidence point towards a muted recovery in 2013. Consequently, there is probably no need currently to adjust QE or interest rates. Any tightening in interest rates risks a further weakness in Britain’s broad money supply at present. The argument for a tightening based on the misallocation of resources under QE is a tempting one. However, an immediate rate rise could prove counterproductive. This is because a higher Bank Rate could reduce the broad money supply, which would hasten the need for an offsetting, and economically distorting, expansion in QE in turn.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To Raise Bank Rate.

The British economy has, as expected, been downgraded from AAA status – first by Moody’s. Moody’s key driver for this decision – the poor medium-term growth outlook for the UK – is entirely correct. Most discussion of growth policy in the UK is highly confused. Monetary and fiscal policy can move growth around in time, so as to achieve the country-wide equivalent of household consumption smoothing, limiting recessions in exchange for lesser booms.

However, we need to recall the old truth that it is only supply-side and structural reforms that can increase medium-term growth rates, not government borrowing or loose monetary policy. That is the central lesson of macroeconomics of the past forty years, and yet people forget it so easily: if we have a medium-term growth problem we cannot solve it with fiscal or monetary stimulus, since neither fiscal nor monetary policy can increase medium-term growth; they can only reduce it if they are done to excess.

Monetary policy has passed that point of excess. Remarkably, at the last MPC meeting three members voted to increase QE even though the Bank itself forecast inflation to be far above target for years – illustrating how little the inflation target constrains policy any more. MPC members have stopped even pretending that their decisions to print extra money are driven by the need to avoid inflation falling below target several years hence in some model that systematically under-predicts actual inflation. Now they are content to vote for even more inflationary measures when they themselves say inflation will be above target.

Monetary policy is a powerful short-term tool. It can limit damage during the first eighteen months of a severe recession. It can limit the peaks and troughs of more normal and gentle cycles. It can prevent inflation running away. What it cannot do is to create medium-term growth.

Interest rates were cut to near-zero in late 2008 and early 2009. Good. We started printing money from early 2009. Excellent! But at some point any serious economist should accept that monetary looseness has had its go and must make way for longer-term policies. Six years into the financial crisis, and four years into zero rates and quantitative easing, it is surely reasonable to ask whether the short term has now turned into the medium term.

To put the point the other way around: almost everyone is agreed that current policy is not working, and many say it’s time to try something else. We have tried the path of ‘über’-looseness and it did not work. Might we not, whilst there is yet time to try something else, try the path of merely extreme-looseness, tightening a little to see if it helps?

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

It should be reasonably clear by now that the UK has slow growth for ‘fundamental’ or ‘supply-side’ reasons. First, the huge rise in raw material prices has impoverished us. Since the Bank of England has done little to stop this raw material inflation passing through into consumer prices, a rough measure of how much living standards have been driven down as a result is provided by the cumulated excess of inflation over the 2% target since 2006. This will be 7% up to the end of this year on the assumption that inflation averages 2.8% in 2013. The hike in raw material costs is probably the biggest element in causing the drop in real income; an adverse movement of this size in the terms of trade is just like a fall in productivity. Essentially, it means that, for the economy not to spend permanently more than its income, spending must drop by this amount. Notice that this cannot be offset by higher demand from government, say, because it is permanent; any attempt to do so would lead to excess international borrowing and hence solvency problems.

Along with this, there is a consequent fall in output, as permanently lower demand deprives various home-focused industries of their market: housing is the most obvious but other industries particularly affected by high material costs are also hit, notably transportation and travel. Hence we notice that certain sectors, such as volume cars and house building, have great excess capacity. However, since demand cannot be stimulated in a general way, this excess is ‘structural’ and has to be disposed of by accelerated depreciation. This is no doubt why measures of relevant ‘excess capacity’ (i.e., in sectors where there has not been the same structural collapse) are small.

Then, we come to the collapse of the UK’s two most productive sectors, North Sea oil and banking. This collapse appears to account for the bulk of the fall in labour productivity since the crisis. Both collapses were partly due to circumstances – with the North Sea, it was the exhaustion of extractable reserves and with banking, the crisis itself – and were partly due to government actions. With the North Sea our governments have been ‘time-inconsistent’, constantly changing the rules to squeeze extra income out of the industry; the extractive oil and gas industry no longer has much confidence that any further exploration/extraction efforts will not be milked by HM Treasury. With banking, the Coalition government has, as I have argued repeatedly, over-reacted in its new regulative agenda while also failing to restore bank competition; hence the industry is contracting sharply. This was an avoidable disaster.

Finally, we come to the main side-effect of the banking collapse – the fatal blocking of the credit channel. This is another ‘structural’ element in our economic situation which is turning out to be non-remediable by monetary means; no amount of QE and bureaucratic schemes like FLS has loosened this constraint because the regulations create massive incentives for bank contraction.

So, like it or not, our situation is one of weak growth forced on us by fundamental constraints. Only supply-side action can change this situation. Apologists for ‘demand stimulus’ argue that the government could spend more on infrastructure, which is true as borrowing against good long-term projects is not difficult and does not undermine solvency. However infrastructure projects are held up by planning and political hurdles, not particularly by lack of funds. Other apologists point to the effect of the Second World War in stimulating output. Of course, a war changes an economy’s structure towards the production of armaments and military consumption, and a one-industry state can commandeer the means of production and force them to operate at high capacity; but in peacetime the economy is diverse and structural/supply-side issues have to be solved by peacetime policies to get the resources into the right places and permit growth based on market forces.

Where does this leave monetary policy? The answer is in a difficult place. QE and ultra-low interest rates are doing nothing to change growth, as one would expect. They are in fact massively distorting the market for savings by creating a privileged borrower, HM Treasury, at the expense of those committed to lending to it (e.g., for pension reasons). They are also subsidising bank profits on their existing balance sheet by giving banks a large arbitrage profit on the bank reserves produced by QE. Through this subsidy the present policy is distorting credit supply in favour of large existing firms, which seem like ‘zombies’ to be on bank life-support. It is time to put an end to these distortions and return to a realistic monetary policy that understands its limited capability.

If the government wants to stimulate money and credit, then it should look to the serious loosening of the new regulative framework and also a renewed push for bank competition, perhaps by break-ups of the large Treasury bank holdings into several smaller banks. In my view, the ring-fencing debate is an irrelevancy and an intrusion into industrial structure – the banks have argued persuasively that they need to be able to fulfil multiple functions. What matters is the number of banks and the competition they engender, which has been curbed sharply by the new cartelised set-up. Of course if the government did succeed in this loosening up, the huge overhang of QE would be an inflationary threat as existing bank reserves would be rapidly converted into credit expansion. Far better therefore to unwind this programme while there is still no threat, because the banks are immobilised by regulation. In summary, I recommend a rise in interest rates by ½%, no further QE, and a programme to unwind QE, while raising rates to normal levels, over the next two years.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up and fully privatise state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

With the UK Budget scheduled for 20th March and something of an inter-regnum in place at the Bank of England until Mark Carney takes over on 1st July, it is most unlikely that Bank Rate will be altered when the MPC meets on 7th March. In addition, it is improbable – albeit, possible – that any substantial new QE initiative will be announced, either. This does not mean that a rate rise might not be desirable on economic grounds simply that it is unlikely to happen. An interesting aspect of the MPC minutes, published on 20th February, was the sign that officials were already anticipating the more activist monetary stance believed to be preferred by the incoming Governor. This clearly helps to smooth the transition. It is possible that Sir Mervyn King’s unexpected vote for an extra £25bn of QE in February reflected the discussions that he had been having with his successor. Given that a well-run monetary policy should minimise the shocks it delivers to the real economy, this would all be very reasonable and civilised if that is what actually transpired.

Such civilised niceties should not be allowed to disguise the fact that UK fiscal policy is now massively – and, humiliatingly for Mr Osborne – off course and that British policy makers are losing their credibility in the financial markets, as can be seen from the decision by the Moody’s rating agency to withdraw Britain’s AAA rating. One result is that a 1976 style stabilisation crisis can no longer be ruled out, particularly as we draw closer to the 2015 general election date and the prospect of a Labour government or a Labour/Lib-Dem Coalition. For anyone who remembers that period, there are aspects of the current UK economic conjuncture that are reminiscent of the policy errors of the mid 1960s and early 1970s that culminated in the December 1976 International Monetary Fund (IMF) bail out of the British economy. First, the groundwork for the mid 1970s crisis was laid because the supply performance of the economy was severely damaged by the more than 10 percentage point increase in the share of government expenditure in GDP under the 1964 to 1970 Labour government, just as it has been by the broadly similar rise between 2000 and 2010. Second, in both cases, the growth of potential real GDP collapsed to some 1% to 1½% per annum because of the ‘crowding out’ – particularly, of private investment – that resulted. However, the authorities failed to adjust their policies accordingly, ran an unduly lax monetary policy and created stagflation, not growth. Third, between 1970 and early 1974 an ineffectual Conservative administration then tried to use a Keynesian demand stimulus to boost the economy, in which they were aided and abetted by a central bank which was politically subservient and intellectually soft on inflation. Finally, and following the humiliating collapse of the Conservative Heath administration in February 1974, the new Labour government let public spending rip, ignored rising inflation and the deteriorating trade deficit, aggressively raised taxes, and piled populist intervention upon intervention, until the markets finally lost patience.

One important difference with this earlier period is that the recent growth of broad money and credit has tended to be too low because of a misguided and pro-cyclical regulatory tightening, whereas the mid-1970s still suffered from the monetary overhang build up in the earlier Heath-Barber credit boom. However, accelerating inflation can result from a collapse in the exchange rate in a small, open and trade-dependent economy such as Britain’s. Furthermore, higher inflation does not have to be validated by a faster monetary expansion if the real exchange rate falls. The real exchange rate can tumble out of bed because the perceived post-tax rate return on human, physical and financial capital is reduced – perhaps as a result of higher taxes or populist anti-business rhetoric – or if the markets lose faith in the competence with which the economy is managed. The present Governor seems to believe that a weaker pound is necessary to re-balance the economy and to stimulate private demand. However, it is by no means certain that a weaker pound is indeed stimulatory. Whether or not currency depreciation boosts activity is essentially a quantitative question that depends on the deeper structure of the economy and the precise values of certain key parameters. A lower exchange rate will increases activity if: 1) the price elasticities of demand for exports and imports are high; 2) the pass through from the exchange rate to domestic prices is partial and slow; 3) higher inflation does not provoke adverse feedbacks, such as a rise in the savings ratio, and 4) there is ample spare capacity in the sector of the economy that engages in international trade. The Bank has published remarkably little research as to whether these conditions are currently satisfied. Instead, official rhetoric sometimes appears to be re-cycling a warmed up version of 1960s Cambridge Keynesianism, which implicitly assumed that these conditions held.

Unfortunately, it is no longer possible to examine the properties of a wide range of UK macroeconomic forecasting models to see how far these conditions are satisfied, as one could have done twenty or thirty years ago. Indeed, we are still waiting for details of the Bank’s new forecasting model COMPASS to be published, although that is promised to happen in the next few months. For what they are worth, the properties of the current version of the Beacon Economic Forecasting (BEF) macroeconomic model suggest that: 1) competiveness elasticities have fallen sharply and consistently in recent decades and may now be zero in the case of imports; 2) the pass through from the exchange rate to domestic prices is eventually 100%, and 3) higher inflation reduces activity through a range of mechanisms. That high and variable inflation reduces growth has also been found in international panel data studies, which try to explain the long run growth performance of a set of countries, and also in much of the empirical work published in the 1970s and early 1980s. The Bank’s apparent belief that higher inflation is positively associated with stronger activity appears to have forgotten this earlier research, which generally indicated the opposite. Finally, one must have reservations as to whether an economy with some 5½ million government employees and some 2½ million working in manufacturing – which is the current British situation – has the same capacity to increase output in response to a lower exchange rate as one with 3¾ million government employees and 7¾ million in manufacturing, which was the UK situation in the mid-1960s, for example.

As far as the forthcoming 20th March Budget is concerned, “sufficient unto the day is the evil thereof” applies. However, it needs emphasising that, in terms of the fiscal stabilisation literature, all that Mr Osborne has attempted has been a ‘timorous Type 2’ fiscal consolidation programme, in which tax increases have been front-end loaded, public investment has been cut, and current government expenditure and welfare costs allowed to rise. There exist countless international studies showing that Type 2 packages lead to unexpected output weakness and a worsened fiscal position. One can only despair at either the quality of the advice that the Chancellor has been receiving, or his willingness to listen to it. In contrast, a ‘bold Type 1’ package of tax cuts, public consumption reductions, tight control of welfare bills and no public investment cuts – which the Conservatives should have prepared while in opposition and then implemented immediately – is normally associated with positive output surprises, reduced joblessness and an improved fiscal position.

However, before giving up in despair it is worth noting four chinks of light penetrating the gloom. The first is the recent strength of world equity markets, which might be regarded as a longer-leading indicator of the economy. Some central bankers have expressed concern that this development represents a return to bubble conditions. However, the normal monetary transmission mechanism is for financial markets to respond first to monetary stimulus, and then commodity prices, before activity picks up and eventually inflation at the end of the process. The second has been the consistent acceleration in the growth of the M4ex broad money measure from 1.5% in December 2011 to 5.2% in December 2012. This development could be derailed easily by ill-considered regulatory interventions. However, if the acceleration continued much further, there could be concern about its longer-term inflationary consequences. Third, there has been the parallel and linked turn round in the housing market, with the Office for National Statistics (ONS) house price index declining by 0.4% in the year to December 2011 but rising by 3.3% in the year to December 2012. Finally, there has been the continued decline in both official measures of joblessness. This development may encourage consumer confidence, even if it is hard to reconcile with the ONS growth figures.

As far as the March Bank Rate decision is concerned, the breakdown of fiscal discipline, the recent weakness of sterling, the faltering market confidence in UK policy making, and the likelihood that higher inflation reduces activity, suggest that it is time to introduce a ½% hike in Bank Rate. This is not because of any economic effects that it might have, which would be small, but in order to demonstrate that the Bank of England has not just become a supine underwriter of fiscal profligacy. A second reason to raise Bank Rate is to head off the possibility of a major run on the pound developing because speculators would no longer face a one-way bet after a rate rise if they short sold sterling. The stock of QE should be left where it is for the time being and only added to if broad monetary growth threatened to nosedive, perhaps as a result of renewed problems in the Euro-zone. Because recent UK inflation overshoots have probably reduced economic activity, it is now time to say enough is enough. The Bank of England should act with the same counter-inflationary resolve as the pre-EMU Bundesbank would have done under current circumstances and not as it did itself in the 1960s and 1970s when Britain was reduced to the ‘sick man of Europe’.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

UK monetary policy has been thrown into even greater disarray, if that were possible, by speculation over impending changes in HM Treasury’s remit to the Bank of England, hints that incoming governor Mark Carney will alter the substance and style of policy and the news that the present Governor voted with a minority to raise the amount of QE to £400bn. The side effects of these developments, especially their impact on overseas holders of Sterling, are unequivocally bad for inflation outcomes. The latest Bank of England Inflation Report contains a notably downbeat inflation assessment and Martin Weale’s balance of payments speech spells out the risks of external inflation.

While there may be some glimmers of hope regarding UK output and export volumes for the year ahead, these remain vulnerable to the resumption of debt hostilities in the Euro area and the potential for disappointment regarding the FLS. Nevertheless, with a more stable demand outlook than seemed possible a few months ago, the time to begin the normalisation of Bank Rate is now. It would serve the added purpose of rebutting the charge that the Bank of England has forsaken its responsibility to preserve sound money. There remain four months before Mark Carney arrives. This is far too long an interval to allow the weak Sterling trend to go unanswered.

The Bank of England must not lose sight of its goal of normalising short-term interest rates. Running policy on the basis of a permanent emergency is sending a depressing message to the entrepreneurial sector. If there is a role for ‘forward guidance’, it is to reassure of the Bank’s determination to take rates back to the region of 2% to 2½% over the next two years, beginning with a move to ¾% immediately.

The suggestion that the Bank should consider the purchase of other assets besides gilts is worth pursuing. The Bank of England could learn from the experience of the Bank of Japan, that relatively small purchases of private sector assets – for example commercial property, exchange-traded equity funds and commercial paper – could have potentially more powerful effects on the real economy and business confidence than further huge purchases of government debt. At the same time, the gradual withdrawal of Bank funding of the budget deficit would help to discipline fiscal policy.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

So far this year, the economic data in the UK have continued to be broadly flat: some indicators have pointed to faster growth others to slower. There is as yet no decisive trend suggesting a sustained recovery is underway. That said the economy will probably grow this year compared with last but only a lacklustre recovery, with growth close to 1%, seems on the cards at present. It is not a recovery that leaves the MPC comfortable that enough has been done, if the minutes of the February meeting are anything to go by. Clearly, it has also left the rating service Moody’s uncomfortable as it cited weaker growth than expected at this stage of the recovery as the principal reason for the decision to downgrade the UK’s credit rating from AAA to AA1. That having been said, the downgrade was not a huge surprise and probably means very little for the UK’s cost of borrowing. After all, official borrowing costs have remained low in the US and France – which is, probably, the better example for the UK – even after they were downgraded.

However, the MPC still appears comfortable with the prospect of inflation remaining above the 2% target until 2015. We know this because they said so. The voting at the February meeting showed that Governor King and Paul Fisher joined with David Miles in wanting more QE but these three were outvoted by the six other members of the Committee. This suggests that the biggest concern for the three is economic growth (is there more bad news in the forthcoming data that they are aware of?) and that even above target inflation would be accepted. Actually, the minutes showed that the whole MPC accepted above-target inflation, but the three dissenters wanted further easing now, implying a greater willingness to risk inflation for growth. Of course, their view is that inflation will eventually fall below target, if no action is taken now to boost the economy. In other words, that there can ultimately be no long lasting inflation threat if growth stays weak. For now, the financial markets have accepted this, although inflation expectations are creeping up.

To some extent this is borne out by the latest labour market data, which showed wage inflation of just 1.4% in the year to December. With consumer price inflation running at 2.7% this implies a drop in real pay of 1.3%. If there is sustained consumer price inflation, it certainly seems unlikely that it will be of the cost-push variety. However, producer price inflation did come in higher than expected, with the usual suspects of higher food prices and utility charges to blame. Meanwhile, manufacturing shows only a modest recovery and retail sales continue to struggle, though UK automobile sales remain remarkably resilient.

Claimant count unemployment fell by 12,500 in January (with December’s fall revised to 15,800 from 12,100). The Labour Force Survey (LFS) measure of employment surged again, and was up by 154 thousand in the fourth quarter of last year. With GDP contracting again in 2012 Q4 this suggests that the UK productivity puzzle – i.e., why it has remained so sluggish – continues. The softening in annual earnings growth to 1.4% on a headline basis in the three months ending in December is consistent with weak productivity gains. The problem is that weak productivity is consistent with weak growth, so how to break the link? Perhaps the Budget on 20th March may have something to say on that score.

My vote is for keeping interest rate at ½% and QE at £375bn for now, but with a bias to ease via more QE but with more variety in the assets being purchased. If economic activity weakens further - or shows no signs of recovering - economic growth in the first quarter of this year looks like it will be around plus ¼% or so, based on data from the latest Lloyds Bank Commercial banking's business survey. If this growth projection still holds as more data for 2013 Q1 are released, it may not be enough for the MPC. After the action from Moody’s, they may be even more willing to try to boost the economy than before. 

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, February 03, 2013
IEA's shadow MPC votes 6-3 for surprise rate hike
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 15th January, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 7th February.

Four SMPC members wanting an increase of ¼%, while two advocated a rise of ½%, implying a rise of ¼% on normal Bank of England voting procedures. The recommendation of a rate rise in February was the first time since September 2011 that a majority of the SMPC had voted in favour of higher interest rates.

One reason was that fiscal policy seemed even further off course than was previously believed, and risked damaging the credibility of all UK policy making. Another was that the lull in the storms engulfing the Euro-zone provided an opportunity to raise Bank Rate while the markets were still reasonably calm.

However, there were also some noticeable intellectual differences between the SMPC majority, who wanted a rate rise, and the approach more commonly favoured by UK policy makers and the financial media. In particular, it was believed that the almost unprecedented degree of government intervention in the UK economy in recent years was leading to major problems with aggregate supply and preventing the re-allocation of resources from Zombie sectors to those with genuine growth potential. It was also feared that sustained artificially low interest rates were leading to a growth-destroying misallocation of capital.

However, three SMPC members believed that there was a genuine demand shortfall, which would be alleviated by additional monetary stimulus. Most SMPC members thought that there should be no additional Quantitative Easing (QE) for the time being, however.

Minutes of the meeting of 15th January 2013Attendance: Phillip Booth (IEA Observer), Roger Bootle, Jamie Dannhauser, Anthony J Evans, Graeme Leach, Andrew Lilico, Kent Matthews (Secretary), Patrick Minford, David B Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.
Apologies: Tim Congdon, John Greenwood, David H Smith (Sunday Times Observer), Mike Wickens.
Chairman’s introductory comments

The Chairman commenced the gathering by recording the thanks of the Committee for the contribution made by the retiring SMPC member, Ruth Lea, over many years. He then welcomed the newest recruit Graeme Leach, Chief Economist of the Institute of Directors, to his first physical meeting of the Committee. As there were eleven members in attendance, the Chairman announced that the comments of members that arrived after the first nine turned up would be recorded but not counted for the final rate recommendation. This followed the precedent of the rare previous meetings when the gathering had been super-quorate. The ’extra’ pair of comments and votes have not been ‘lost’, however, but are recorded in full in the Appendix to the main vote. The Chairman then invited Andrew Lilico to give his assessment of the global and domestic monetary situation.

Economic Situation

Andrew Lilico started his presentation by listing the risks faced by the different economic blocks that made up the world economy, beginning with the USA. The risk facing the USA was that the present activist stimulus policy could generate only a temporary expansionary effect, followed by inflation. The risks confronting the British economy included a small likelihood of a gilts crisis and the loss of its AAA rating. The Euro-zone crisis remained in the wings. Looking further afield, the risks of higher inflation in China, and of an oil crisis arising from geo-political tensions, were ever present. Last year had been a poor one for the Euro area and the outlook remained flat. Furthermore, the developing and emerging economies had not been unaffected by the weakness of the developed economies. The leading indicators compiled by the Organisation for Economic Co-operation and Development (OECD) had signalled positive for the UK and USA but less so for China and the Euro-zone.

There followed a short discussion about the fiscal situation. This had been initiated by Phillip Booth asking about the projections for the US economy. David B Smith said that the rise in the share of the general government sector in US GDP to over 40% – i.e., what used to be considered European social-democratic levels – would almost certainly have impaired America’s long term growth. He added that the ‘big government’ policies of George W Bush and President Obama may have had a qualitatively similar – but smaller – impact on America’s supply side to Gordon Brown’s policies in Britain. However, Graeme Leach, Trevor Williams and Andrew Lilico were more sanguine about US long-term growth prospects citing: the political deal with the Republicans, who will be looking for spending cuts; the utilisation of shale gas, and the resurgence in US manufacturing productivity.

Resuming his presentation, Andrew Lilico stated that broad money growth had weakened in the USA and China but had picked up in the Euro area and Britain. UK GDP grew in 2012 Q3 but may have contracted in the final quarter of last year (Editorial Note: the ‘flash’ output based measure of fourth quarter real GDP, released on 25th January showed a quarter-on-quarter decline of 0.3% but no change on the year-on-year comparison). The Bank of England’s central projection for GDP was that it would not regain its 2007 peak until 2014/15.

Since the first violation of the inflation target in March 2007, the price level had risen 8.4% above the level that would have prevailed if the 2% target had been continuously met. Nevertheless, the Bank of England continued to project easing inflationary pressure based on current interest rates and £375bn of QE.

Andrew Lilico went on to present his analysis of the economy in the context of the Wicksellian theme of the natural rate of interest (Editorial Note: Knut Wicksell, 1851 to 1926, was a pioneering Swedish monetary economist).

Interest rates below the natural rate were good for growth in the short run but bad for growth in the long run because of the misallocation of capital that resulted (i.e., so-called ‘mal-investment’). Interest rates had been near zero for almost four years now and there had been further stimulus from QE. At some point, the long-run negatives would outweigh the short-run positives arising from the current ultra-lax monetary stance where the world economy was concerned. QE had boosted the demand for bank reserves. However, this had not been translated into an increase in bank lending. Commercial banks were prepared to lend at low rates to existing business customers – in effect, this was a strategy of ‘gambling for resurrection’ where Zombie companies were concerned – while new and viable businesses had to bear higher rates. This lending priority: first, created a competitive distortion; and, second, led to a misallocation of capital towards areas where its productivity was lowest.

In summary, the policy challenge was to raise the long-term growth rate, not just to recover from a temporary recession. Monetary policy had run its course. This meant that the objective had to be to normalise interest rates in periods of market calm, in Andrew Lilico’s opinion. While recent Euro-zone developments had led to a calming of markets, a rise in Bank Rate of ½% immediately, followed by later rises would not be inappropriate.

Discussion

The Chairman thanked Andrew Lilico for his thorough and thought-provoking presentation. He then asked Roger Bootle and Patrick Minford to make their respective comments there and then as he was aware that they both had to leave early. Roger Bootle then said that he had not heard a cogent argument as to how supply-side policies would get translated into consumer demand. Andrew Lilico and others said that an increase in aggregate supply would work through expected future income, which was a standard transmission mechanism in New Keynesian models. Patrick Minford added that, after four years, it was hard to continue to label the state of the economy as a lack of demand.

Roger Bootle said that four years needed to be compared with the length of the Great Depression of the 1930s which lasted nearly a decade. As to the fall in potential GDP, he agreed that this may have occurred but it was a question of degree. To argue that it was all a matter of the supply-side was a mistake. He said that he had never believed that QE would create growth. The alternatives he mentioned were that that the exchange rate should be lower but not a precipitous decline that would endanger a collapse. The Funding for Lending Scheme (FLS) may yet have some effect.

Akos Valentinyi said that the interventionist policy of the Roosevelt government delayed the recovery in the USA in the 1930s. Recovery may well have come sooner in the absence of the New Deal. Jamie Dannhauser disagreed and said that he had a lot of sympathy for Roger Bootle’s position. He added that the micro evidence did not support a supply side interpretation. Both supply and demand were interrelated. Demand could come from corporate investment and exports. Roger Bootle said that, if the 1930s was not a situation of weak demand, he asked why the Second World War created demand. Philip Booth said that the comparison of a wartime economy with a functioning market economy was inappropriate.

Kent Matthews added that a study of the Roosevelt Works Progress Administration programme in the 1930s by Dan Benjamin and himself, published by the Institute of Economic Affairs (IEA) as a Hobart pamphlet in 1992, reported research that showed that for every ten jobs created by government intervention in the New Deal, nine jobs were destroyed in the private sector. In a similar way, Bank intervention in keeping rates so low for so long was probably creating more harm than good. David B Smith added that it was worth bearing in mind that the British experience in the 1930s had been very different to that of the US. Since he had recently published an article on the subject (Britain in the 1930s: Lessons for Today, in B & O, The Quarterly Journal of the Economic Research Council, Summer 2012, Volume 42 No. 2, www.ercouncil.org) he would not comment further, apart from noting that the draconian fiscal discipline of the time, which saw a rise in the constant employment budget surplus to a peak of some 4.2% of GDP in 1933, was quite consistent with an average growth in real GDP of 4¼% per annum between 1933 and 1937. If only we were so fortunate today.

Kent Matthews next proposed that Andrew Lilico’s analysis of the relative ease with which insiders and outsiders had access to bank credit fitted the facts. A recent report by Deloitte suggested that the number of Zombie companies being kept alive by low interest rates and available credit could be as high as one-in-ten. These insider borrowers were kept alive by banks that were afraid to ‘pull the plug’ for fear of the negative outcome of accepting the resultant write offs on their balance sheets. The other side of the coin was that new credit was not being granted to viable companies, except at high interest rates and tough collateral conditions. In the case of insiders, risk was being ‘under-priced’ whereas it was ‘overpriced’ for outsiders. Recessions normally lead to a clear-out of unprofitable companies through the Schumpeterian process of ‘creative destruction’. However, this can only work if credit markets were well functioning. Exceptionally low interest rates for this length of time work against the process of efficient credit allocation and acted as a hindrance to a natural recovery.

Having already taken the votes of Roger Bootle and Patrick Minford, the Chairman stated that it was now time to go round the table and record everybody else’s votes. These are listed in their customary alphabetical order below. As Kent Matthews and Roger Bootle were the last to arrive the Chairman ruled, in line with established SMPC practice, that these two would have their views recorded but their vote discounted. To avoid confusion, these two comments are set out in an Appendix.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: Expand and widen QE.

Jamie Dannhauser said that he had no disagreement with the supply-side arguments that called for greater deregulation. These arguments had merit. Nevertheless, it was a question of balance. The danger was that the economy sleep walked into a Japanese state of long-run minimal growth. Jamie Dannhauser added that it would be better to err on the side of a more aggressive monetary stance and, possibly, ease further, employing more and wider QE beyond gilt purchases. He said that the dominant risk was the Euro-zone crisis. QE would have worked if it had not been for the uncertainty created by the events in Continental Europe. What was needed now was wider, and marginally more, QE.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%.
Bias: No further QE; raise Bank Rate further as the opportunity arises.

Anthony J Evans said that he did not believe central banks were out of ammunition and there was more that they could do to loosen the monetary stance. Nevertheless, the risk was that additional intervention would be more likely to make things worse rather than better. The existing low interest rate policy was causing damage and rates should not be kept low indefinitely. Central bank activism had failed because policymakers had failed to lift expectations – it was better to threaten a loose policy but actually keep it neutral, than it was to forecast low growth and keep it loose. In his opinion, the Bank of England should not do any more QE. Anthony J Evans concluded that interest rates should be moved towards the natural rate and that the current situation presented a window of opportunity to do so. He voted to raise Bank Rate and had a bias towards further increases.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and hold QE.
Bias: Neutral on Bank Rate but maintain additional QE available as a contingency measure if Euro crisis worsens.

Graeme Leach said that the economy seemed to be condemned to a low growth scenario due to supply-side influences and in particular the size of the state, which was undermining potential GDP growth. Whilst there was scope to support demand through further QE, he argued that any decision to further boost QE should await clearer numbers as to the sustainability of the slight improvement in broad money growth on the M4eX measure seen towards the end of 2012. He also stated that a significant expansion in QE was almost inevitable at some stage over the next twelve months, in view of the high probability of a further flare up in the Euro crisis.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank rate by ½%; hold QE.
Bias: To raise Bank Rate.

Andrew Lilico said that the Bank of England could generate a temporary expansion through an easy monetary stance but that this would be followed by higher inflation. Monetary policy had to be rebalanced and the interest rate should be allowed to revert to a higher Wicksellian norm. The rate of interest could not stay at the current level forever. The calm in the markets provided this window of opportunity for rates to rise.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

Patrick Minford stated that he agreed with Andrew Lilico’s assessment. Money could not be used to systematically stimulate growth. The forthcoming Bank of England Governor, Mark Carney, had implied that more QE would be deployed and that the inflation target would be abandoned. Patrick Minford said that any abandonment of the inflation target would represent the worst kind of time inconsistency. He said that it was time to signal that monetary policy could not be used indefinitely to stimulate growth. He said that he was getting used to being a lone voice. He voted to raise Bank Rate to 1% immediately, followed by further rises in future months.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate further and hold QE.

David B Smith said that the economy was facing a macro supply-side contraction – fundamentally, this was caused by the massive increase in the public spending and regulatory burdens since 2000 – but also the culmination of a whole series of microeconomic problems. The recent spate of changes to the international environment, and the marked rise in energy costs since 2005, meant that many individual sectors of the economy, as well as specific companies, were now technically obsolescent. This was something that some household name retailers had recently found to their cost. However, the same argument applied to wider swathes of the UK economy. The implication was that resources needed to be reallocated rapidly from the Zombie economy to the sectors that had a future. This required a background of low regulation and frugal tax costs if the necessary flexibility was to be achieved. Unfortunately, the political process – as well as the commercial banks’ wish to keep bad debts off balance sheet – militated against the required re-allocation of productive resources to socially more useful ends.

In this situation, monetary policy was not a workable source of stimulus and neither was a conventional fiscal demand boost. The more he had examined the details of the December 2012 Autumn Statement, the worse things appeared. Despite his rhetoric to the contrary, Mr Osborne appeared to be acting in practice as the ‘son of Gordon Brown’, rather than the ‘anti-Brown’ that the economy needed. The Bank of England had lost all credibility and the yield on 2½% Consols – where yields had probably been less distorted by QE – had already broken upwards through 4% at the start of the year. Policy-induced nervousness was likely to see gilt yields rising further (and sterling weakening) and not necessarily in a controlled manner. A shakeout of the British government bond market looked particularly likely if the financial markets suspected that one reason for Mr Carney’s appointment was Mr Osborne’s desire to whip up an unsustainable credit boom before the 2015 general election. He said that a modest rise in Bank Rate was needed to signal a change in monetary stance to the market and that the monetary authorities were not simply supine accomplices to the breakdown of fiscal integrity. David B Smith voted to raise rates and to hold QE (subject to events in the Euro-zone) with a bias for further rises in Bank Rate until it was somewhere in the 2% to 3% range.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate further.

Akos Valentinyi said there were three sources of uncertainty that impinged on UK interest rate policy. The first was the Euro crisis; the second was domestic regulatory policy, and the third was US fiscal policy. He said that he believed monetary policy had run its course and keeping interest rates at the current level worsened the misallocation of capital. QE had distorted bond yields. He voted to raise rates with a bias to further increases.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; no extension of QE.
Bias: To raise Bank Rate further.

With reference to the earlier discussion regarding the competing diagnoses of aggregate demand deficiency or supply-side bottlenecks, Peter Warburton argued that the UK economy suffered from a combination of both. Excessive credit growth in the global economy over a number of years had been accompanied by physical over-investment in some sectors, under-investment in others and mal-investment in yet others. Some industries faced structural over-capacity and were deliberately running down the capital stock, resulting in a lengthening of the median asset life. There was a suspicion that additional labour resources were being deployed to keep aging assets in operation. In other sectors, including energy, transport and food, there had been under-investment in the infrastructure and supply constraints were evident. A shortfall of demand in relation to productive capacity could just as well be read as a signal for supply to contract as for demand to expand. Certainly, with public expenditure representing such a large proportion of GDP, there could be no presumption that government should act to remedy a supposed demand deficiency. The size of the government sector lay beyond the range of effective counter-cyclical fiscal policy. It was highly probable that further additions to public current spending would have a negative impact on GDP.

Peter Warburton then added that QE, in terms of government bond purchases, should be thought of in global terms and not just nationally. The aggregation of QE in different countries had a pooled effect in the global bond market, rather than a ring-fenced effect in the national bond market. Peter Warburton said that he agreed with Jamie Dannhauser that there was a need to widen the scope of QE by extending it to other assets. However, this should not be through additional QE but by reallocating the existing stock of QE, perhaps up to £50bn, over a wider range of assets. The overall stock of QE should be increased only as a contingency. The Bank of England needed to learn from the experience of the Bank of Japan, that relatively small purchases of private sector assets – for example commercial property, exchange-traded equity funds and commercial paper – could have potentially more powerful effects on the real economy than huge purchases of gilts. At the same time, the removal of Bank funding of the budget deficit would help to discipline fiscal policy. On the basis that more could be done to leverage the Bank’s existing balance sheet size, he believed that it was time to revisit the normalisation of Bank Rate. He voted to raise Bank Rate with a bias towards further increases.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold. No further QE.
Bias: Neutral.

Trevor Williams said that a rise in the Bank Rate at this juncture would be a disaster. Households would be less likely to spend and corporations less likely to invest. In some sense, they had a ‘desired’ target in mind. So, if rates rose and debt payments went up, they would have to save more to make up the gap between desired saving and the actual. There were both demand and supply issues and ‘Minsky moments’ that were unfolding, according to Trevor Williams. The Bank of England could not do anything about Europe except to react. UK economic growth over the past five years had just been a smidgen better on average than that of Spain, despite the latter’s well documented problems. It was difficult to resolve all the problems that the British economy faced with interest rate policy alone, since many of these were structural and long term in nature. Public spending needed to be cut and the need for a rebalancing of policy remained an important issue in the medium term. While Trevor Williams felt that there should not be any further QE, for now, he believed that the Bank should continue with its efforts to reduce the cost of credit to small businesses. He said the Bank of England needed to think more creatively about monetary policy. He voted to keep interest rates on hold.

Policy response

1. On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in February.
2. There was disagreement as to the extent at which rates should rise. Two members wanted rates to rise by ½% – which would have been the traditional policy response in the past, when rates came down in quarters but rose in halves – while four said that rates should rise by ¼%. One reason for limiting the recommended rise to a ¼% was so as to avoid an undue shock to the financial markets after such a long period of stasis.
3. All those who voted to raise rates expressed a bias to raise rates further.
4. There was a general agreement that the delay in implementing Basle III was welcome because it allowed commercial banks more time to rearrange their balance sheets and made it less likely that there would be a damaging and internationally-synchronised reduction in the supplies of money and credit to the private sector.

Date of next meeting
16th April 2013.

Appendix to Main Vote

This appendix sets out the views of the two SMPC members who attended the gathering but did not have their views recorded in the main vote, because nine members had already arrived.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold Bank Rate. (Vote discounted)
Bias: Neutral.

Roger Bootle said that monetary policy may have reached its limit however that was no argument for raising interest rates. UK demand was weak because of weak consumption. Therefore, he would have voted to maintain the rate of interest.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%. (Vote discounted)
Bias: To raise Bank Rate; additional QE to be used only if the Euro crisis re-emerged
.

Kent Matthews said that QE was always available as a contingency if the Euro crisis flared up again, as it certainly would in due time. However, QE should not be used to bolster domestic monetary policy until then. A rise in the rate of interest would certainly cause pain in the short term but it was a necessary action for two reasons. First, it was necessary to signal to the market that monetary policy was being rebalanced towards some normal position that would create the conditions for the efficient allocation of credit and a natural recovery. Second, monetary policy would have no traction at interest rates already at near zero in the event of a terminal Euro-zone crisis. Correspondingly, Kent Matthews would have voted to raise rates and to hold QE as a contingency.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, January 06, 2013
IEA shadow MPC votes 7-2 to hold rates
Posted by David Smith at 09:00 AM
Category: Independently-submitted research

In its most recent e-mail poll, finalised on 31st December, the Shadow Monetary Policy Committee (SMPC) decided by seven votes to two that Bank Rate should be held at ½% on Thursday 10th January. One dissenter wanted to raise Bank Rate by ½%, while another desired an increase of ¼%. Most SMPC members thought that there should be no additional Quantitative Easing (QE), given that annual broad money growth had recently picked up to 4% to 4¼%.

However, additional QE might still be needed if this monetary acceleration went into reverse. More generally, unduly heavy handed financial regulation was seen as a major cause of the UK’s weak money and credit growth. Using QE to offset regulatory shocks was a roundabout and undesirable way of stabilising the monetary aggregates. Less intrusive regulation, and reduced QE, was a simpler and better course.

Several SMPC members expressed their disquiet about the fiscal weakness revealed in the 5th December Autumn Statement. This made an unpropitious background to the conduct of monetary policy. In addition, the rapidly diminishing credibility of the official fiscal projections made it difficult for the Bank of England to carry conviction, especially given its history of inflation overshoots.

With the volume of general government current expenditure in the third quarter of 2012 already 4.5% higher than the Chancellor had intended in 2010, it was also felt that Mr Osborne was already on ‘Plan G’ or ‘Plan H’, let alone the ‘Plan B’ advocated by Labour. Some SMPC members expressed reservations about the idea that nominal GDP targets should replace those for inflation. Nominal GDP targeting was a theoretically appealing concept but was likely to prove a nightmare to implement in practice.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate and pause QE.
Bias: Adjust Bank Rate and QE to achieve appropriate growth in broad money.

The UK’s M4ex broad money definition rose by 0.4% in October, the last month for which official money data are available at the time of writing (28th December). Over the six months to October, the annualized rate of growth of M4ex was 6.2%, clearly above the norm over the last five years of the Great Recession and its sequel. The relative strength of money growth in the recent past has owed much to QE, which might be regarded as artificial. All the same, the numbers are consistent with a marked easing of balance-sheet strains throughout the British economy. Late 2012 has not been an exciting time for the British economy but cyclical excitements are to be avoided. Share prices have moved ahead, the housing market has improved, London commercial real estate is quite active and companies’ expansion plans are not cash-constrained.

Retailers have reported a satisfactory Christmas, albeit with a continuing shift from the High Street to web-based suppliers. Even unemployment has been falling. Given a mildly favourable international background, the UK macroeconomic outlook for early 2013 is also mildly favourable.

The persistence of the budget deficit at extremely high levels is a sign of weak government, not of fundamental economic weakness. Nevertheless, it may lead to the loss of the UK’s triple-A credit rating. According to the Autumn Statement, ‘public sector net borrowing’ is to be £99bn in 2013/14, compared with £80bn in 2012/13. The rise in the deficit may be justified in Keynesian circles by the argument that aggregate demand will be stronger because of the rise in the budget deficit. However, there is no evidence whatsoever that – in recent decades in any major economy – the growth of demand has been positively correlated with changes in the cyclically-adjusted budget deficit, as the Keynesian argument requires.

It is now appropriate to make two brief comments on the international background. First, a great media hullabaloo about the USA’s ‘fiscal cliff’ seems to have persuaded some participants in financial markets that the US economy and, hence, a large part of the world economy may fall into another recession in 2013. May I simply repeat my observation in the last paragraph, that ‘there is no evidence whatsoever that – in recent decades in any major economy – the growth of demand has been positively correlated with changes in the cyclically-adjusted budget deficit, as the Keynesian argument requires’? Far more important to the US cyclical prospect are recent and imminent movements in key asset prices – i.e., the prices of real estate and quoted equity – and critical to these movements are the quantity of money, broadly-defined, and hence the behaviour of the banking system. Although the US banking system, like others in the G20 nations, is unfortunately subject to the misguided Basle III rules, US broad money is growing at present, if only slowly.

Moreover, the Conference Board’s leading indicator index is rising gently. In my opinion, US economic activity would be little affected in 2013 by a large fall in the Federal deficit. Furthermore, the USA’s financial image would be greatly enhanced by a big move back towards a balanced budget over the medium term.

Secondly, fears of a Eurozone rupture have abated since spring 2012, largely because Germany, in particular, has shown increased willingness to underwrite debt issuance in the Club Med countries. However, Eurozone break-up fears will probably return at about the time of the German elections in September 2013, when German taxpayers realize the scale of the contingent liabilities now being incurred to their potential cost and have the opportunity to pass judgement on the subject. More fundamentally, the trend rate of economic growth in the Eurozone (i.e., Western Europe without the UK, more or less) is now pitifully low, perhaps even indistinguishable from zero. This low or negligible trend growth rate will constrain the demand for the UK’s exports in 2013, but growth outside the EU – particularly in Asia – should revive after a rather mediocre 2012. Overall, the global outlook for UK companies, which are increasingly refocusing away from the EU, is fine.

My view on monetary policy is the same as at the end of November. There is no hurry to move to a higher level of short-term interest rates for the present, although I find it possible that I will be advocating a rise in interest rates in 2013. As ever, the overriding objective should be stable growth of the quantity of money at a low non-inflationary rate. QE has been paused, partly because of the slight upturn in broad money growth. However, the ‘monetary authorities’ (i.e., the Bank of England, the Treasury and the Debt Management Office as a Treasury agency) need at all times to coordinate the management of the public debt, so that the state’s transactions in public debt help in maintaining a low and stable rate of money growth.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Expansion of QE, including purchase of non-gilt assets.

The decision regarding additional monetary ease was a close call this month. UK output growth remains sluggish. Although the recent volatility in monthly data series makes it tricky to ascertain the underlying strength of demand and economic activity, there is scant evidence that the economy is doing anything other than bumping along the bottom. Certainly, output growth appears currently to be weaker than had been anticipated a few months ago.

Particularly discouraging were the latest revisions to UK GDP, which revealed a much larger contribution to third quarter output growth from inventory accumulation than was indicated previously. In addition, the level of nominal spending, which is a potentially more relevant variable for monetary policymakers, was revised down by 0.7%.

Looking ahead, puzzlingly strong construction output in October could imply a stronger (or more likely a less weak) headline reading for fourth-quarter GDP than many have recently been forecasting; but there was disappointing news from the much larger service sector (77% of UK gross value added) which saw activity in October no higher than it had been on average in 2012 Q3. Similarly poor figures have recently emerged from the retail sector, where the volume of spending appears to have declined in the final three months of the year.

Outside of the UK, the economic environment is mixed. The trough in Chinese growth appears to be behind us, but emerging world growth more generally does not look set for a strong revival. If anything, the persistent slowdown in broad money growth in emerging markets (EMs) over the last six months suggest that sub-par rates of economic expansion in EMs should continue for a while yet. At the time of writing, there was no agreement amongst US politicians on how to deal with the ‘fiscal cliff’. A messy compromise is ultimately likely to be reached, which prevents a retrenchment worth 5% of GDP impacting the economy in 2013; but US economic activity will still be restrained by relatively sizeable fiscal tightening over the coming quarters. Improving US monetary conditions suggest private domestic demand should continue to grow at a reasonable clip in the face of this tightening, albeit we may still be some way from consistently above-trend output growth. The main external threat to the UK economy comes from the Eurozone, which is a long way from safety despite appearances to the contrary. Activity is still declining, and investor confidence could easily be shattered, as Europe’s politicians approach one of the many hurdles they still have to clear.

Given the dangers to Britain’s long-term supply potential from persistently sluggish demand growth, there is a strong case for erring on the side of doing too much at this stage with monetary policy. The on-going regulatory barrage faced by UK banks, despite the potential benefits it may bring in terms of long-term financial stability, is undoubtedly constraining private sector spending, and more importantly the rebalancing of capital and labour resources within the UK economy. Since politicians of all stripes are swinging behind a ‘punish the banks and bankers’ agenda, monetary policy has to do the heavy lifting. The FLS appears to be having some effect at the margin in easing credit supply, particularly in the mortgage market. However, additional Bank of England asset purchases would seem warranted. Despite the recent increase in UK broad money growth, it is not yet at a rate consistent with the pace of nominal demand growth that seems desirable. With such uncertainty hovering over macroeconomic policy in the world’s major economy, there would seem to be a strong argument for postponing a final decision until next month. But barring any major surprises, another round of QE is likely to be necessary very soon.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Maintain asset purchases at £375bn; only increase the total to offset declines in M4ex.

Why is the British economy refusing to respond to a supposedly very stimulatory monetary policy after failing to react to a very large dose of fiscal stimulus? On the monetary side, the answer is that policy is not what it appears. Macro-economic textbooks take it for granted that lower interest rates – or a near-zero Bank Rate – will lead to easier monetary or credit conditions, but this is not always true. If the demand for credit falls (or the credit demand curve shifts to the left) more than the increase in supply (typically a rightward shift in the supply curve), then it is entirely possible to have very low interest rates and a negligible increase in bank credit. Broadly this summarises the situation in Britain today. First, households have drastically cut their willingness to borrow because: with house prices down 24% in real terms since their peak in 2007 Q3, new full-time jobs scarce, and income growth weak, their ability to repay mortgages or other debt has fallen sharply. Second, larger companies are able to borrow more cheaply and for longer terms in the bond market than directly from banks. Third, the banks are hardly growing their balance sheets at all due to their need to reduce their dependence on borrowed (i.e. non-deposit) funds and to improve their capital ratios. In fact, official data show total sterling assets and liabilities have declined from £4.066 trillion in January 2010 to £3.644 trillion in October 2012, a fall of 10.4%, with most of that decline occurring in the first half of 2010. Since then bank assets and liabilities have remained essentially unchanged, exactly replicating the experience of Japanese banks in the 1990s. In short, Britain has low interest rates but tight credit.

Given the size of the private sector (the gross liabilities of households, non-financial and financial firms together amount to about fifteen times GDP), it would require an immense injection of money via QE to offset the tendency of all these private entities to contract their balance sheets. In effect, private sector de-leveraging is overwhelming public sector attempts to re-leverage the economy. The clear implication is that the economic recovery may continue to disappoint until the point at which private sector balance sheets are well on the way to repair. Assumptions by the Office for Budget Responsibility (OBR), the Bank of England and others, of a fairly prompt return to 3% growth, are wildly at odds with this analysis. More fundamentally, the lesson for policy-makers is that monetary stimulus can only work effectively in an economy where leverage is not already excessive.

On the fiscal side, the OBR is projecting that underlying Public Sector Net Borrowing (PSNB) defined to exclude special factors will be £120.3 billion, or 5.1% of GDP in fiscal 2012-13. This might appear to be very large and supportive of private spending. However, it is not the absolute or relative size of the deficit that matters, but the increment in the budget deficit that is the key measure of stimulus. On this basis the years of greatest stimulus were in 2008-09 (when the PSNB increased by 4.3% of GDP) and in 2009-10 (4.3%). Since then the Coalition has deliberately attempted to narrow the deficit: 2010-11 (minus 1.6%), 2011-12 (minus 1.7%), and an OBR-projected minus 2.8% in 2012-13. In other words, the maximum PSNB increases served to prevent the economy suffering an even more catastrophic decline in output in 2008-10, but no such stimulus can now be expected.

Like monetary policy, fiscal stimulus also can only work under certain conditions. Typically fiscal stimulus will only be effective up to some indeterminate point where either the level of government debt becomes too large to attract buyers – hence, driving up interest rates as in the peripheral Eurozone economies – or where the scale of government spending and transfers as a share of the GDP becomes counterproductive and inhibits the growth of the private, wealth-generating part of the economy. The judgement of the markets as expressed in the yield on UK government gilts may be unclear. However, the preference of the Coalition for reducing the deficit as a fraction of GDP in the shortest reasonable timeframe is well known, even if the timetable may be slipping a little.

If the core problem is damaged household and financial sector balance sheets, then central bank and government policy should be directed to helping the private sector to repair their balance sheets as soon as possible. However, both the traditional policy tools have been maxed out. Monetary policy, which works by expanding the loans and deposits available to the private sector, is blocked because the banks do not want to lend and households do not want to borrow. Of course, low interest rates minimise debt repayment problems, but this is secondary. It still takes households far longer to repair balance sheets than either the corporate or banking sector. Fiscal policy, which works by expanding the liabilities of the government, is blocked because at some indeterminate level of government debt there is a serious risk of driving up interest rates for all borrowers.

An alternative approach would be to adopt some form of debt forgiveness, for example by government stepping in to take over (say) half the outstanding mortgage debt of households, and replacing those mortgages on the books of the banks with government debt. However, this creates huge problems of moral hazard. In addition, the distributional effects would be very unfair because it would mean reducing the debt of new mortgagees by much more than those whose mortgages are almost fully repaid. Another problem in modern financial markets is that the mortgage is often no longer on the books of the originator, having been securitised and sold on, possibly several times. Variations of these debt forgiveness or foreclosure forbearance strategies have been attempted in some countries, but without much success. Against this background the Bank of England must learn to pay far more attention than it did in the past decade to the state of balance sheets across the economy. For the present, it should hold Bank Rate stable at ½%, thereby helping borrowers to repair their balance sheets, but be prepared to undertake additional asset purchases if M4ex growth registers absolute declines.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

This time of year is notoriously difficult for interpreting the economic tea leaves, particularly as there have been highly mixed reports from individual retailers in the run-up to Christmas and the subsequent New Year sales. January is not the time to jump the gun with a change in interest rates or QE, in the absence of a very clear message from elsewhere in the economy.

The signal from the performance of M4ex broad money performance over recent months is that the UK economy can avoid a triple-dip recession but that GDP growth at a rate above 1% to 1.5% is unlikely during the first half of 2013. If the December and January M4ex figures show a weakening in broad monetary growth, then a further expansion in QE will probably be required.

However, and whilst accepting that QE can be employed to support the demand side of the economy, too little attention is being paid to the underlying supply-side weakness as a result of the total government intervention index – this can be defined as the combined impact of public spending, taxation and the regulatory state. Consequently, any increase in money GDP as a result of QE, continues to risk being led more by inflation than real growth. The UK outlook continues to be constrained by the absence of a genuine supply side policy, capable of boosting private capital formation and total factor productivity growth.

On the international front there are three clear threats to the global economy in 2013. The first is the US fiscal cliff. Second, there is the risk of an intensification of the Euro crisis. The third such threat is the possibility of pre-emptive military activity by Israel or the US against Iran. At the time of writing, the US appeared to be heading over the fiscal cliff, without any agreement between the White House, the Senate and the House of Representatives. Anyone who followed the deficit reduction negotiations during the first Obama administration will know just how far apart the House of Representatives is from the Senate and the White House on this issue. A deal based on substantial tax simplification, which takes an axe to deductions and in so doing permits lower marginal rates and higher overall tax revenues, (plus sharp reductions in entitlement spending) might be attainable in the long-term. However, it seems impossible to bring this about in a matter of days before the New Year. The political standoff between higher taxes and lower spending seems set to continue. At best, only a short-term politician’s fudge is likely to prove achievable as a consequence.

The Draghi Plan has provided a temporary respite to the Euro crisis. However, it is very unlikely to prevent a Greek exit from the Eurozone at some point over the coming year (Editorial Note: the reasons are set out in Still Going Down? in the Institute of Directors Big Picture, Winter 2012, which can be downloaded from www.iod.com). Consequently, precautionary behaviour towards business investment will remain a source of weakness. The final economic threat is a real and present danger. The level of uranium enrichment by Iran is no longer the key issue because the pursuit of weapons grade enrichment has been obvious for years. However, the threat that this enriched uranium will be incorporated in a deliverable weapon is a red line for the US Government, and not just for the Israelis. Consequently, a significant geo-political risk will hang over the world economy in 2013.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

One of the strange things about the current debate about monetary policy and inflation targeting is how many of the protagonists, from finance ministers through central bank governors to the International Monetary Fund (IMF) and the Bank for International Settlements (BIS), have forgotten all they were taught about macroeconomics. They seem to believe that monetary policy, now to do with fresh injections of central bank money (QE), can create growth when everyone can fully see the injections from well in advance of the act and long after the original banking crisis has given way to a weak, ‘new normal’, recovery. Yet even the most ‘New Keynesian’ model, with long-duration price/wage rigidity, does not predict that money can boost output much in these conditions. A model, on the other hand, with a fair degree of price/wage flexibility is definite that no effect at all on output will result.

The main channel through which New Keynesian models see effects on output occurring is through future interest rates being kept low and so stimulating investment, perhaps also consumption. The argument is that the central bank sets interest rates and can influence expectations of where it will set them in future by a special monetary intervention addressed to the future. Nowadays, these models are usually supplemented with a banking sector which charges a premium on its loans that varies with the strength of lending demand. As we have seen, the lending premium has remained stubbornly high in spite of the monetary stimulus applied.

What we have observed here and in the US – and, indeed, in most western economies including the northern Eurozone – is weak growth in spite of massive monetary stimulus. Businesses can see little need to invest, consumer spending is growing slightly, government spending is of course restrained; monetary policy is having little effect on any of these sources of demand. Ironically, the area where it might be having most effect is government where QE, allied to general fear, has brought down the cost of government borrowing to the point that real interest rates have become negative. Even so, governments are in no mood to commit to new spending levels when they are rightly concerned about long-run solvency.

Accounting for all this weakness is a challenge to our understanding. Some say it is due to ‘deleveraging’; in a literal sense this is true as people and firms are not spending and so running down debt. However, this is purely a description not a causal explanation. The question is why they are de-leveraging so relentlessly in the face of low interest rates. To this, the most plausible answer is that prospective returns on capital are low and expected real incomes growing little because productivity growth is slow and promises to remain so.

The deep reasons for this appear to lie first in the massive shift in the terms of trade for oil and raw materials against western consuming countries. Indeed, producing countries of the West, such as Canada and Australia, and of the developing world – such as Africa – are in much better shape.

The second reason is the regulative backlash against the banking system in the West. This has most effectively blocked the banking channel of monetary policy. It is a commonplace of recent surveys, such as those carried out by the Bank of England through its agents, that Small and Medium-sized Enterprises (SMEs), which account for some 50% of employment and a slightly smaller share of GDP, cannot get loans from the banks on reasonable terms or in some cases on any terms at all. One symptom of this banking channel blockage is the exceptional weakness of broad money growth and the non-existent growth of credit. Governments and regulators are convinced this regulative tightening is both necessary and will make the economy ‘safe from crises’ in the future. In this they are likely to be quite wrong. This is because capitalism is naturally crisis-prone, since productivity growth is inherently unpredictable and subject to potentially large swings in both directions. Recent Cardiff Business School research suggests that, simply due to these swings, crises of some depth can occur quite regularly and will generally trigger banking problems as well. While our elite classes get to grips with this reality, their heavy-handed regulative intervention is worsening the economic ‘supply-side’ on top of the weakness induced by the raw material terms of trade shift. Printing money to get over such real supply-side weaknesses will not have much if any effect, as indeed we are observing in practice.

There is increasing talk of raising the inflation target both here and in the US. No less a man than the Bank of England Governor to be, Mark Carney, has made a high profile speech arguing for some ‘temporary’ raising of the inflation target. He is a bit late in this since the Bank has been indulging in this sport for a few years now, having overshot its target substantially. His reason for suggesting this is that it will boost growth. But, surely, everyone knows the theory of ‘time-inconsistency’ in monetary policy under which the desire of policy-makers to boost growth by creating extra inflation generates inflation without succeeding in boosting growth? The reason for this is that once people begin to think inflation is being used as a tool for boosting growth they will expect the ‘inflation target’ to be regularly breached whenever growth is disappointing. They will then calculate how much inflation will seem worthwhile as the price of getting more growth; this rate will then become the ‘inflation expectation’. Wage inflation will then rise in line with these expectations and fuel this very inflation rate. Growth in employment and output will not increase as the channel of higher competitiveness (lower real wages) will be frustrated.

One might add that interest rates too will rise as inflation expectations rise. This will not aid recovery and could harm it. It will indeed mean that the value of government debt falls so that the public debt ratio will fall. This can be thought of as the effect of the ‘inflation tax’. However, the whole idea of inflation targeting was to make sure governments did not use this tax rather than orthodox taxation; voters disliked the random redistribution generated by high inflation and that underlay the legislative move to the target. So far, inflation expectations have remained moderately anchored in spite of such loose talk. However, authors such as Bennett McCallum have warned that time-inconsistent behaviour is a deep problem of political economy. Those of us involved in the public debate have to be constantly on the watch for its recurrence in ever-plausible guises. It seems that the Carney speech is particularly dangerous as it has been welcomed by George Osborne as the ‘start of a debate’. It is a dangerous one. This is because it is one thing to print money when you are committed to reversing it, whenever that may be appropriate, and quite another to have no commitment to reversing it because you are aiming for higher inflation.

In sum, present monetary policy is badly adrift. It needs to be recognised that monetary policy is only a tool of stabilisation in response to shocks. Once the situation has become one of persistently weak growth, monetary policy can no longer have much, if any, effect; it will only drive inflation higher. The only reason the massive loosening of money has had little effect so far on inflation is that: first, the inflation target is still there; and, second, that the banking system has largely killed off money creation as fast as it has occurred because of regulative overkill. Regulative overkill will be with us for some time because of current government fashion. It is undermining growth but we just have to live with that.

Monetary policy so far is not causing much inflation. However, it is also not helping growth. All it is really doing is redistributing income from savers to the general taxpayer; this is politically unsustainable even if economically it is just a transfer and so has no clear welfare implication. Nevertheless, if the UK monetary authorities were to move to a commitment to generate growth by printing as ‘much money as it takes’ and abandoning the inflation target by also by ‘as much as it takes’, then matters would be alarming indeed. Accordingly, it is really time to get back to normality in the demands on monetary policy and in its behaviour. QE should stop and be reversed over the next year or so. Bank Rate should be raised towards normal levels, starting with a ½% increase forthwith.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: Avoid regulatory shocks; break up state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

In line with its now-customary pre-Christmas sadism towards the economic forecasting community, the Office for National Statistics (ONS) released a mass of new economic figures on 21st December, which have not yet had time to be incorporated into the wider macroeconomic debate. The new data included not only a revised and more detailed set of GDP accounts for 2012 Q3 but also new third quarter statistics for the balance of payments current account and the general government accounts broken down by sub-sector and economic category. In addition to the new third quarter data, there have been back revisions to previously published official statistics. These have generally extended back to the first quarter of 2011. The new ONS figures supersede the national accounts data, published on 27th November, which were employed to generate the 5th December OBR forecasts released with the Autumn Statement (see: OBR Tables 1.1 and 1.2, which are rounded to the nearest £bn., however).

The volume of general government consumption in 2012 Q3, which was the base date for the OBR forecasts, has been revised up from £84.5bn in chained 2009 prices to £84.685bn, for example, while the volume of general government fixed capital formation has been revised up from £7.0bn to £7.384bn. However, there have also been noticeable downwards revisions to the current price figure for general government current expenditure in the third quarter – from £88.3bn to £85.956bn – and for general government fixed capital formation, from £7.8bn to £7.634bn, as the result of revisions to the implied costs of these items. Taking 2012 Q2 and Q3 together, which corresponds to the first half of the 2012-13 fiscal year, the value of general government consumption expenditure has been revised down from £175.9bn to £170.1bn (minus 3.3%) and current price fixed capital formation by general government has been revised from £15.7bn to £15.1bn (minus 3.5%). These two items make up not quite 54% of total government spending; the rest is mainly transfer payments such as welfare benefits and debt interest. It is conceivable that overshoots elsewhere are offsetting these gains. However, there also remains a chance that the Autumn Statement forecasts are slightly too pessimistic on the spending side, even if one suspects that they may also be too optimistic where receipts are concerned.

At present, it is almost impossible to discuss the UK fiscal situation without getting sucked into the ‘Plan B’ debate. Plan B advocates have been given more credibility than they deserve. This is largely because of the Chancellor’s failure to mount his soapbox and explain why fiscal retrenchment is so desperately required. In practice, there are at least four sources of economic evidence that are relevant to this debate: the fiscal stabilisation literature; international cross-section/panel data studies; simulations on macroeconomic forecasting models, and direct reduced form statistical relationships between, say, private investment and the budget deficit. None of this massive literature, which has been built up over the past three or four decades, supports the ‘Plan B’ approach, nor has it had a look-in in the UK fiscal debate. In terms of the fiscal stabilisation literature, what Mr Osborne has attempted has been a ‘timorous’ Type 2’ fiscal consolidation programme, in which tax increases were front-end loaded, public investment was cut, and current government expenditure and welfare costs were allowed to rise. There exist countless international studies showing that Type 2 packages lead to unexpected output weakness and a worsened fiscal position, as has happened in the UK. In contrast, a Type 1 package of tax cuts, public consumption reductions, tight control of welfare bills and no public investment cuts – which should have been implemented but was not – is normally associated with positive output surprises, reduced joblessness and an improved fiscal position, particularly if it is done ‘boldly’.

Furthermore, it is apparent that the volume of general government consumption is running well ahead of Mr Osborne’s original intentions, even if it is difficult to be precise because of the constant re-basing of the national accounts. The first volume projections for the level of general government expenditure were released by the OBR with the November 2010 Autumn Statement. At that point, it was believed that the volume of general government current expenditure would have contracted by 2% between 2010 Q2 and 2012 Q3. In the event, it rose by 2.5%, representing a cumulative Keynesian ‘boost’ of 4.5% of government consumption – the equivalent of 1% of real GDP. The implication is that we have already more than received the alleged Keynesian stimulus that Mr Balls has been asking for, but as a consequence of grossly inadequate spending discipline rather than by design. In other words, Mr Osborne is already on ‘Plan G’ or ‘Plan H’. One can only apprehend the day that the financial markets wake up to this reality.

In the light of the various 21st December ONS releases, it now looks as if the ‘headline’ measure of UK real GDP measured at market prices was largely unchanged on average in 2012, while the arguably more informative basic-price measure of non-oil GDP increased by an annual average of 0.2%. After so many ‘false dawns’, most macroeconomic forecasters are probably too shell shocked to predict a strong recovery in 2013 and subsequent years, even if experience suggests that, once an upswing commences, it tends to be far stronger than anticipated. Furthermore, it is normally several quarters into the new cyclical phase before most commentators realise that the business cycle has turned. For what they are worth, the latest forecasts generated on the Beacon Economic Forecasting (BEF) macroeconomic model suggest that ‘headline’ GDP will increase by 1.3% on average in 2013, 2.8% in 2014 and 2.5% in 2015. Two reasons for this modest optimism are that UK broad money growth has picked up and that the 2013 prospects for Continental Europe and the US look slightly better than they were in 2012¬ – despite the likelihood that some peripheral members will leave the Eurozone and that the US will indeed plunge off the fiscal cliff. While on the subject, and as an aside, the mandatory spending cuts that would result from a failure to resolve the US fiscal crisis would almost certainly be economically beneficial in the medium term. It is the prospect of higher taxes that should really scare people because of their adverse effects on aggregate supply. However, damaging tax hikes are likely to occur under President Obama, regardless of whether or not there is an agreement with the Republican majority in Congress.

The latest UK inflation figures show that the target CPI increased by an unchanged 2.7% in the year to November, while the all-items RPI and the old RPIX target measure increased by 3.0% and 2.9%, respectively. The ‘double-core’ retail price index – which excludes mortgage rates and housing depreciation and is the most historically consistent inflation measure – rose by 3.0% over this period, compared with the 3.2% recorded in October. The latest BEF forecasts suggest that CPI inflation will ease slightly to 2.4% in the final quarter of 2013 but then accelerate to 3.2% in late 2014 and 4.4% by the closing three months of 2015. There are two proximate reasons for this acceleration. The first is that inflation in the Organisation for Economic Co-operation and Development (OECD) area is expected to accelerate from 2% in 2013 Q4 to 3.5% in late 2014 and 4% by the end of 2015, compared with 1.9% in 2012 Q4. The second is that the sterling exchange rate index is expected to weaken by a cumulated 17% or so between 2012 Q4 and 2015 Q4, amplifying the effects of increased inflation overseas. At a more fundamental level, both developments reflect the long-lagged effects of the long period of ultra-loose monetary policy and supply-damaging fiscal and regulatory actions, internationally and domestically, since 2008.

Higher inflation could be averted by a pre-emptive rise in Bank Rate during the course of this year – our forecasts have assumed that Bank Rate will be held at ½% until 2013 Q3 - and robust measures to improve supply-side performance; by which, one means genuine public spending reductions, reduced marginal tax rates and a bonfire of regulatory controls, including those on the banking sector. However, it is unlikely that the politicians or the monetary authorities have the stomach for such measures in most Western democracies. Instead, any official response is likely to be too little and too late, unless the international bond markets get the bit between their teeth and enforce the adoption of the more conventionally orthodox fiscal and monetary policies required for the achievement of economic stability in the longer term.

Moving on, it has recently been suggested that inflation targeting should be replaced by the targeting of nominal GDP and both the next Bank of England Governor, Mark Carney, and the Chancellor have flirted with the idea ¬ – the latter, possibly, because he sees whipping up a pre-election, money-supply led boom as his last political hope for a 2015 general election. However, nominal GDP targeting is an example of an appealing theoretical idea that could prove a nightmare in practice. The facts that government spending is around one half of GDP and that imports are a negative item in the GDP identity means that nominal GDP targets can easily give perverse policy signals, even if one ignores the significant practical measurement problems involved. Targeting private sector domestic expenditure, which is all that monetary policy can influence, would make more sense. However, it remains difficult to disentangle this concept from public sector transactions, given the way in which the national accounts are put together. This is a weakness that could be fairly easily rectified by appropriate action on the part of the ONS, however.

As far as the January Bank Rate decision is concerned, the temporarily reduced uncertainties in Continental Europe suggest that there is a window of opportunity to raise rates and that it is now time to introduce a modest ¼% hike in Bank Rate. This is not because of any economic effects that it might have, which would be trivial, but in order to demonstrate that the Bank of England has not just become a supine underwriter of the surreptitious fiscal profligacy contained in the Autumn Statement. The medium-term aim should be to get Bank Rate into the 2% to 3% range at which it re-engages with the money market rates that determine borrowing costs. A prompt move to such a Bank Rate during the course of 2013 would help forestall the pickup in inflation seen in the BEF forecasts for 2014 and 2015. International growth studies indicate that both the mean rate of inflation and its standard deviation have a negative impact on the level and the growth of real GDP per head. Recent inflation overshoots have reduced economic activity, not boosted it as some Bank officials appear to wrongly believe.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

We begin 2013 with diminished expectations of UK economic improvement. Three new pieces of information have become available over the past month: the contents of the Autumn Statement, the first quarterly report on the Funding for Lending Scheme (FLS) and the detailed national accounts for 2012 Q3. None of these has provided comfort on the UK economic situation.

The principal objective of the Autumn Statement appears to have been to make the Shadow Chancellor look foolish. By crook, more than hook, the fiscal deficit projection for the current year retains a downward bias. However, it is surprising, to say the least, that the OBR saw fit to endorse the assumptions that allowed Mr Osborne to avoid the embarrassment of reporting a rising deficit for 2012-13. This is still the most likely outcome, particularly in the light of the December public finances release. One of the few remaining planks of supply-side transformation, the reduction in the absorption of resources by the public sector, has run aground.

The overall stance of the coalition’s economic policy, as commonly understood, was to combine fiscal tightening, monetary ease and currency flexibility. Fiscal tightening fizzled out in 2012; monetary ease has been overruled by undesirably tight credit conditions, and our currency has drifted higher in the light of more aggressive monetary policy measures taken elsewhere. Policy implementation rates are poor.

The FLS is beginning to have a favourable impact on mortgage accessibility, but mainly at the upper end of the income distribution. Unfortunately, it is also having the unintended effect of depressing interest rates on savings accounts as banks substitute cheaper FLS funds for retail deposits. FLS is counteracting the market-driven interest rate increases attributable to Eurozone risk, but does not seem close to the degree of impact hoped for by its architects.

The third quarter national accounts confirmed the slump in construction output, weighted towards residential housing (down 14% in the latest quarter) and the bloated contribution of government expenditure and income transfers to the GDP total. Inventories are accumulating while net exports are weakening, not aided by Sterling appreciation. If it had not been for the disbursement of Payment Protection Insurance (PPI) mis-selling compensation, household consumption might not have edged to a 1.3% year-on-year gain in the third quarter of 2012.

Ultimately, the restoration of a confident expectation of even a modest pace of economic growth requires the private sector credit system to operate much more efficiently than at present. All policy energies should be directed to this end, since no schemes will succeed on their own merits in the absence of affordable credit and a positive framing of policy. Replacing the governor of the Bank of England should make some difference to the latter, but probably not to the former. Ironically, had Mr Osborne aired the dirty linen of the UK public finances he may well have repelled some of Sterling’s fair weather friends. As it is, the UK has the pretence of fiscal rectitude (and has preserved its AAA sovereign rating) but not the reality.

Finally, rather than Japan taking a leaf out of the UK’s policy playbook (in its emulation of FLS), the UK should consider copying the Bank of Japan’s purchases of Exchange Trade Funds (ETFs), Japan Real Estate Investment Trusts (J-REITs) and corporate bonds. The leverage obtained from small purchases of beaten-up private sector assets makes far more sense than the massive purchases of (over-priced) government bonds. The Bank of England should be looking to raise Bank Rate through 2013, but it does not seem like now is a good time to start.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate for now.

The most interesting development in the last month has been the announcement that Mark Carney is to be the new Governor of the Bank of England and his reported statement that he favours a change in the way that monetary policy is conducted in the UK from inflation to nominal growth targeting. Would this be a good idea? It has received much support in the media. It would also crown Sir Samuel Brittan’s advocacy for this, which has been conducted in his Financial Times column for the last forty-five years. The reason why this old proposal has been resurrected is the recent poor real growth performance of the UK, the US and the Eurozone. The apparent implication is that by targeting real growth instead of inflation, monetary policy would have been different and growth would have been higher. The intellectual underpinnings for the use of monetary policy to target economic growth may be attributed in modern times to Milton Friedman’s claim that monetary policy is more effective than fiscal policy in stimulating output in the short run. The stylized statistic is that the stimulatory effect of an increase in the money supply lasts for about eighteen months. In contrast, estimates of the fiscal multiplier have steadily fallen: it was assumed to be between 1 and 2 during the high days of Keynesianism in the 1960s when the UK had a fixed exchange rate, it is now estimated to be much less than 1.

A serious analysis of the relative effectiveness of monetary policy and fiscal policy as implements to increase economic growth would need to take into account the particular policy instruments being considered (e.g., interest rates or one of the many measures of the money supply; current or capital government expenditures), methods of financing deficits (tax, debt or money), whether the exchange rate is fixed or floating and the state of the economy (full or under employment). There is also the issue of how much risk should be transferred from the private to the public sector in order to increase investment spending. Until the financial crisis, the monetary history of the UK under a floating exchange rate had pointed to the efficacy of inflation targeting compared with trying to control the money supply or targeting a nominal exchange rate such as the former Deutschemark. Moreover, the academic literature favoured focusing solely on inflation (strict inflation targeting) over also taking into account economic growth (flexible inflation targeting) because this was thought to minimise the welfare loss to the economy from fluctuations in both inflation and output. This implies a rejection of targeting nominal growth as this would give an equal weight to inflation and output growth.

Nonetheless, strict inflation targeting is not without its problems. It is, for example, much better suited to dealing with a positive demand shock (which raises both inflation and output) than a negative supply shock (which raises inflation but reduces output). Raising interest rates following a positive demand shock would, as required, reduce output and inflation but, following a negative supply shock, not only would it reduce inflation but output too. A second problem is the zero lower bound on interest rates. Both constrain the ability of interest rate policy to stimulate the economy. These limitations have been evident in the current recession and have undermined the effectiveness of monetary policy. For example, real GDP in the UK has fallen by 2.9% since the end of 2007, while nominal GDP has grown by 8% and CPI inflation has averaged 3.5% per annum. This appears to be evidence of a classic negative supply shock. Other examples of a negative supply shock in the UK were in 1974/5 following the oil price hike, when inflation rose to over 26% and output fell by 1.5% and in 1980/1 when inflation rose above 17% and output fell by 3.2%.

The implication of this discussion is that the case for switching to nominal income targeting must rest largely on its ability to raise output following a negative supply shock as this is when strict inflation targeting is least effective. It is clear, however, that the monetary policies pursued during the current recession by the Bank of England, the US Federal Reserve and, to a lesser extent, the ECB, have had little to do with strict inflation targeting. The Bank has not responded to inflation by raising interest rates (as strict inflation targeting would require) even though inflation has been double its target value. Rather, it has kept interest rates at an historic low, and has accompanied this with a large expansion of the money supply via QE - in effect, open market operations. It is difficult to think of how a monetary policy geared to nominal growth targeting could have done more. The Bank of England has never even claimed to be a strict inflation targeter. It has always taken a close interest in output, if only because it took the view that interest rates affected inflation through their effect on output. It is also able to choose how fast to bring down inflation, and hence how much to curtail output in the process.

To sum up, there seems to be no advantage to switching to nominal growth targeting. Indeed, it could make matters worse if taken too seriously because inflation takes time to adjust and, if the aggregate rate of price increase is high, it may be necessary to engineer a deep recession to achieve the nominal growth target. In my view, it is better to give priority to controlling inflation with the aim of maintaining longer-term inflation expectations – but to permit inflation to exceed its target in a recession. In short, the Bank should continue to do what it does now. This is not, however, all that can be said about the operation of monetary policy. Perhaps the most important feature of the Bank of England Act of 1997 was that it sought to make monetary policy independent of fiscal policy and of political interference. Optimal macroeconomic policy aims to control inflation and stabilise economic growth, though not by targeting nominal growth. A combination of monetary and fiscal policy is therefore required. Consequently, given the Act, fiscal policy should take on a large part of the burden of stabilising output particularly when, as now, the Bank has run out of monetary policy options and appears to be impotent to raise output further. For example, the possibility remains of injecting a further monetary stimulus via fiscal policy by temporarily money financing part of the deficit – in effect a ‘helicopter drop of money’. In this way the continuing expansion of debt could be halted and, if clearly understood to be a temporary expedient, inflation expectations may not be greatly affected. Perhaps this is what Friedman had in mind.

Comment by Trevor Williams
(Lloyds Banking Commercial Banking)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

The evidence so far suggests that the UK economy seems to have ended 2012 with little or no growth impetus. The Purchasing Managers’ Indices (PMIs), for construction and manufacturing remain below 50, whilst the services PMI remains only a little above, suggesting that output contracted in the final quarter of 2012. Output remains about 4% below the peak level seen in 2008. Taking the five years to 2012, the economy has been flat. This represents easily the worst recovery from recession since World War II and a grim reminder that the issues facing the economy are more structural than cyclical. For comparison, the UK economy has barely performed better than Spain since 2008 and worse than France, even though the UK is not in the Eurozone. Indeed, the UK has the poorest growth record of any of the G-7 leading economies, relative to its trend rate of growth prior to the economic crisis. On even optimistic growth scenarios, the UK economy is unlikely to regain its pre-recession level of output until 2015 at the earliest. It is clear that the UK has entered a low-growth, low-wage inflation trajectory since 2007. The former could be described as pay back for the roughly decade long debt fuelled growth that now has its apotheosis in the deleveraging that companies and households are now undertaking, which means they are not spending.

With consumer spending constrained by a lack of desire to borrow, and companies sitting on cash rather than investing, low growth seems the only outcome since fiscal policy cannot offset this loss of consumption. The government now has to deleverage too – or, at the least, promise to do so in the medium term – if it is not to face a rise in borrowing costs. Furthermore, low interest rates will not ‘solve’ the problem either, since this is a problem of excessive debt that only debt reduction can resolve. It does help to mitigate its effects, however, as it allows the repayment amounts to be low and keeps down defaults, thus preventing an even greater desire to save and a worse retrenchment.

However, the problem is deeper than demand, as the fall in the exchange rate has not prevented a rise in the UK’s current account deficit to some £55bn in 2012 after a narrowing to £20.4bn in 2011 from £37.4bn in 2010. Weak growth should have meant some decline in the deficit, although the recession in the UK’s key export markets is an offsetting factor. Low wage inflation is one response to this, as it allows UK firms to be competitive, or at least more competitive than would be otherwise the case. It is also a positive for the UK’s economic prospects, as it signifies that people are willing to take cuts in real pay to offset the collapse in productivity, which is over 4% lower now than in 2007. If it had risen at the same pace as prior to the 2007 crises, it would be some 8% to10% higher.

A rise in the UK’s relative costs has not been offset by increased efficiency of labour or capital so leaving the economy vulnerable to shocks from abroad, of which inflation is just one example. This might be down to the trend decline in North Sea output and the subsequent rise in real energy costs for UK firms. However, and whatever the source, the widening in the current account deficit and fall in productivity are clear signs of a problem on the ‘supply’ side of the UK. Other ‘supply’ side candidates are a tighter regulatory burden or too high a share of government spending in GDP. It is promising though that at least the labour market has responded by showing a willingness to accept cuts in real take-home pay. The boost that this development has given to employment suggests that the UK is willing to work hard to get its economy back on track.

A rise in the domestic money supply, together with improved growth in the emerging markets and the US in 2013, should give the UK economy some prospects of recovering, albeit at the ‘new normal’ rate of 0% to 1%. In this environment, low interest rates are essential, as is a commitment by the authorities to reduce the fiscal deficit in the medium term. Asset purchases should be resumed if broad money (i.e., M4ex) looks as if it is falling once again, but otherwise should remain at £375bn.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Banking Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Sunday, December 02, 2012
Shadow MPC votes to hold rates, warns on blurring of monetary-fiscal lines
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, completed on 27th November, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be held at ½% on Thursday 6th December. Two dissenters wanted to raise Bank Rate by ¼% immediately, while another desired an increase of ½%.

Most SMPC members thought that there should be no additional Quantitative Easing (QE) for the time being. One reason was that Mr Osborne’s 9th November decision to transfer £37bn of gilt coupon payments from the Asset Purchase Facility (APF) to the Exchequer represented a de facto monetary easing. Several SMPC members expressed concern that the announcement blurred the distinction between fiscal and monetary policy, risked politicising the latter and brought forward revenues into fiscal 2012-13 at the cost of increased borrowing in later years.

The SMPC poll was largely completed before the announcement that Mark Carney would be the next Governor of the Bank of England. To the extent that SMPC members expressed a view of the appointment, it was that this was an excellent choice that sent a clear signal about the openness of the UK to global talent. The contrast between the strong Canadian economy and the weak British one helps explain Mr Osborne’s decision.

However, Canada has been helped by a noticeably less-competitive and internationally-open banking system and a far stronger fiscal background than Britain experiences. There was some concern that the new Governor might prove an unduly hard-line financial regulator in a way that was not appropriate at the current depressed point in the cycle.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate and pause QE.
Bias: Adjust Bank Rate and QE to achieve appropriate growth in broad money.

The last five years have been the most difficult for the British economy since at least the 1970s and perhaps since the Second World War. The disappointments on both output and inflation have been severe, and were more or less completely unexpected in 2007. It is therefore worth emphasising that the data of the period are again consistent, in general terms, with the monetary theory of national income determination. A salient fact is that in the five years from mid-2007 to the third quarter of 2012, the compound annual growth rates of M4ex (2.4%) and nominal GDP (2.1%) have been extremely close. Despite the turmoil of events, the latest five-year period has seen both the lowest rate of increase in the quantity of money and the lowest rate of increase in nominal GDP since the 1950s. Moreover, in the period of the sharpest downturn from autumn 2007 to mid-2009, the parallelism of the changes in money and nominal GDP was striking, with money having a short lead over nominal GDP, just as Milton Friedman would have envisaged. The Great Recession in the UK, like the Great Depression in the USA, is to be interpreted – above all – as a monetary phenomenon.

The continuing validity of the monetary theory of national income determination needs to be emphasised not just to restate an essential truth in economics, but also to comment on two of the latest fashions. The first fashion is to claim that the effectiveness of QE is subject to ‘diminishing returns’, so that the Bank of England will have to find another, new method of conducting expansionary monetary policy. The ‘diminishing returns’ claim has been made, for example, by Professor Charles Goodhart of the London School of Economics and Jeremy Warner of The Daily Telegraph. It is bunkum. The state can always create money balances, simply by making larger payments to the non-bank private sector than the non-bank private sector is making to it, while the effect of a 1% (or 5% or 50%) increase in the quantity of money is to raise – roughly speaking – the equilibrium level of money national income also by 1% (or 5% or 50%).

Secondly, at various points in the last few years concern has been expressed about the risk of high and rising future inflation. Inflation has indeed been disappointingly high in the immediate sequel to the Great Recession and the official inflation target has been exceeded by more than 1% for much of the five years since 2007. However, to characterise the UK as in the grip of a runaway inflationary process, akin to the 1970s, would be absurd. Also, the increase in nominal GDP since 2007 has been lower than in any other quinquennium for the past sixty years, if not longer. The setbacks on inflation should be seen as the consequence of the big 2008 devaluation and the economy’s poor supply-side performance.

The point here is that alarmism about inflation is justified only if the trend rate of money growth is changing. The latest data do show an upturn in the growth rate of M4ex. In the six months to September, M4ex rose at an annualised rate of 6.1%. Given that the low return on money balances is compatible with a fall in the ratio of money to income/expenditure, that rate of money growth ought to be consistent with at least a 5% growth rate in nominal GDP. However, it does not seem to me that inflation is ‘out of control’ or anywhere near ‘out of control’. The recent upward blip in money growth can be attributed to the resumption of QE operations, for which the justification was far less than clear-cut than it had been in early 2009. The QE operations should be paused, at least for a few months until there is greater visibility in the money growth outlook. One possibility should be welcomed, that the UK banking system is now able – at last – to resume steady growth ‘under its own steam’. In other words, banks can respond to their customers’ credit needs by expanding their balance sheets, in the way that was seen as normal before the regulatory excesses of the Great Recession.

Before closing, it is worth making a couple of rather miscellaneous comments. The first is that the numerous media stories about ‘the UK slipping back into recession’, which appeared in the middle of 2012, were misleading. Admittedly, they were based on the official statistics compiled by the Office for National Statistics (ONS), but the UK’s GDP statistics are not reliable in short-run macro analysis. Far better in understanding the latest trends are business survey information and employment numbers; these have indicated an economy growing at about its trend rate or perhaps a little above it in recent quarters. The trend growth rate is maybe only 1% to 1½% a year. However, and in that context, growth of a mere 1½% to 2% is above-trend and we should be grateful for it! It cannot be overlooked that unemployment has been generally falling throughout 2012, while a detailed comparison of the ONS growth figures for the period 2002 Q1 to 2007 Q4 published in 2008 with the latest official estimates reveal that the ONS underestimated the growth rate by an average of 0.44 percentage points during this earlier period or a cumulated 2½% or so. If this 0.44% were added to the annual growth rate for every quarter in the past three years, the present ‘recovery’ would look appreciably more like a ‘normal’ cyclical recovery than the present ONS statistics are suggesting.

The second of the miscellaneous comments relates to the world economy and, hence, the international environment for British exports and for British companies with a high ratio of foreign to domestic earnings. Too much attention is paid to the Eurozone and to Europe as a whole. Sure enough, the various dysfunctional features of the single currency area are now glaringly on display. They have caused a major economic and social disaster in our neighbours, and seem likely to continue to do so for a few years yet to come. That is bad news and will hold back our own economy to a degree. However, the Eurozone now accounts for only a sixth of world output and its share is falling rapidly. There is nothing much the matter with the rest of the world economy and it is reasonable to envisage a trend growth of total world output of at least 3% a year in the rest of the 2010s. In particular, the USA seems likely to enjoy a relatively standard cyclical recovery in 2013 and 2014. The US banking system has absorbed most of the losses of the sub-prime mortgage debacle and is now well-capitalised by past standards. The hullabaloo about the USA’s ‘fiscal cliff’ is entirely misplaced. The return to positive broad money growth in the last few quarters and virtually zero short-term interest rates imply a rather good year for US economic activity in 2013.

As far as the UK’s monetary policy dials are concerned, my view is that there is no hurry to move to a higher level of short-term interest rates for the present, although it is possible that a rise in interest rates will be needed during the course of next year. The overriding objective should be stable growth of the quantity of money at a low non-inflationary rate. As mentioned above, with broad money growth quite strong in recent months, QE should be paused. However, the pausing of QE does not mean that debt management policy is unimportant or that it has ceased to be effective as an instrument of macroeconomic policy. The Bank of England, HM Treasury and the Debt Management Office (as a Treasury agency) need to coordinate the management of the public debt at all times, so that the state’s transactions in public debt help in maintaining a low and stable rate of money growth.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Additional asset purchases, ideally in private assets.

UK Consumer Price Index (CPI) inflation remains above the 2% target. It is unlikely now to fall below that level until the end of 2013 given larger-than-expected increases in domestic energy prices and the effect of the government’s decision to hike university student tuition fees. Does this invalidate the Bank of England’s decision to continue with ultra-easy monetary policy? A gaggle of commentators continue to argue that the explosion of the Bank’s balance sheet represents a major threat to price stability in the UK. Based on a crude version of the quantity theory of money, this view should be refuted with vigour – broad money, the variable that is relevant for nominal demand and ultimately inflation (M4ex in Britain’s case) has barely grown over recent years. Monetary indicators do not suggest that medium-term inflation will exceed the Bank’s target. If anything, absent a swift pick-up in UK broad money growth (which remains unlikely without another large dollop of asset purchases), monetary data continue to suggest downside risks to price stability.
Concern about inflation, such as it is, stems from the real side of the economy. Output has been broadly flat over the last couple of years. Survey evidence suggests activity is growing but only just. Although real GDP expanded by 1% between the second and the third quarters this figure was heavily distorted by the loss of working days in the second quarter caused by the Diamond Jubilee and the August Olympics. There remains considerable debate about the causes of this weakness. Does it reflect permanent supply-side damage which has worsened the trade-off between output and inflation? Is it caused by temporary factors which have depressed effective supply? Or is it simply caused by insufficient demand? Undoubtedly, all three explanations are relevant. Amongst UK policymakers there is a growing sense that the weakness of UK output is a supply-side phenomenon, and that it is likely to be permanent. The MPC, for instance, recently revised down its expectations for UK growth in the medium-term and argued that underlying productivity, which has been extraordinarily weak in recent years, would only expand slowly in the years ahead. This is a notable admission – the Monetary Policy Committee (MPC) not only believes that the crisis has had a large one-off effect on potential output, but also that it will constrain potential output growth over the medium-term.

Yet, the MPC also places weight by the view that demand and potential output will move together over the years ahead; i.e., that the weakness of productivity is in large part due to effective supply failures and sluggish demand. If so, a failure to stimulate demand sufficiently today will cause lasting and avoidable supply-side damage. MPC members are right to acknowledge the limits of asset purchases, and monetary policy more generally – monetary action cannot bring about the necessary real adjustments in the UK economy and elsewhere. However, the MPC, and other UK policymakers, are increasingly being gripped by policy defeatism. In the aftermath of a severe banking crisis, the feedback loops between demand and potential output are likely to be much more powerful than in normal times. Overall macroeconomic policy must err on the side of doing too much in the current environment. In light of the planned fiscal tightening, the heavy-lifting must be done by the Central Bank. Ideally, this would be supported by an easing of capital and liquidity restrictions on UK banks, which although desirable in the long-term, are counterproductive in the current environment. The transfer of accumulated coupon payments on the BoE’s gilt holdings to HM Treasury represents an additional degree of monetary accommodation. As the funds are transferred, the government’s need to issue gilts to fund the budget deficit will be reduced – this should boost broad money by an equivalent amount and work in a similar manner to Bank of England asset purchases. The benefits of the Funding for Lending Scheme (FLS) should also filter through to overall monetary conditions in the months ahead. It is worth waiting to see how much support the scheme provides. Monetary policy will also have to respond quickly if conditions in the Eurozone worsen. On balance, however, additional monetary ease is likely to be needed, even if the Euro area muddle-through continues.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Maintain asset purchases at £375bn; only increase the total to offset declines in M4ex.

We live in a world where the monetary transmission mechanism works well most of the time, but at certain times it fails. Keynes called this problem ‘magneto failure’ (i.e., comparable to the failure of the electrical system in a car). What Keynes meant was that in a modern economy broad money is created mainly by commercial banks making loans, not by central banks creating bank reserves. In normal times, the rate of growth of broad money is a good guide to the rate of growth of nominal spending. However, when households or firms or financial institutions are reluctant to borrow – as they tend to be after a bubble has burst, and when, in addition, banks are reluctant to lend, then the monetary transmission mechanism does not work. Under these conditions, no matter how low interest rates fall, the reluctance to borrow and lend may frustrate the authorities’ wish to maintain adequate rates of money growth to ensure full employment GDP.

In Keynes’ 1930 Treatise on Money he argued for extreme measures of monetary expansion (“monetary policy à outrance”), or QE as we would say today. “These extraordinary methods are, in fact, no more than an intensification of the normal procedure of open-market operations. I do not know of any case in which the method of open-market operations has been carried out à outrance.” However, he had concluded by his 1936 General Theory that the authorities would either not do this (“Central Banks have always been too nervous hitherto”) or that the economy could remain far below full employment for extended periods even with such measures. Consequently Keynes came to the view that the economy should fall back on government borrowing and spending to ensure adequate aggregate demand at such times of ‘magneto failure’.

Central banks and government Treasuries face exactly the same dilemmas today. On the one hand, the Bank of England, the US Federal Reserve and the European Central Bank (ECB) have all been expanding their balance sheets. The Bank of England and the Fed have done this mainly by adding to their holdings of securities, while the ECB has done it mainly by making loans, and yet real GDP growth in each area remains far below desired growth rates and levels, while unemployment remains disappointingly high. In general, central bankers are nervous about going to extremes and flooding their economies with excess money as this would arouse fears of inflation. Similarly, and on the other hand, governments have been increasing their borrowing and spending in order directly to boost incomes, output and employment. Yet they, too, are acutely nervous of excessively increasing their indebtedness beyond some undefined limit in case investors react by rejecting their debt offerings, driving up government bond yields, and having knock-on effects on other public and private borrowing costs.

If this is the intellectual backdrop to the debates on QE and austerity in Britain today, what should policy makers do – follow the Keynes of 1930 or the Keynes of 1936?

On the monetary side the key question is: what is the appropriate rate of growth of broad money? If Keynes were alive today he would surely say that ‘animal spirits’ were depressed and the reluctance of households and financial institutions to borrow and the reluctance of banks and others to lend was inhibiting the rate of money growth as a consequence. On the face of it, this means that there is a strong case for continued asset purchases by the central bank. However, the problem here is that while M4 declined by 3.5% in September compared with a year earlier, M4ex (which excludes intermediate other financial corporations’ holdings) increased by 4.1% over the same period and by over 7% p.a. on a three month annualised basis. This was probably, in part, due to the £50 billion asset purchase programme initiated in July.

Since CPI inflation has recently increased to 2.7% in October, the Bank should probably err on the side of caution for a while. Having made the serious error of presiding over excessive monetary growth between 2004 and 2009 (with M4 growth mostly in the range 8% to 14% p.a.), the Bank of England should now be much more careful to maintain broad money growth below 8% for the foreseeable future. In my view, therefore, the Bank was probably correct to suspend asset purchases in November. Nevertheless, this question should be reviewed if money growth shows signs of weakening in future. Against this background, the Bank of England should hold rates stable at ½%, but be prepared to undertake additional asset purchases if M4ex growth falls abruptly.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; gradually withdraw QE.
Bias: To steadily raise Bank Rate to 2%, then pause to review.

The economy will grow faster over the medium term if interest rates are closer to the natural rate – which probably sits at around 3.5% at present and hopefully will rise to about 5% over the next five years. With positive GDP growth last quarter, the MPC has another window of opportunity to raise rates. With inflation rising again, it should find that straightforward to explain in terms of the inflation target, insofar as that is still a relevant determinant of policy – i.e., very little. A rise of ½% initially then increments of ¼% to ½% each month until 2% is reached would provide an initial phase of normalisation.

QE was originally envisaged as gradually phasing itself out as coupon payments came in and bonds were redeemed. With the Treasury's decision to take £37bn in interest payments as a notional ‘profit’ on QE - notwithstanding the fact that the scheme currently stands to lose £48bn on a hold-to-maturity basis - the Bank of England faces a situation in which its original intention to withdraw £37bn of QE automatically next year will not be realised, unless there is an explicit decision to do so. Without such a decision, QE would only be withdrawn as bonds are redeemed or, alternatively, if bonds are sold into the market. However, the latter course would surely result in a significant fall in bond prices. There has already been too much QE. Nevertheless, it would shake confidence to explicitly withdraw QE at this stage by selling bonds. It would be better to allow QE to be phased out gradually by retiring the money of coupons as they are paid and for the Treasury then simply to make its standard claim on the profits of the Bank. This should be done.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

Unfortunately, it is difficult to talk about monetary policy today without referring to regulatory policy. These two branches of policy will now be put under one roof, with the new Governor of the Bank of England in charge of both. It is hard to feel much confidence in the future conduct of either branch.

Looking over recent events, we observe that inflation has been above its target for several years. It was forecast to come back below 2% by the end of this year, but it now looks as if it will rise again towards 3% or more over the next twelve months. The Bank’s response to this further failure of control is to blame ‘individual price rises’ yet again; this time it is university tuition fees besides the old favourite of utility prices. Of course any month’s inflation figure is bound to be the result of some individual price rises but the point about higher inflation is that this is the way it always presents itself. The Bank has again taken no action in the face of this deteriorating inflation outlook. True, it has not done any further QE but neither has it ruled out more QE. As it has noted, the ceding to the Treasury of the debt interest on the gilts it has acquired represents a monetary loosening in the sense that it allows the Treasury to issue less gilts to private lenders than otherwise – it is as if the Bank had done this much QE and bought gilts issues to this amount.

It is now hard to see the Bank as independent of the Treasury and this government. The implicit ‘deal’ had been that: a) there would be fiscal tightening; b) this would be ‘offset’ as far as possible by monetary loosening, regardless of the inflation developments; and c) there would be extensive regulative tightening of the banking system. The Bank is a wholly-owned subsidiary of the Treasury so none of this is new. What is new is the subservience over the one part of the Bank’s remit where it was supposed to have ‘instrumental independence’ – viz. the targeting of inflation. The Bank was to be the outward manifestation of the de-politicisation of inflation, the keeper of the new anti-inflation consensus, much like the Bundesbank once was in Germany. Instead, it has neglected its credibility and inflation is adrift in a potentially dangerous way.

The one thing that is holding inflation down is the other major failure of this policy: the regulatory attack on the banking system that has resulted in the collapse of lending, especially to small companies. The UK’s ramping up of the Basel III requirements for capital and other tiers has made lending highly expensive, particularly for borrowers with high risk status. The point has repeatedly been made by Per Kurowski that Basel biases lending heavily away from risky borrowers anyway, since at the margin banks must not only suffer the extra risk of these loans but also load on the extra tier-capital costs the loans imply. Thus banks are incentivised only to lend to ‘low-risk’ parties – viz. certain governments and at a pinch top corporate borrowers.

So we have the worst of all worlds: a paralysed banking system awash with liquidity which it is unwilling to lend, so holding back growth in the economy. However, the fears aroused by this liquidity are undermining the inflation target’s credibility. It is said that we need all this regulation to stop future crises. But the evidence we have been able to gather in our recent research on the US, the UK and the Euro-area (see my academic page on www.patrickminford.net) suggests that crises will happen anyway and that if we have a banking system that is appropriately active in lending such crises will often involve the banks too. Furthermore, the UK as one of the great banking centres will necessarily have large foreign asset and liability positions: this has been its role through the ages and a major way the UK has earned its GDP. The liabilities are mainly deposits and the assets loan positions around the world. The Bank of England has been proud to be the overseer of this activity in the past. Now, and partly under orders from a government ignorant of such things, it is presiding over the ruin of this system in what can only be seen as a colossal loss of nerve.

We need to remind ourselves that efficiency in banking suggests that the margins between deposits and loan rates be kept to the minimum. Individual risk is not social risk in lending; socially there is pooling of individual risks. Society is best off when lending is cheap and priced as competitively as possible – see recent papers on the role of banking and regulation by Anton Korinek of the University of Maryland. Recent regulatory action is driving us further and further away from this social objective. It is ironic that the UK government, which should be supporting its major industry, is helping to organise its destruction.

It is said by the Vickers Commission that the investment banks must be deprived of access to deposits that are insured by the taxpayer; hence the proposed ‘ring-fencing’, a sort of bureaucratic Glass-Steagall arrangement. Yet the commercial banks used these deposits to make loans that went as badly wrong as did the investment banks with their more exotic loans. Deposit insurance is there to prevent runs on banks by making small depositors feel secure. Banks still lose money if they make poor loans, surely a powerful incentive against the ‘moral hazard’ of being secure about keeping their depositors. The main implication of the social optimum is that we need competition between banks, to drive down rates and encourage lending again. Bureaucratic schemes like ‘Funding for Lending’ cannot substitute for such incentives.

When policy is so badly adrift, it is hard to know what advice to give for that branch of it that merely deals with monetary policy. Some SMPC colleagues have naturally been impressed by the banking paralysis and the slow growth in the economy of which this paralysis is an important cause; these have prompted them to recommend keeping rates low and open the QE taps more. Yet it is obvious that these actions have not led to any rise in lending nor have they produced (as a result of this failure to stimulate lending) a healthy rise in the money supply. All that has been achieved is a very low cost of government borrowing and record low returns to savers on safe assets.

Getting monetary policy right, however, could lead to an improvement in regulatory policy, since then the government would realise that it could not rely on monetary ease to substitute for excess regulative enthusiasm. It would be forced to ease the regulative burden by the need to get lending and money supply growth and so growth in demand going up again against a backdrop of rising interest rates and reversed QE.

It is for this reason that interest rates should be raised forthwith by ¼% with a bias to raise Bank Rate further in a steady manner. QE should be stopped and reversed steadily over the next twelve months. These actions should be taken to remove the future threat to inflation posed by the QE-induced liquidity overhang; and by the loss of Bank credibility over its inflation target. As monetary policy is returned gradually to normality, excess regulative burdens should be removed from the banking system and competition reintroduced in a manner mimicking the entry of building societies into the banking high street in the 1980s and foreign banks in the 1990s. To help this process on its way, the Treasury should dispose of its stakes in Lloyds and the Royal Bank of Scotland group by breaking these huge banks up into competing parts.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: Avoid regulatory shocks; break up state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

It is increasingly likely that the 1% increase in UK GDP in the third quarter – which was confirmed by the revised estimate released on 27th November – was an aberration that largely reflected a catch-up from the negatively distorted second quarter figure. The very sketchy output and expenditure data for the fourth quarter suggest renewed weakness, although a lot will hang on the strength of household demand over Christmas. The UK is not alone in this fourth quarter faltering, however, and recent figures show a closeness of fit between the annual increases in UK real GDP and that in the wider OECD area which suggests that the British economy is to some degree being swamped by the turbulent events happening overseas. This is unfortunate because international indicators suggest that activity in the leading industrialised economies lost momentum in the fourth quarter. One example is the latest Munich based CES Ifo ‘World Economic Climate Indicator’, which continued to fall in 2012 Q4, albeit only slightly. The decline was due to less favourable assessments of the current situation and reduced expectations for the outlook over the next six months. The largest drop in the CES Ifo measure was recorded in Western Europe, and there was a more mixed picture in North America. However, even Asian respondents reported that current economic activity remained at an unsatisfactory level. The conclusion drawn by the CES Ifo economists was that the world economy was currently treading water. This seems to be as fair an assessment as any of the international background in which the UK economy is trying to operate.

Turning now to domestic matters, this commentary was prepared before the announcement of Mr Osborne’s 5th December Autumn Statement and the release of an updated set of forecasts from the OBR – the first time that these will have been updated since the 21st March Budget. There is little point in speculating about the details of the Autumn Statement, given that it will be announced only a few days after this note is released. However, it is clear that the March Budget forecasts for the public finances have proved overoptimistic and that the Chancellor’s fiscal policy strategy is badly off course. The fundamental reason is that, in practice as distinct from rhetoric, Mr Osborne has been attempting a Type 2 fiscal retrenchment predominantly weighted towards tax increases, rather than a Type 1 strategy in which spending discipline takes priority and taxes are not raised. This explains the sogginess of national output – although the situation has clearly not been helped by the weakness of many of our trading partners – and the unfavourable nature of the current output/inflation trade off. Unfortunately, the Chancellor also appears to have failed to get a grip on departmental spending. In particular, civil servants appear to have been running rings around Mr Osborne when it comes to their reward packages by using all the re-grading and other tricks they first learnt during the incomes policies of the 1960s and 1970s. It is questionable whether this situation can be turned round in time to fight a successful election campaign in 2015. Fundamentally, the Conservatives wasted their thirteen years in opposition, when they should have been devising a market-based, pro-growth strategy. They have since been learning from their mistakes while on the job but have done so too slowly to get a grip on events.

The contrast between the strong performance of the Canadian economy over the past five years and the worse performance of the British one may be one reason the Bank of Canada Governor, Mark Carney, has been appointed to follow Sir Mervyn King in June 2013. However, while the Bank of Canada clearly performed well in avoiding the worst excesses of the pre-2007 international credit boom and the subsequent crash, it was helped by a less highly-competitive and internationally-exposed banking system than Britain’s and by a far more responsible fiscal policy background. The latest figures from the OECD indicate that General Government outlays amounted to 39.4% of Canadian GDP in 2007, compared with 43.9% in Britain. Government outlays then soared to 48.7% in Britain in 2012, according to the OECD, but were still only 41.8% in Canada. The Canadian government had enjoyed a financial surplus of 1.4% of GDP in 2007 and its General Government Financial Deficit appears to have been a modest 3.5% in 2012. In contrast, Britain had already suffered a General Government Financial Deficit of 2.8% of national output in 2007 when it should have been running a substantial surplus on normal Keynesian demand management grounds. This deficit figure was still 6.6% in 2012, the ratio having peaked at not quite 11% in 2009. Fortunately, the strong international reputation of the new Governor will add to the credibility of UK macroeconomic policy. This is important given the poor outlook for fiscal consolidation and the need to avoid a collapse in overseas confidence ahead of the next general election. However, Mr Carney may have to undertake a major institutional re-building of the ‘old’ parts of the Bank, which failed badly in 2007 and 2008, as well as having to integrate its new regulatory responsibilities.

Meanwhile, it has been revealed by the independent Stockton review into the forecasting capability of the MPC, mounted on the Bank’s website on 2nd November, that the Inflation Report forecasts have been largely generated by a new macroeconomic model – known as ‘Compass’ – since November 2011. This has replaced the previous Bank of England Quarterly Model (BEQM) that had underpinned the Bank’s forecasting efforts for many years and was heavily criticised in the author’s May 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). One of the main criticisms of BEQM in 2007 was that it contained a highly simplistic model of monetary policy in which only one short-term rate of interest was included and that there was no representation of other traditional monetary tools such as funding policy. According to the Stockton review, Compass represents an even more parsimonious Dynamic Stochastic General Equilibrium (DSGE) approach than BEQM, with only sixteen variables at its core. As far as one is aware, a detailed technical account of the new model has yet to appear in the public domain. However, it is unlikely that any of the so-called unconventional monetary policy tools, such as QE, now being employed by the Bank can be represented in the context of such a small model.

Another issue that probably cannot be encompassed in the new Bank model is the effects of negative regulatory shocks to the supplies of money and credit which have caused so much concern on the SMPC. Here one can only express agreement with Patrick Minford’s comments in this note and add four minor points. First, the payment of state-backed deposit insurance should be limited to a number of say 90% rather than the present 100% up to £85,000. This would encourage prudence on the part of depositors. Second, the most senior bank executives should have unlimited personal financial liability. There is ample historic evidence that this would remove a major source of moral hazard where the behaviour of senior executives is concerned. Third, because all the major banking groups are the product of numerous mergers over many years, the simplest approach to the ‘too big to fail’ problem would be to break them up into their original constituents using normal anti-monopoly legislation. Finally, some arrangement would have to be made to allow the demerged banks to share their computer systems for cheque clearing etc. on a fair basis until they have time to develop their own. This could probably be done by voluntary agreement. However, there might have to be an official arbiter on standby for cases of disagreement.

The more one thinks about the Chancellor’s 9th November decision to transfer gilt coupon payments received by the Asset Purchase Facility (APF) to HM Treasury, the harder it becomes to understand the political thinking involved. What may have happened is that the internal briefings on the forthcoming 5th December Autumn Statement indicated that the public finances are not coming right and this was a book cooking attempt to bring cash receipts forward – at the risk of an offsetting or larger reverse flow in future – in order to make the figures look better or, alternatively, too complex for anyone to understand. However, that means less cash flow in future, which is odd if one is thinking in terms of a 2015 election. The PSNB was already being pushed down by the once-and-for all £28bn receipts from the Post-Office pension fund in the present financial year. Even before the 9th November announcement, there was the likelihood of a sharp borrowing rebound in fiscal 2013-14 given the lack of progress in reducing the underlying deficit. The fact that the Post Office and APF announcements have artificially reduced borrowing by a total of £65bn in 2012-13 at the cost of large extra financial commitments in later years has substantially increased the likelihood that the government will go into a May 2015 general election with the PSNB way off track. Under these circumstances, massaging down this year’s borrowing at the expense of even worse figures in the run up to the election seems political suicide.

Meanwhile, the latest inflation figures show that the target CPI increased by 2.7% in the year to October, compared with 2.2% in September, while the all-items RPI and the old RPIX target measure increased by 3.2% and 3.1%, respectively. The ‘double-core’ retail price index – which excludes mortgage rates and housing depreciation and is the most historically consistent inflation measure – rose by 3.2% over the same period, compared with the 2.7% recorded in September. Producer output prices, which some people consider an early indicator of consumer prices, showed an unchanged year-on-year inflation rate of 2.5% in October, while the yearly rise in producer output prices excluding food, beverages, tobacco, and petroleum products accelerated slightly to a still modest 1.4%, compared with 1.2% in September. With the annual increase in economy-wide earnings a modest 1.8% in the year to the third quarter, there seems to be little risk of UK inflation accelerating too far in the immediate future, as long as confidence in sterling holds up, whatever one fears about the longer term inflation risks associated with current fiscal and monetary policies.

As far as the December Bank Rate decision is concerned, the temporarily reduced uncertainties in Continental Europe suggest that there is a window of opportunity to raise rates and that it is now time to introduce a modest ¼% hike in Bank Rate. The medium-term aim should be to get Bank Rate into the 2% to 3% range at which it re-engages with the money market rates that determine borrowing costs. The 4.2% annual rise in M4ex broad money in the years to both August and September, and the signs that broad money growth is accelerating, suggests that there is now a much weaker case for holding Bank Rate at the low emergency levels appropriate when the authorities were acting as a lender of last resort. Mr Osborne’s recent grab for the interest savings generated by QE has confirmed that such free funding has generated political moral hazard and allowed the Chancellor to avoid the hard public spending decisions required to stabilise the official finances. QE should be strictly reserved for lender of last resort purposes from now on and not employed as an instrument of day to day monetary policy.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

The weakness of corporation tax receipts is a warning not to read too much into the 1% rebound in third quarter GDP. The fiscal outlook for the economy has worsened appreciably this year, not so much because of weak growth as the legacy of the latest inflationary lapse. Indeed, public sector services made a chunky contribution to economic growth in the third quarter. The evidence is accumulating that more can readily be achieved with less (fewer employees) in the public sector, which can hardly come as a surprise. Unfortunately, productivity has been weakening in a number of other private sectors, including financial services.

Of even greater concern is that the impetus behind corporate investment has faltered again. This partly reflects the depressing messages from the Eurozone economies, but possibly a more general perception that the developed world is locked into a low-growth phase. The downgrading of future capital expenditure requirements may help to explain why asset lives are lengthening throughout the developed world and why so many global corporations are willing to return cash to shareholders. What does all this mean for the conduct of monetary policy?

The Bank of England must not lose sight of its goal of normalising short-term interest rates. Running policy on the basis of a permanent emergency is sending a progressively negative message to the entrepreneurial sector. The more reckless the policy, the greater is the risk to the real return on capital spending. If there is a role for ‘forward guidance’, it is to reassure of the Bank’s determination to take rates back to the region of 2% to 2.5% over the next two years. For now, the economy could do without any more tinkering. QE has reached the end of the road.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate.

The immediate background to the next monetary policy decision is Mr Osborne’s December statement on fiscal policy. This will be for a British economy that remains flat and has a high and still rising level of debt – the latter constrains any scope for a fiscal stimulus. The only good news for monetary policy is that smoothed inflation has fallen somewhat, despite the uptick in October, due to energy price rises a year ago now dropping out of the year-on-year CPI.

The main problem for the UK economy is a lack of demand. Household expenditures are still suffering from the sharp rise in the savings rate in 2008 as households tried to reduce debt. This has been sustained by households saving for big ticket items rather than borrowing as previously. Investment expenditures and house building also remain depressed. These are both significant constraints on the effectiveness of monetary policy and QE. Historically low interest rates and plentiful bank reserves have failed to offset rock-bottom household and business confidence. To make matters worse, exports have fallen in 2012 due to recession in the EU – a main export market – and imports have risen. A steady appreciation of sterling during 2012, reflecting in part the perception that the UK is a safe-haven, has contributed to this worsening of the current account.

Falling government expenditures have added to stagnant aggregate demand. Even so, it is worth noting that in 2011/2012, as a proportion of GDP, the primary deficit has continued to increase as revenues have fallen more than expenditures. The consequent continuing rise in government debt – when combined with the fear of having to pay much higher interest rates as a result – remain a major constraint on the government’s willingness to borrow more to finance a substantial fiscal stimulus.

To make matters worse, according to recent public statements made by various members of the MPC, including the current Governor, there is little that monetary policy can do to provide a stimulus. Interest rates are already close to their lower bound and bank lending is no longer liquidity constrained. Furthermore, a flatter term structure due to further QE is highly unlikely to induce more private sector borrowing for business investment or for household expenditure. Significantly, QE is not much different from new government borrowing and therefore has done little more than offset the negative effects on the economy of this additional borrowing. It is worth noting that the lower-bound constraint on interest rates shows up in simulations of macroeconomic models as a negative monetary policy shock, implying that monetary policy is tighter than it would be if unconstrained.

A recent announcement is that £37bn in interest payments to the Bank of England arising from its purchases of government debt from the market will be returned to the Treasury. How to interpret this in terms of its effects on monetary and fiscal policy depends on how the ONS decides to incorporate it into the national accounts. Assuming that the interest payments are still included in the government budget constraint, then this is an increase in the money supply which will reduce the deficit and hence new debt issuance. The consolidated government budget constraint, which combines the government and the Bank budget constraints, is unaffected, however.

With monetary policy ineffective at present, there has been mention of an even more unconventional monetary policy: i.e., making a so-called ‘helicopter’ drop of money. This is a theoretical concept associated with Milton Friedman and the printing of money. The attraction is that it puts immediate spending power into the hands of income- and credit-constrained households who should then spend it, in theory. In practice, this could be achieved by a one-off cut in taxes or increase in benefits that is money, and not debt, financed. The apparent objection of the Bank of England is that it would be inflationary and would destroy the hard-earned credibility of the inflation anchor, probably the most important achievement of monetary policy since 1992. Although it would be expected to raise inflation temporarily, this fear would only be justified if the expansion of money growth were permanent and not one off. It may, therefore, be worth giving this serious consideration in order to get more growth. Such a policy would not, of course, be pure monetary policy; rather, it would remove the separation of fiscal and monetary policy of recent years.

Comment by Trevor Williams
(Lloyds Bank Wholesale Markets)
Vote: Hold Bank Rate.
Bias: Neutral.

In the minutes of the November meeting, the MPC highlighted the continued fragility of UK economic recovery. Whilst overall policy remained unchanged this month, the MPC is clearly watching domestic and global events carefully and is poised to react as and when necessary. However, the first question that arises is which way are the current economic trends pointing? In summary, they seem to be pointing lower where activity is concerned. However, there then comes the follow-up question of how to ease most effectively? A new approach may arrive with the new Bank of England governor, Mark Carney or, perhaps, not.

The MPC meeting saw only one vote for a further £25bn increase in QE, which was largely in line with market expectations. The 8 to 1 majority in favour of maintaining QE at its current levels was undoubtedly influenced by the early November announcements that the £37bn accumulated net interest on gilts that the Bank already held was to be transferred to HM Treasury. The effect of this was deemed to be akin to QE, negating the need for further monetary easing, according to the minutes of the MPC November meeting. However, that does not mean that further QE is completely off the agenda. The MPC did not rule it out. Instead, the monetary authorities were willing to assess the impact of programmes like the Government’s Funding for Lending Scheme, which appears to be finding some traction in particular in household borrowing.

Following wide consultation with a number of financial bodies, the MPC was explicit in ruling out any reduction in the bank rate from the current ½%, which was widely expected. It noted that a cut would hit the profitability of financial firms, further undermining confidence and future economic recovery. Regarding inflation, the effects of increases in household energy costs, rising fuel duty and higher tuition fees led the MPC to anticipate that the rate of inflation will remain above target over the coming year. Nevertheless, they project a return to around the 2% target once these pressures subside.

On that basis and considering the potential for a slowdown in output in the UK and the Eurozone in the final quarter of this year, the MPC acknowledged that there may be a case for further monetary easing in 2013. Despite the higher near-term inflation profile, the MPC noted that ‘a case could be made for a further easing in monetary conditions’. The minutes said that undertaking further stimulus could help to discourage ‘any further appreciation of sterling’ and ‘might help to avoid lasting damage to the supply capacity of the economy’.

My recommendation is that policy stays on hold, but if inflation were to approach last year’s levels of 5%, rates might have to be increased, given the damage that inflation has done to real growth. Nevertheless, this outcome seems highly unlikely as weak growth in Europe – and only a modest recovery elsewhere – do not suggest that we are on the cusp on an inflation surge. The question of what is damaging UK growth cannot be addressed by monetary policy alone. Also, the question of balance sheet adjustment – whether it is a supply of credit problem or a demand for debt problem or neither – cannot be addressed by interest rate policy. Hence, low rates may be here for some 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 poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Wholesale 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 exactly nine votes are always cast.

Sunday, November 04, 2012
IEA's shadow MPC in 6-3 vote to hold rates
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 16th October, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Britain’s Bank Rate should be held at ½% on Thursday 8th November. Among the dissenters, one wanted to raise Bank Rate by ¼% and another wished to see a ½% increase while – at the opposite extreme – one shadow committee member thought that Bank Rate should be reduced to a nominal 0.1%.

Looking further ahead, six SMPC members believed that Bank Rate should be raised in the near future, provided there were no further major shocks arising from overseas, and seven said that there should be no additional tranche of quantitative easing (QE). However, two members voted to increase the stock of QE by £50bn and £200bn, respectively. In addition, several SMPC members argued that QE would be more effective if it included the purchase of more private sector assets.

There was a widespread view on the IEA’s shadow committee that a substantial part of the UK’s poor growth performance since 2008 reflected supply-side weaknesses, including those caused by the hugely increased share of government and government-financed expenditures in national output since 2000, and that these weaknesses could not be overcome by injecting more nominal demand into the system. Unfortunately, the contrast between the weak output figures and the stronger trend showed by the labour market data up to 2012 Q2, made it hard to know how much spare capacity was available. However, the strong third quarter GDP figures, released after the SMPC gathering on 25th October, suggest that the underlying growth trend currently may be the equivalent of some 1¼% per annum.

Minutes of the meeting of 16th October 2012

Attendance: Roger Bootle, Jamie Dannhauser, Anthony Evans, Andrew Lilico, Kent Matthews (Secretary), David B Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.
Apologies: Philip Booth (IEA Observer), Tim Congdon, John Greenwood, Ruth Lea, Patrick Minford, David H Smith (Sunday Times observer), Mike Wickens.

Chairman’s Comment

The Chairman said that he was pleased that one of the newer and younger members of the SMPC would be doing the background presentation that evening, for the second successive quarter. Any committee that had maintained as much of its original membership as the SMPC had done since its establishment in July 1997 – he noted that no less than four founder members were physically present that evening – needed an infusion of new blood from time to time. He added that the SMPC was not a closed shop and that applications to join the committee from qualified younger monetary economists would be welcomed. The Chairman then invited Jamie Dannhauser to give his assessment of the global and domestic monetary situation.

The Global Economy

Jamie Dannhauser referred to his presentation which showed that the recovery in world trade had been slower than that which had followed any other world trade downturn since 1974. Global industrial investment had slowed. The savings and investment figures for the advanced and emerging economies indicated a history of excessive saving and overinvestment in the global economy. Fiscal consolidation had continued in the developed economies that had seen recent deficits in excess of wartime experience. World monetary and credit conditions remained weak and the lending survey of banks in emerging markets showed gradually tightening credit conditions. The Chinese economy had experienced a sharp growth slowdown. A hard landing had already occurred and there would be little policy stimulus until after the leadership changeover in China. There were some signs of improvement in the current quarter but underlying growth in China could remain weak for some time.

Recent work by the International Monetary Fund (IMF) on fiscal multipliers indicated the potential impacts of the expected US fiscal squeeze in 2013. The consolidation programme was taking place against the backdrop of easing credit conditions. The commercial banks in the USA had increased credit availability. However, the growth of US broad money on the M3 definition, which was currently around 4% year-on-year, had been boosted by portfolio outflows from bank debt into monetary assets, which suggested an increase in money demand rather than in money supply. There remained other reasons for caution, one of which was the still low level of real business lending relative to other post-war recoveries. Another reason was that US banks were still heavily reliant on foreign funding from non-banks.

In the Eurozone, lending to the public sector continued to grow but lending to the non-bank private sector had fallen. Broad money had grown moderately but the European Central Bank (ECB) lending survey indicated a continued tightening in lending standards. To the extent that the Spanish bailout package imposed even deeper fiscal retrenchment, it could be a disaster for Spain if the country was to sign up. It had the validity of a treaty and Spain would be stuck in an agreement that would be undeliverable with the outcome of a potential walk-away by Germany.

Bank lending rate spreads to firms and households have continued to widen and coincident indicators of activity in the Eurozone continue to point downwards. Nevertheless, money market conditions were much improved as evidenced by the continued decline in the Libor-OIS and FX swap spreads.

UK Monetary Conditions

In the UK, the underlying monetary picture remained weak. Spreads on syndicated loans had been rising. Nevertheless, companies were sitting on cash. The corporate liquidity ratio had been rising and there was no issue of a lack of access to credit by the company sector as a whole. Spreads on mortgage products had increased in the past year and were now in the range of 300 to 500 basis points (bps). Meanwhile, the marginal cost of sterling funding to UK banks had been falling. The Bank of England credit conditions survey indicated that, except for mortgage loans, credit availability was unlikely to change much in the coming quarter.

The Funding for Lending Scheme (FLS) represented a sizeable funding subsidy, which should encourage a greater supply of credit. How big a monetary stimulus it would provide remained unclear, however a Financial Services Authority (FSA) rule change had allowed banks to use their existing capital base to support new loans under the FLS which effectively imposed a zero risk-weight on new loans funded by the scheme.
UK Activity and Inflation Trends

Activity indicators showed a stagnant profile for the British economy. The UK economy was bumping along the bottom and experiencing zero-growth but there was probably no double-dip recession. Firms were prioritising cash on the balance sheet. UK goods exporters were benefitting from the weakness of sterling. However, this was being offset by declining exports from the services sector.

Household net worth and the savings ratio had risen but the story was less of a balance sheet repair than a labour market one. Employment intentions suggested a slowing in employment growth. Unit labour costs were rising and this would lead to deterioration in the jobs market if it continued. Real government departmental spending was expected to decline in absolute terms over the coming years. Fiscal multipliers under normal circumstances would be low but this was questionable in the current circumstances.

Inflation at 2.2% was marginally above the official target and was expected to rise in the coming months under the pressure of rising energy costs. The above-target outcome for inflation was entirely because of the pass through effects of increased costs. Underlying inflation was about 1½%. Inflation expectations on indirect and survey measures had fallen. While the recession had destroyed capacity, estimates of the output gap were probably in the region of 4%.

Discussion

Peter Warburton questioned Jamie Dannhauser’s conclusion that there had been over investment in the pre-2008 period, saying that the figures were based on a dubious adjustment for purchasing power parity (PPP). Jamie Dannhauser responded that he believed the figures were appropriate but would go back and check the basis on which they had been compiled. Akos Valentinyi said that the backdrop to the fiscal consolidation in the developed economies was the emergence of the sort of budget deficits previously only encountered in wartime. Jamie Dannhauser said that what was important was what the monetary offset would be.

Andrew Lilico and David B Smith then discussed whether the Chinese economy would slow down to in a similar way to the Japanese one, which had also enjoyed 10% plus real growth rates in the 1960s and early 1970s. The general view was that it would be another twenty years before China’s economy began to resemble the Japanese situation, although the longer-term demographic outlook for China was clearly not favourable.

Peter Warburton said that fiscal consolidation may not result in actual fiscal change. Jamie Dannhauser said that considerable political uncertainty existed about the fiscal consolidation programme in the USA. Akos Valentinyi said that the uncertainty of the fiscal consolidation extended to Europe with the problem of the democratic deficit in Greece, no structural adjustment was likely to occur.

As Roger Bootle had indicated that he had to leave by 6.30pm and time was pressing, the Chairman next asked him to make his comments before asking everybody else to cast their votes. These are listed in alphabetical order below. Because a full set of nine SMPC members had attended the meeting, there was no need for any votes in absentia this quarter.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Cut Bank Rate. Increase QE.
Bias: Carry on increasing QE as necessary.

Roger Bootle said that he was puzzled about the underlying truth of the economic statistics. In his experience, London did not feel like a city in recession. However, the outlook was not very good. There was no hope of an expansion in bank lending. Real disposable income would rise if inflation eased but the signs were that inflation would rise in the short term. The discrepancy between the stronger employment data and the weak GDP figures remained a puzzle and QE could be used more effectively to stimulate activity, in his view. He therefore voted to cut the rate of interest further to 0.1% and to increase QE by a further £200bn, to take the total QE stock to £575bn.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate. Do not extend QE.
Bias: To increase QE and expand asset purchases to include private-sector assets, specifically bank debt.

Jamie Dannhauser said that he was not as bearish as Roger Bootle, although he generally held a similar view. He said that he wanted to wait and see what the effects of the FLS would be. The stresses related to the Eurozone had fallen back but he remained deeply concerned about the ultimate resolution of the crisis. He added that he was concerned about the hysteresis effects of a stagnating economy. Jamie Dannhauser’s conclusion was that rates should stay on hold but QE needed to be extended to include non-bank private sector assets.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%. No QE.
Bias: To raise Bank Rate.

Anthony J Evans said that it looked as though a corner has been turned in the domestic economy but that the recovery would be like a barbeque – long and slow. Monetary policy had a role as a preventative but QE was now suffering from diminishing returns. Nominal GDP was increasing but this was largely through price increases. He said that this pointed to a supply-side problem. Inflation was set to rise. Monetary policy could still be useful if the situation changed and there was a genuine liquidity emergency. However, if interest rates were to return to normal at some point, they needed to be increased. It was unlikely there would be an ideal time to do this. Nevertheless, there was currently a window of opportunity and policymakers might also learn important lessons about the transmission mechanism from a moderate rate rise. Policy had to be rebalanced. He said that there should be no further QE and Bank Rate should be raised.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no further QE.
Bias: To raise Bank Rate.

Andrew Lilico said that policy makers missed the chance to raise rates in 2010 and early 2011 and now should be looking for every new opportunity that presented itself. The correct policy concern was to raise the medium-term rate of growth, not the short-term rate. There existed a real danger of unemployment rising: firstly, as firms shed low productivity employees, and, secondly when, inflation having risen, policymakers do finally act against it. Credibility was not just about what rate of inflation is expected but about the belief that, if inflation were to rise, the Bank would conduct appropriate policy to bring it down — such credibility had gone, and it would be expensive to get it back. He said that the economy could experience both rising inflation and rising unemployment. Monetary policy had long-since done all that it could, and there was a need to normalise as quickly as could be achieved without tipping the economy over into slump. He voted to raise Bank rate by ½% with no further QE.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate. No further QE.
Bias: To raise Bank Rate.

Kent Matthews said that there was growing evidence that this particular financial crisis had been followed by significant capacity destruction. Research published in the American Economic Review showed that financial crises could lead to permanent and unrecoverable output contractions. The problem for monetary policy was that, if the output gap was small as a result of a permanent contraction in output, then QE was not just ineffective but was also storing up an inflationary balloon that would eventually burst with negative consequences for future monetary policy.

Kent Matthews added that there was a need to return to a ‘normality’ in which real interest rates were non-negative. The question of when Bank Rate needed to rise was a matter of fine judgement. With each passing month, economic uncertainty provided further reasons for keeping interest rates where they were. Right now, the weakness of Europe dominated the short term position of the UK. However, interest rates would have to rise in the near future to bring the economy and economic policy back into the realms of normality. He said that he was less optimistic about a resolution to the Eurozone crisis, which would continue for the foreseeable future and economic uncertainty along with it. If the crisis were to worsen, it would be better for the Bank to have room to manoeuvre by lowering rates from a position of normality. Supply-side policy should be the medium-term objective of the government.

He said that he too wanted to give the FLS a chance to work. However, and if it looked as if the commercial banks were using the scheme to widen spreads and increase liquidity rather than to increase lending, the case for raising rates was strengthened. For now, Kent Matthews voted to maintain Bank Rate at its present position with no further QE.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate. No additional QE.
Bias: To avoid regulatory shocks, raise Bank Rate and hold QE.

David B Smith said that he had attended the Office for National Statistics (ONS) conference on the discrepancy between the output and employment data immediately before coming to that evening’s SMPC meeting. Furthermore, a paper dealing with the issue by Peter Paterson The Productivity Conundrum, Explanations and Preliminary Analysis had been placed on the ONS website that day (i.e., 16th October). Nevertheless, it still remained difficult to reconcile the weak GDP figures with the strong employment data. He added that his main concern about Roger Bootle’s call for a further substantial bout of QE was the political ‘moral hazard’ it gave rise to in encouraging fiscal fecklessness. He accepted that the immediate economic impact of further QE need not be inflationary provided that the broad money supply was constrained by other – but probably, inherently undesirable – means such as regulatory-induced credit rationing, which was where we were at present. He was also concerned that, if Roger Bootle’s proposal was implemented, the gilt-edged market would be so socialised that it would cease to function properly or be available as a normal implement of monetary policy thereafter.

David B Smith added that his recommendation was to hold Bank Rate, but with a bias to raise it in the near future, and that it was time to prepare the financial markets for a putative rate rise. He also said that there should be no further use of QE, except in a lender of last resort situation. The increase in government’s share of the economy, which had been accompanied by increased and damaging regulation of the financial and energy sectors, had slowed the growth of potential GDP. International growth studies suggested that the rise in the share of the economy devoted to public sector consumption since 2000 had knocked the growth of potential GDP down from 2¾% to 1¼% at best.

Current policy was dominated by the short term. If the Coalition was not prepared to tackle the fiscal crisis through a package of genuine public spending cuts and lower taxes, then it was essential that it did everything in its power to improve the supply side through other measures, such as deregulation of the labour and goods markets and tax simplification. He added that an open economy, such as the UK, which had experienced a current account balance of payments deficit of 4% of market-price GDP in the first quarter and 5.4% in the second quarter was not obviously suffering from a deficiency of aggregate demand relative to total supply, to put it mildly. For much of the post-War period, officials would have argued that the balance of payments equalled the Keynesian demand gap with sign reversed.

His final comment was that institutions did matter. Like a defeated army, the Bank of England now needed a thorough institutional overhaul and the choice of the new Governor of the Bank of England would be crucial in that respect. Monetary policy was discredited and a new Governor had to restore credibility to the Bank through rebuilding its existing institution as well as taking on its new regulatory responsibilities. However, he welcomed the story on the front page of the 10th October Financial Times that the Financial Services Authority (FSA) had been quietly relaxing its crucial capital and liquidity rules in order to stimulate lending. This suggested that regulatory policy would be less perversely pro-cyclical than it had been hitherto, with consequent benefits to the real economy.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate. No additional QE.
Bias: To raise Bank Rate.

Akos Valentinyi said that the coordination of fiscal and monetary policy was important but that growth before the crisis was above potential. Part of the downturn was the correction in output from this overshot position. However, there remained uncertainty about the size of the gap although his view was that there will be inflation pressure in the future. Political uncertainty also impinged upon policy and there was a case for keeping rates on hold in consequence. He voted to end QE and to raise rates in the near future.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate. No additional QE.
Bias: To raise Bank Rate and diversify QE into private sector assets.

Peter Warburton said that UK macroeconomic policy was at a dangerous juncture and risked coming apart at the seams. The whole presumption that it was possible for the Bank of England to operate an independent monetary policy was at stake if the Government were to steer away from fiscal normalisation. Subject to a re-affirmation of the fiscal policy course on 5th December, it was appropriate to leave monetary policy on a loose setting. Indeed, the case for an easing of banks’ capital constraints was mounting, given that these appeared to be binding on economic outcomes, particularly the achievable rate of real economic growth. Abstracting from a number of temporary distortions, it seemed reasonable to suppose that the underlying growth rate for the UK was in the region of 1%, much less than before the global financial crisis. The financial crash was part of the crowding out transmission mechanism.

Over the longer term, this constraint could be lifted by improved supply-side policies, but the concern in the short term was that attempts to stimulate economic growth would merely deliver high and unpredictable rates of inflation. Given the likely positive impact of the FLS, Peter Warburton believed that there should be no further asset purchases of gilts. These had created an undesirable boom in the gilts market, which had been exacerbated by foreign demand for bonds that were not contaminated by the situation in the Eurozone. Bank Rate should stay on hold while the FLS was being evaluated but there should then be a bias to tighten. The existing QE pool should be diversified into private sector assets.

Comment by Trevor Williams
(Lloyds Bank Wholesale Markets)
Vote: Hold Bank Rate. Increase QE by £50bn in November.
Bias: Neutral.

Trevor Williams said that the global economy was weakening and the challenges facing the UK remained as intense as at any time in the last year, with some risks predominating to the downside. Key amongst these was the weakness in our key export markets and the deleveraging by households and companies. Hence policy should remain loose for now. With the backdrop just described, the announcement of a further £50bn tranche of QE in November seemed appropriate. However, the increased QE needed to be concentrated on private sector assets rather than gilt-edged securities, as hitherto. Thereafter, policy should be kept neutral, with a bias to tighten should recovery become sustainable. The outlook for fiscal policy should become clearer after Mr Osborne’s 5th December Autumn Statement. However, an expansionary monetary policy looked as if it had to be one of the offsets to economic weakness until such time as recovery appeared more certain.

Policy response

1. On a vote of six to three the committee agreed that Bank Rate should stay on hold.

2. Six members said that Bank Rate should be raised in the near future and seven said that there should be no further QE activity.

3. Two members voted for an immediate rise in rates and one voted for a further cut.

4. Two members voted to increase QE and two voted to extend QE to include private sector assets.

Sunday, September 30, 2012
IEA's shadow MPC votes 6-3 to hold Bank rate
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent e-mail poll, completed on 25th September, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Britain’s Bank Rate should be held at ½% on Thursday 4th October.

Two of the dissenters wanted to raise Bank Rate by ½% immediately, while another desired an increase of ¼%. There was a further divergence with respect to quantitative easing (QE). Most SMPC members thought that QE should be held at its present level. However, there was one who wanted a phased withdrawal on counter-inflationary grounds, while another believed that additional monetary stimulus would be needed if the recent improvement in financial-market sentiment proved transitory.

The Draghi proposals for the Eurozone, which had led to the improved market sentiment, were believed to have bought time but not, necessarily, to have produced a permanent solution.

In addition, there was a body of opinion on the SMPC that the longer-term risks associated with current monetary policies were increasing and could lead to a damaging upwards ‘gear shift’ in inflationary expectations. The US Federal Reserve’s QEIII proposals were a particular concern because of their open-ended nature. There were also reservations as to whether the European Central Bank’s theoretically unlimited commitment to purchase peripheral Eurozone debt could be anything more than a gigantic bluff.

Most of the sixteen German Federal States were themselves net fiscal recipients. This meant that the Eurozone’s public debt stock was effectively being underwritten by Bavaria and, to a lesser extent, Baden-Württemberg, not Germany.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; continue with agreed asset purchase programme.
Bias: Additional monetary stimulus.

The release of the detailed ‘Draghi plan’, and the announcement of additional monetary stimulus in the US, has buoyed financial markets. Equities have rallied further. There have been even more dramatic moves in Eurozone periphery government bond markets. For instance, the yield on Spanish ten-year paper has fallen by nearly 100 basis points (1 percentage point) since the early September European Central Bank (ECB) meeting. There have been signs of further improvement in bank funding markets as well. An indicative measure of UK banks’ marginal funding costs for variable rate sterling loans has fallen further in recent weeks and is now around 150 basis points below its May peak. This could be due, in part, to actions by the Bank of England to ease funding pressures on UK banks. The Extended Collateral Term Repo (ECTR) facility has brought sterling London Inter-Bank Offered Rates (LIBOR) closer to the expected path of Bank Rate. The fall in sterling LIBOR-OIS spreads has been larger than that for other major currencies, consistent with a beneficial impact from recent Bank of England initiatives. The Funding for Lending Scheme (FLS) is unlikely to have had much effect on the market cost of funding. However, it will offer UK banks a major subsidy, the size of which will be linked directly to the quantity of lending to the real economy. Commercial banks with outstanding loans to UK households and non-financial businesses of some £1,200bn have applied for access to the scheme. Relative to what would have happened otherwise, it should reduce both the cost of credit and the degree of credit rationing, potentially to a substantial extent. This should boost demand and potential output, leaving the effect on inflationary pressures uncertain.

Upward pressure on global food and energy prices suggests the near-term path of UK inflation will be slightly higher than previously expected. The implications for medium-term inflation are, however, limited. Higher food and energy costs have occurred alongside softening emerging world growth and downward revisions to global growth further out. This suggests that they are driven predominantly by supply disruption. The net effect on UK domestic spending is likely to be negative to the extent that credit constraints are preventing the normal process of consumption smoothing. At a global level, demand may also be reduced – higher commodity prices generally transfer income to countries with lower spending propensities.

However, the most difficult monetary policy judgement relates to the Eurozone crisis, and the lasting effects of the ‘Draghi plan’. These proposals could have a dramatic impact on asset prices and demand in the near-term, if they manage to reduce uncertainty about the Euro’s future and the disaster premium that is evident in parts of the financial markets. A clear path to resolving the mess in the Eurozone would go a long way to lifting the cloud of uncertainty that hangs over the global economy, notwithstanding the widespread concern surrounding the ‘fiscal cliff’ in the US. The Federal Reserve’s promise of open-ended monetary stimulus, until its employment objective is achieved, is an important move. It would seem to be the first of many steps towards the more formal targeting of nominal demand.

However, downside risks remain significant. Although Europe has cleared two important hurdles – the German constitutional court ruling and the Dutch elections – successfully, there remain several still to jump. Thus, the progression towards banking union in the Euro area is already stumbling. The farce in Athens continues. Spain is yet to apply for a bailout, and therefore ECB bond buying. While it looks like it will get there soon, there is the potential for a bust-up between Madrid and Berlin further down the line. Mr Rajoy is adamant that he will not take orders from the Troika on fiscal policy or supply-side reform. However, he may have to, given that Spain looks set to miss its budget targets by some margin this year – the general government deficit appears to have been 9% of GDP in the first half of 2012, compared with a full-year target of 6.9% of GDP. Then, we come to Italy, where application for a bailout remains a distant prospect.

In short, the improvement in market sentiment may not be long-lasting. Much can still go wrong. Now is not the time for a change in the monetary policy stance. In coming weeks, it will be important to assess the initial effects of the FLS on banks’ willingness to lend and the durability of the post-Draghi recovery in sentiment and risk appetite. On balance, it is still likely that additional monetary support will be required in the months ahead. As noted in previous months, this is not simply because demand will be insufficient to close the output gap; but also because persistently weak demand will impose unnecessary long-term costs on the economy, by depressing Britain’s long-run supply capacity. In the aftermath of a severe banking crisis, when demand, potential supply and the economy’s sustainable level of output are closely intertwined, monetary policy should err on the side of doing too much.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼ %.
Bias: Hold QE.

It continues to be troubling how the Bank of England has switched from an explicit inflation target to an implicit nominal GDP growth target. This goes against one of the key principles of the present monetary regime, which is transparency with the general public. While some savers can benefit from loose monetary policy – due to the subsequent increase in asset prices – those attempting to build their wealth are being hit hard. As the brilliant 19th Century French economist, Bastiat, would have pointed out, this is a classic case of policy makers favouring the visible – in this case, inflated asset prices – over the unseen (foregone returns). The counterfactual claim that, without monetary stimulus, all savers would be harmed on account of a financial meltdown cannot hang over the public indefinitely. We are now four full years from the height of the crisis, and need to take a step back. Recent Fed announcements come disturbingly close to an election cycle, and QE infinity is simply a free pass for profligate government spending.

At some point an attempt must be made to restore interest rates to their natural rate, and it cannot wait until conditions are ideal. As things stand, the Consumer Price Index (CPI) is stubbornly above target, output is sluggish but stable, and the Eurozone crisis is having a lull. There is a risk that tightening monetary policy now could change this. Nevertheless, if you believe that interest rates are some distance from the natural rate, a minor rate rise would still constitute a loose monetary policy. Furthermore, it would be useful to see just what impact such a rise would actually have on market rates.

The government continue to trial new policies attempting to improve the flow of credit to the real economy. The downside risk is that regime uncertainty is increasing. This can have the unintended consequence of dampening aggregate demand. It would be helpful if the Bank of England restated the full suite of monetary policy they have at their disposal, and clarify the conditions under which they would be used and, indeed, eventually retired. If the Eurozone implodes, or a stock market crash occurs this autumn, interest rate decisions now will not make a massive difference. It is important that the Bank of England is willing and able to prevent liquidity crises. Nevertheless, the pre-emption of tail risk should not be part of the monthly vote on Bank Rate. Rather, that should be guided by the level of interest rates consistent with an economy growing at or near potential, with low inflation, and a sustainable equilibrium in the market for loanable funds. This may appear to be a somewhat schizophrenic approach to monetary policy, but there is no such thing as a policy decision that’s right for all scenarios.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold at 0.5%.
Bias: Maintain asset purchases at £375bn; only increase the total to offset declines in M4.

The British economy continues to make slow progress against at least three headwinds: firstly, the need to repair balance sheets in the household and financial sectors; second, the weakness of economic activity abroad, particularly in the Eurozone, our largest trading partner, and, third, the tendency for inflation to exceed personal income growth over the past year or two, thus eroding purchasing power in the crucial consumer sector. None of these headwinds will be overcome quickly, and none can be suddenly circumvented by any magical fiscal or monetary solution.

Given the high levels of outstanding debt among householders and the overriding need to restore stability to the banking sector, policy-makers can only take limited measures to accelerate balance sheet repair. A review of the historical evidence on the recoveries from past financial crises suggests that the time taken to achieve a full recovery depends on factors such as: the extent of leverage at the onset of the crisis; where, or in which sectors, the leverage was concentrated; the national savings rate, and the underlying growth rate. Unfortunately, Britain scores very poorly on all these measures, implying a prolonged and painful climb back to full economic health.

The repair of household and financial sector balance sheets is proceeding slowly. The debt-to-disposable income ratio of households has declined from a peak of 175% in 2008 Q3 to 152% in 2012 Q1, equivalent to the leverage ratio reached in 2005. Some economists have pointed out that financial assets of households have increased by an amount comparable to the growth of debt, implying zero increase in net debt, but this is simply the consequence of the buyers or borrowers paying the sellers for their assets. What matters is that, since house prices have declined and credit conditions have tightened, a substantial fraction of households have a debt level higher than desired and wish to reduce it. It is impossible to know how far households will wish to reduce their debt-to-income ratio. However, and based on the experience of the 1990s this is likely to take the best part of a decade, as it did then.

With respect to the banks, they entered the crisis with leverage ratios in excess of 50 times (measured as un-weighted assets to common equity) and that ratio has declined to about 33 times. For better or worse, Basel III is proposing a leverage ratio of 22 times (4.5% capital to risk assets, supplemented by an additional 2.5% capital buffer) and the Vickers Commission has proposed a leverage ratio of 10 times for large retail banks, so there is still a considerable way to go.

On the external side, the crisis in the Eurozone (and the consequent recessions in the periphery and slowing growth in the core), the sub-par growth of the US economy, and the slowdown in China and the rest of east Asia are all contributing to weak demand for British exports. Slower growth of Britain’s exports than might otherwise be the case implies a longer period will be needed to rebalance the economy away from consumption and housing towards exports and business investment. Needless to say, the UK government can have almost no meaningful influence in accelerating the recoveries of foreign economies.

Probably the area where the authorities can make the most contribution is in overcoming the tendency over the past year or two for inflation to exceed personal income growth, which has had the effect of eroding purchasing power in the crucial consumer sector. However, the solution is not straightforward even here. Promoting additional domestic spending by monetary or fiscal means may weaken sterling and encourage inflation; restraining domestic spending too much could weaken the recovery and delay private sector rebalancing.

CPI inflation slowed to 2.5% year-on-year in August, and should decline further. The fact that Britain has suffered higher CPI inflation than either the US or the Eurozone over the past two years reflects three factors: the surge in monetary growth in 2009 and 2010; the fiscal choice to raise indirect taxes such as VAT, fuel duties, and air passenger duties, and the weakness of sterling. However, now that monetary growth has slowed as the demand for loans has plummeted and the fiscal accounts are gradually improving (albeit too slowly to meet the Coalition’s target of stabilising the debt-to-GDP ratio by 2015/16), there are better prospects of nominal incomes exceeding inflation in 2013. This in turn should promote real GDP growth. In this environment, the Bank should hold rates stable at 0.5%, but be prepared to undertake additional asset purchases if monetary growth plunges again.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; complete the latest £50bn QE stimulus.

Sir John Major tempted fate recently with his talk of the ‘green shoots’ of economic recovery and the omens remain poor at present. Even though the 2012 Q2 GDP figure may be revised up again to show a fall of 0.4%, compared with the preliminary 0.7%, as a result of the latest revisions to the construction output data, the underlying picture looks depressed ¬– even if there will almost certainly be a positive GDP ‘bounce’ in 2012 Q3. The employment figures remain, at face value, puzzlingly strong. However, once allowance has been made for: the rise in part-time work; higher self-employment; an increase in the numbers on government training schemes, and a short-term ‘Olympics factor’, the increase in employment looks less impressive. It is admittedly true that there has been a pick-up in August’s Markit Purchasing Managers Index (PMI) for the services sector but the balance (at 53.7) remained down on the figures recorded earlier in 2012. Meanwhile, the August PMI for manufacturing merely showed an “easing in the downturn” – i.e., no green shoots there – and the construction PMI recorded the “fastest drop in new orders since April 2009”.

The Chancellor recently announced the date of the Autumn Statement (5th December) when the revised forecasts from the Office for Budget Responsibility (OBR) will surely show a further deterioration in the projections for both GDP and the public finances compared with March. The latest official statistics indicate that the cumulative PSNB in the first four months of the 2012-13 fiscal year was around £10bn higher than in the equivalent period of 2011-12, once allowance has been made for the £28bn transfer of the Royal Mail pension fund. It seems almost certain that meeting the rolling fiscal mandate will slip another year – i.e., to 2017-18 – compared with the 2014-15 date originally forecast by the OBR in June 2010. In addition, the fixed ‘supplementary target’, which specifies a falling debt/GDP ratio in fiscal 2015-16, will probably be missed. It seems unlikely that the Government has the appetite for the spending cuts and/or tax hikes required to meet this target. Indeed, the markets are already being softened up for the target to be missed. Sir Mervyn King said recently that it was ‘acceptable’ to miss the target if the economy continued to grow slowly.

Under these circumstances, the Bank of England looks set to maintain its very accommodative monetary policy for months, if not years, to come. Nevertheless, the Bank is unlikely to make any further move before November as officials are in ‘wait and see’ mode. They will take stock of the impact of both the current £50bn of QE stimulus and the FLS scheme before making further moves. More QE is anticipated before the end of the year, but the Bank is not expected to cut interest rates further. It makes sense to continue to support a very accommodative monetary policy, but the time to consider a further tranche of QE is November at the earliest. Bank Rate should be left at 0.5%. There is little point in cutting it further.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no more QE.
Bias: To raise Bank Rate further and restore interest rates to 2% in fairly short order.

Relatively little has changed in the macroeconomic picture in recent months. Data-miners search for evidence of turning points in car sales or sentiment indices or try to cast doubt upon the GDP figures by comparing them with employment data. Suppose that both the GDP and output data are correct – output is falling slightly whilst employment is rising. What would that mean? If we think of a fairly standard production function, in which there is capital and labour and each has a share in output (for the technically-minded, I have in mind a Cobb-Douglas form), then if output is falling whilst labour rises, that must mean either that labour's share in output is falling or that the stock of capital is falling. Given that wages have been rising more slowly than prices for some time, it might be natural to imagine that the key factor is a fall in labour's share in output; prices are rising more quickly than salaries, so salaries comprise a reducing proportion of total expenditure. There may be something in this, but it is also true that a significant driver of price increases has been rises in the cost of other factors, including energy and raw materials.

An alternative, and not-incompatible, hypothesis is that the real output value of the capital stock is falling. There are many reasons this could be so. There is the straightforward one that with business investment so low there may be depreciation. However, and more significantly, there is a good chance that a significant portion of the current capital stock is obsolete. Partly, that could be the result of technological developments. Investments might have been made in the late 2000s on the basis that, with total demand growing rapidly, there would still be residual demand that would not be satisfied by internet-based or other new technology based services. However, the shrinkage in the economy has made it possible to serve a larger portion of the demand purely with new technologies, rendering the capital supporting older technologies obsolete.

There could also be significant geographically-based obsolescence. Much human or other capital could have been based on servicing demand stemming from the Eurozone. However, the composition of UK trade is likely to switch decisively away from the Eurozone over the next few years. This could be driven by regulatory changes such as the UK's departure from the EU or by big shifts in international tastes (e.g., increasing future Chinese tastes for consumption).
Reflecting upon these points, we note first that the GDP and employment data may not be as incompatible as they first appear. Secondly, if the above factors are in play, then the economic challenges the economy faces are even less likely to be malleable through monetary policy. If labour's share in income is indeed falling, then even some output recovery may not see wage-based households finding it easier to service their debts (e.g. their mortgages), implying an even more challenging five-year outlook for the UK's banks. If capital is obsolete – and likely to become more so, potentially – then attempting to stimulate demand through low interest rates and QE is futile and counterproductive.

Monetary policy is an excellent and powerful short-term tool. Active demand management can have potentially extremely valuable impacts over a timescale of, say, nine months to three years. However, we are now five years in to the financial crisis and have seen interest rates at zero for three and a half years. Monetary policy cannot help the economy any more than it has already done. It is long past time for it to withdraw from the field. From here, desperate and futile attempts to engage in ever more monetary stimulus can only serve to increase the risk that, if and when the economy does finally start to recover, we have to deal with strong inflationary pressures – meaning a further recession early in the true recovery. As monetary policy-makers, we have done our best. It is time for active monetary management to retire gracefully from this battle and leave the task to other more suitable mechanisms.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks.

The steadily improving labour market data suggest that the British economy is now growing. It seems likely that the third quarter GDP figures will show a good rebound when we get it in a month or so and that the process of upward revision of the previous figures will continue. This is why, disregarding the arithmetic implied by the earlier Office for National Statistics (ONS) estimates, we will continue to show growth for the current year. There have been some side benefits of the poor GDP figures and all the popular talk of ‘double dip recession’. These have come in the form of several policy changes, as the coalition have had to focus on ways of delivering growth, at the expense of their previous priorities of the green agenda, anti-banker populism with manic reregulation, and infrastructure decisions designed to make non-economic points (such as the HS2 rail link and the denial of the third Heathrow runway). Mr Osborne has taken charge of the new direction and we now have: 1) the new FLS programme under which the marginal costs to the banks of making extra lending will be cut; 2) urgent consideration of how business lending can be boosted – perhaps by creating a new business bank, perhaps by spinning off parts of the two behemoth banks under government control as new banks, designed to boost competition and lending on the high street; 3) a review of airport provision, opening up the issue of runways from 2015; 4) a new labour regulation reduction for Small and Medium Enterprises (SMEs) based on much of the Beecroft Report, and 5) a new Cabinet in which the balance has tilted towards ministers who want to deregulate more actively, and a programme to liberalise planning decisions.

How far these measures will make a difference remains to be seen. However, with the help as well of a calming of the Eurozone crisis by the ECB’s announcement of direct purchases of weak governments’ bonds when their yields are threatened by crisis, we may now see an easing of the great credit freeze-up, which may well be the key factor holding back the recovery.
We still have poor news on the progress of public borrowing. However, there has undoubtedly been a large cutback in public sector employment. After allowing for reclassification, this reduction has been around 600,000 since 2010, or about 10% of the total. Benefit payments have been boosted by indexation to the soaring RPI. However, it should become easier politically to cut benefit packages as growth strengthens and, with employment improving, payments should gradually fall back automatically. Furthermore, and with profits having grown substantially, the big corporate tax-gathering season in the final quarter of the present fiscal year should be a lot stronger. With retail sales finally rising in volume terms at around 3% we should also see better VAT receipts.

Now that the government has finally come around to a pro-business agenda, the achievements in other areas are starting to come into focus. The first is the austerity programme. Second, is the reform of the National Health Service: it is to be hoped finally embedding the ‘internal market’ started by Lady Thatcher. Third, is the strengthening of the new independent schools programme started by Tony Blair; and the associated attempts to raise the standards of teaching and those set in examinations. Last, but not least, there is the withdrawal of benefits from middle-income households under the various attempts to reform the benefits system. The previous tax credit system had begun to pervert the incentives of the better off. Unfortunately, there is not much that can be done in practice about the effect of the benefit system on the least well off. The best that can be achieved is that the pressures to get into the labour market can be increased, people can be pushed into cheaper housing and huge payments to dysfunctional families can be curbed. Nevertheless, the political commitment to help the poor ensures that incentives at the bottom are weak. The key is to stop the system before it reaches up to pollute incentives for the middle classes. This is politically possible, and economically desirable, even if it produces points just below middle income where marginal withdrawal rates get very high; generally these have little effect on middle class people.

Against this background, monetary policy may be able to get back to some normality in the UK. It is clear that growth is gradually returning in line with improving market fundamentals. If the latest initiatives mean that lending improves, this will help the process along. As recovery proceeds, it will become increasingly dangerous to leave the vast reservoir of bank liquidity created by QE, let alone to add to it. QE, which has mainly had the effect until now of making government borrowing extremely cheap and depressing returns to savers, could start to pose a serious inflationary threat. We could move from credit famine to credit binge rapidly. So the Bank needs to move in good time to withdraw this threat; these things cannot be left until the moment the binge is underway.

The decision by the US Federal Reserve to go for a third round of QE by printing US$40bn a month to buy mortgage-backed securities, until such time as unemployment comes down, is an astonishing decision which seems to forget the basic tenet of macroeconomics: that monetary ease cannot create employment except when applied temporarily as an attempt to counteract a negative shock. The Fed risks an even worse inflationary threat than here in the UK since its commitment is so bare-faced and open-ended.

Summing up the situation in the US and the UK, we have a slow recovery and weak growth; bank credit seems to be frozen. We have a huge regulatory reaction to the past crisis that, with the Eurozone crisis, may well account for this freeze-up. QE seems to have lowered the cost of government funding but not apparently the terms of credit to smaller firms, while it has added massively to bank reserves. It would have been better to tackle the credit problem at its root in excess regulation; and keep some control on the reserves injection. As it is, both governments are beginning to understand the regulative issues and trying to ease up on them. The US is directing QE directly into the credit market, while the UK is subsidising banks’ marginal lending costs. There is a desperation now engulfing monetary policy which looks dangerous – much like the desperation that engulfed the Heath government’s policies in 1971, with every lever being pulled to target unemployment. This desperation needs to be curbed. Interest rates should start to rise and QE should be stopped and then reversed. Bank Rate should go up to 1% at once, with further increases to follow, and QE should be steadily reversed. The unfreezing of credit should be done by easing of capital and liquidity regulations, on top of the new FLS.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate; no immediate increase in QE.
Bias: To avoid regulatory shocks; break up large state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

Both international monetarists and the domestic closed-economy variety might take some comfort from the fact that the annual increase in both the aggregate Organisation for Economic Co-operation and Development (OECD) stock of broad money and its British equivalent appear to have accelerated during recent quarters, albeit continuing to run at historically low rates. In the case of the OECD area as a whole, broad money growth fell precipitously from a rate of 9% in late 2008 and early 2009 to not quite 2½% in the first quarter of 2010 but then started accelerating into the 6¼% to 6¾% range where it has broadly fluctuated since the second half of 2011. Likewise the growth of Britain’s M4ex broad money supply definition had averaged only some 1½% to 1¾% in 2010 and 2011 but had picked up to 3.9% by July 2012. Since these rises are running somewhat ahead of inflation, which was 1.9% in the OECD area in the year to July, real money balances are now growing. At the same time, the demand for the interest-bearing bank deposits included in broad money remains weak because of the low or negative real returns being paid on such assets. The relative strength of oil and non-oil commodity prices, the modest recovery in equity markets since May, and the emergence of positive annual house price inflation in the UK (the ONS index increased by 2% in the year to July), also suggest that there is now a broadly adequate supply of money relative to the demand for it, both overseas and domestically. The fact that there has been only a limited output response so far is consistent with the view that we are still only in the earliest stages of the monetary transmission process towards recovery.

There are three caveats, however. The first is that broad money is notoriously difficult to define and measure. The OECD figures may be distorted because they now include relatively high inflation economies such as Turkey. The OECD used to publish a useful series for broad money excluding the high inflation economies, and its consumer price index equivalent, but ceased to do so a few years ago. The second concerns the distinction between money and credit, in a situation where banks are holding an increasing share of their balance sheets in government debt – partly, because they are obliged to do so on alleged regulatory grounds. The accepted view is that it is the money stock that matters in the long run, irrespective of whether money is being driven by credit extended to the private sector, loans to government, regulatory changes or transactions with the overseas sector. However, the availability as well as the price of credit can be a powerful influence on activity in the short run, even if firms can economise on its use in the long run, just as they can do with other inputs into the production process such as energy or raw materials. The extent to which businesses chose to reduce their reliance on a particular input, such as credit, depends on the costs and benefits involved. However, some two-thirds of small businesses seem to have more bank deposits than debt and would benefit from higher rates of interest. It is important not to be unduly swayed by a vocal minority of credit-hungry businesses, particularly as the credit is often used to support speculative activities rather than the creation of real wealth.

The third caveat is that there is no recovery so robust that it cannot be de-railed by really dumb actions on the part of politicians, the central bank or financial regulators. There have been far too many such blunders in the 21st Century. There are several reasons why the recent recovery has been disappointing. Nearly all of them can be blamed on the political and bureaucratic classes rather than the citizenry. First, the supply side of many leading Western economies has been garrotted by the large increases in government spending since 2000 or so. Almost all the leading economies appear to have moved onto a permanently lower growth path as a consequence. Second, the globally-synchronised move towards increased financial regulation has been introduced at precisely the wrong point in the business cycle. Over-regulation may be in the best interests of the bureaucrats concerned, for ‘public-choice’ reasons. However, it is stopping global banks from properly supporting a private-sector recovery. The third reason has been the tax uncertainty associated with current large budget deficits. The statistical evidence indicates that budget deficits crowd out private activity under most circumstances and do not stimulate it as Plan B advocates allege. Furthermore, there is strong evidence that such crowding out is especially powerful in open economies, with a floating exchange rate and a public debt to GDP ratio approaching 100% – all of which applies to Britain. Finally, politicians have created huge uncertainty for all private-sector economic agents by their misguided policies and grandiose projects. This is an important reason why business is not investing and consumers are reluctant to spend. Here, European Monetary Union (EMU) is the stand out example. However, EMU is almost certainly doomed; if for no other reason than it is impossible for the 12.5m population of Bavaria and, to a lesser extent, the 10.7m citizens of Baden-Württemberg to underwrite without limit the debts of the 317m inhabitants of the Eurozone. The other fourteen Federal German states absorb more fiscal resources than they generate in taxes. So, the Eurozone is effectively being backed by Bavaria, not Germany.

The target CPI increased by 2.5% in the year to August, while both the all-items RPI and the old RPIX target measure increased by 2.9%. The ‘double-core’ retail price index – which excludes mortgage rates and housing depreciation and is the most historically consistent inflation measure – rose by 3% over the same period. These figures are not particularly low by international standards. Annual Eurozone inflation was 2.6% in the year to August and Chinese inflation was 2.0%. The equivalent US and Canadian figures were 1.7% and 1.3% (July), respectively, while the consumer price indices in Switzerland and Japan have fallen by a respective 0.5% and 0.4% over the past twelve months. The ONS series for producer output prices, which some people consider an early indicator of retail prices trends, accelerated from a year-on-year inflation rate of 1.8% to 2.2% between July and August but was still well down on the rates of 6% or just over recorded in the third quarter of 2011. Furthermore, the unchanged yearly rise of 1.2% in producer output prices excluding food, beverages, tobacco, and petroleum products recorded in August was also well down on the recent peak of 3.7% recorded in September 2011. With the annual increase in economy-wide earnings only 1.5% in the year ending in May/July, there seems to be little risk of UK inflation accelerating in the immediate future, whatever one fears about the longer term inflation risks associated with current fiscal and monetary policies. The recovery in the sterling index since the summer of 2011 has been a useful aid to constraining domestic inflationary pressure, even if it has not been a deliberate policy goal.

The latest Beacon Economic Forecasting (BEF) projections suggest that Britain’s national output will contract by an average of 0.3% this year, given the published data available on 25th September – unfortunately, this report had to be finalised before the publication of the revised national accounts on 27th September. The UK economy is then expected to grow by 2.1% on average next year, before accelerating to 2.7% in 2014. However, this assumes that the current official data are reasonably accurate. This is something that many data users have reservations about. It would not be a surprise if the 2012 growth rate were to be revised up to a positive 1% to 1½% in the fullness of time, for example, given the strength of the labour market indices. If one maintains the supposition that the ONS data is reasonably valid, then CPI inflation is expected to ease to 1.9% in the final quarter of this year and 1.5% in 2013 Q4 but then accelerate to 2.4% in the closing quarter of 2014. The annual increase in the ‘double-core’ RPI is expected to be 2.3% in the final quarter of this year, 1.9% in late 2013 and 2.9% in 2014 Q4. However, a disturbing feature of the ten-year ahead BEF projections is that inflation continues to pick up thereafter, with both UK CPI and OECD inflation rates breaking through the 5% barrier in the latter years of the decade.

This predicted shift onto a higher inflation plateau is essentially a delayed consequence of the hyper-loose monetary conditions that have prevailed in recent years, which may take more than half a decade to fully work through. This is an issue that badly needs to be debated, if central banks are to achieve their inflation goals and maintain the credibility needed to avert stagflation without having to aggressively slam on the brakes at some stage. As it is, Bank Rate is expected to be held at its present ½% until the third or fourth quarter of next year before rising to 2% or so by the end of 2014. There have recently been some noticeable downwards revisions to the earlier published figures for Public Sector Net Borrowing (PSNB) which seem to result from Local Authorities – who have also done much of the public sector job shedding – not fully spending their financial allocations. The ONS now claim that PSNB was £119.3bn in fiscal year 2011/12. The BEF projections show the PSNB falling to £86.7bn in 2012-13, rising to £129.7bn in 2013-14, and then easing to £117.1bn in 2014-15. However, these figures have been distorted by the £28bn transfer of assets from the Royal Mail Pension Fund after the start of the current financial year. Without this distortion, the PSNB would have been projected at just over £114.7bn in the current financial year.

As far as the October Bank Rate decision is concerned, the temporarily reduced uncertainties in Continental Europe suggest that there is a window of opportunity to raise Bank Rate and that the Monetary Policy Committee (MPC) should be preparing the financial markets for such a move, perhaps before the year end. However, a rate hike is not being advocated for this month because the markets have not been psychologically prepared and the authorities are metaphorically walking on eggshells where confidence is concerned. The medium-term aim should be to get Bank Rate into the 2% to 3% range at which point it may re-engage with the money market rates that determine borrowing costs. The authorities also strongly need to resist ill-considered regulatory proposals, which unduly hamper the credit- and money-creation processes. Finally, QE should be reserved for lender of last resort purposes only and not employed as an instrument of day to day monetary policy.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

Over the next few weeks the Chancellor of the Exchequer, George Osborne, and his Treasury colleagues have some very important decisions to make in regard to the Pre-Budget Report on 5th December. Since the original budget deficit reduction plans were laid in June 2010, the lacklustre performance of the UK economy has forced a postponement of the date by which the structural element of the deficit is eliminated. Merely to repeat this exercise of ‘extend and pretend’ will fool no-one, least of all the accursed rating agencies whose favour the Chancellor continues to curry.

To fail at the hurdle of fiscal prudence now, despite the obvious disappointment over recent borrowing trends, would carry a deeper significance. If the coalition loses its nerve at this juncture and simulates the policy dilution that Ed Balls has long advocated, its legitimacy will be rightly called into question. Recent activity, trade and employment data suggest that there is no cause for panic on the fiscal front. With the Bank plainly in unconditionally easy mode, it is vital that Osborne holds the line on fiscal normalisation.

The alternative, which is close to becoming a reality in the US, is to open the door wide to a fiscally-generated inflation in which inflation expectations are cut adrift from central bank targets or objectives. The UK may regard itself as a cut above the Eurozone average, but its over-dependence on foreign gilt purchases is a potential source of vulnerability. As UK inflation outcomes explore the upside again, this is no time to abandon ship on the fiscal objectives. This discipline has to come from the Treasury, since the Bank has forfeited the means to offset the absence of fiscal restraint. The UK is at risk of conceding the inflationary argument if it fails to reiterate its commitment to budget deficit reduction. Bank Rate should remain on hold until the UK reasserts a positive GDP growth rate.

Comment by Trevor Williams
(Lloyds Bank Wholesale Markets)
Vote: Hold Bank Rate.
Bias: Neutral.

The UK economy has moved on since QE was announced just a few months ago, with signs that the downturn in the first half of this year is coming to an end. Certainly, the data from early leading indicators, including Lloyds Bank proprietary data, would suggest that the economy will return to growth in the third quarter, perhaps anywhere between 0.5% and 1%. Broadly speaking, the economy appears to be flat. But data point both ways on this. The PMI surveys are suggesting that services and manufacturing activity are either close to or heading above the critical 50 expansion level, so heralding some month-on-month growth in output in these sectors in the quarter ahead.

That having been said, the volume of retail sales fell back by a modest 0.2% in August – or by 0.3% if fuel is excluded. Following July’s pick-up in inflation, the annual rates of increase in the CPI and RPI inched lower in August, driven by slower increases in clothing and footwear prices and the absence of utility price increases, compared with last year. To be more specific, CPI inflation eased from July’s 2.6% to 2.5% in August. Looking ahead, a combination of supportive base effects and a high degree of spare capacity should continue to pull CPI inflation lower. Service sector prices inflation fell from 3.4% in July to 3.2% the following month. Excluding seasonal factors, CPI fell from 2.3% to 2.1% in August. However, the acceleration in global food and oil prices, together with the prospect of a renewed round of domestic utility tariff rises, threatens some upward pressure on inflation going into the end of year. This makes it harder to see a very sharp drop occurring.

Meanwhile, the public finances were a little better than market expectations and basically showed stabilisation on the year. However, 2012-13 has got off to a poor start with the cumulative deficit some £13bn worse than this time last year, excluding the effects of one-off capital transfers. Notwithstanding the other figures, the unemployment data remain most powerful. The labour market report showed further evidence that, notwithstanding the reported contraction in economic activity in the first two quarters of 2012, employment has risen sharply. In the three months to July, employment rose by 236,000 – representing a pace of job growth historically associated with robust economic activity. Despite the strong rise, unemployment only fell by 7,000 people as job growth was met by a sharp rise in the labour force over the same period. Meanwhile, the timelier claimant count measure of unemployment continued to post marked falls, suggesting labour market strength continued into the third quarter. The labour market poses a puzzle for the broader economic picture and continues to cast some doubt on the scale of output loss recorded over the current recession.

The MPC minutes for September’s meeting showed that the official rate setting committee was unanimous in its decision to leave Bank Rate and the asset purchase target unchanged in September. However, some members thought further stimulus was more likely than not in due course, with one member stating there was “a good case” for additional easing this month. Yet uncertainties over the underlying pace of economic activity and the surprising strength of employment growth make October’s decision relatively easy. Bank Rate is expected to remain on hold in October and this will be the right decision for the economy. At the moment, the best policy option is to leave rates on hold and keep the policy bias neutral.

The SMPC

The SMPC is a group of economists who have gathered quarterly at the Institute of Economic Affairs (IEA) since July 1997. That it was the first such group in Britain, and that it gathers regularly to debate the issues involved, distinguishes the SMPC from the similar exercises carried out by a number of publications. Because the committee casts precisely nine votes each month, it carries a pool of ‘spare’ members since it is impractical for every member to vote every time. This can lead to changes in the aggregate vote, depending on who contributed to a particular poll. The nine independent analyses correspondingly should be regarded as more significant than the exact vote. The next SMPC gathering will be held on Tuesday 16th October and its minutes will be published on Sunday 4th November. The next two SMPC e-mail polls will be released on the Sundays of 2nd December 2012 and 6th January 2013, respectively.

Sunday, September 02, 2012
IEA’s Shadow MPC votes 6-3 to hold Bank Rate
Posted by David Smith at 08:59 AM
Category: Independently-submitted research

In its most recent monthly e-mail poll, completed on 28th August, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Britain’s Bank Rate should be held at ½% when the official rate setters meet on Thursday 6th September.

Two dissenters wanted to raise Bank Rate by ½%, while another desired an increase of ¼%. There was a further divergence with respect to the desirability of further quantitative easing (QE). Most SMPC members were content to complete the existing programme – except for one who wanted an immediate phased programme of withdrawal – but there was no consensus whether QE should then be held or a further tranche introduced later on this year. However, there was widespread agreement that QE would have to be used aggressively if the Bank of England again found itself in a lender of last resort situation, perhaps as a result of events in the Eurozone.

In addition, there was a consensus on the SMPC that the UK economy was broadly flat lining, but that the official growth figures were so dubious that it was impossible to be more precise. Several SMPC members noted the contrast between the weak output figures and the stronger picture painted by the labour market statistics.

A substantial body of opinion also thought that output was supply constrained – perhaps as a result of the massive increase in the socialisation of the economy in the first decade of the 21st Century – and that bold supply-side reforms were a necessary condition to get the economy motoring again. Without these, any further monetary stimulus would be dissipated in higher inflation.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: To hold for the time being.

The UK’s national accounts have often given a bad guidance to monetary policy decisions in the past. More reliable aids to understanding current conditions are business surveys and labour market data. These suggest that, for most of 2012, the British economy has been growing and indeed growing at least in line with a miserably low trend figure. Some slowdown seems to have taken place in the last month or two, in the backwash from the Eurozone crisis. However, this deceleration may prove transient. The international background ought, on the whole, to be improving. Monetary policy is being eased in China, while money growth appears to be reviving in the USA.

My recommendation is to leave policy unchanged, with Bank Rate held at ½% and QE maintained at the present level. It is possible that it will be appropriate to favour a rise in interest rates at some point in 2013. However, my bias is for the moment is best described as being for ‘no change’.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; continue with agreed asset purchase programme.
Bias: Additional monetary stimulus.

Following Mario Draghi’s remarks in London at the end of July, and his subsequent comments at the early August European Central Bank (ECB) monthly press conference, there has been a sizeable rally in global equities, an upswing in commodity markets and a generalised decline in credit spreads. These trends largely reflect declining risk premia rather than a re-assessment of global growth prospects. Although August is generally a quiet month in bank funding markets, there have been signs of improvement of late. European banks’ Credit Default Swaps premia have fallen by around 40 basis points on average since late July, most notably for troubled institutions in the periphery. Evidence from foreign exchange swap markets suggests access to short-term dollar funding markets has also improved of late.

Whether this hardening of financial market sentiment can be sustained through the autumn is debatable. For the moment, Mario Draghi’s pledge to do “whatever it takes to preserve the euro” is simply that – a pledge. He may believe that “it will be enough”, but he has to convince sceptical investors of that fact with concrete action. It is clear we will get some kind of ECB-led bond-buying programme; but to be successful in reversing the self-fulfilling loss of market confidence in Spain, Italy etc. it has to be both unlimited and unconditional. We know it will not be the latter – Draghi made clear that no bond purchases will take place until a country has formally applied for European Financial Stability Fund (EFSF)/European Stability Mechanism (ESM) support, i.e., there will be no reactivation of the Securities Market Programme (SMP) which bought sovereign paper without explicit conditionality. Moreover, the pledge to do ‘whatever it takes’ is unlikely to mean unlimited bond purchases across the yield curve. We are told that the ECB is only going to buy short-dated paper – since most of the sellers at this part of the curve are likely to be banks, the direct boost to broad money will be limited. It is even suggested that the ECB will confine itself to the treasury bills of those countries affected. Targeting the spread over bunds at the short-end of the curve is only one of many mooted options. In short, the plan is not shaping up to be either unconditional or unlimited. There is room for market disappointment when the plan is formally revealed.

Markets may also be buffeted by political gyrations this month. The German constitutional court will decide on the legality of the ESM. While it is highly unlikely to be struck down, there are concerns about the constraints the court may place on the Bundestag in providing future financial support to troubled Eurozone economies. On the same day as the ruling, Dutch voters go to the polls. On the basis of recent polling, there is scope for a major upset, with the main pro-euro parties in danger of losing their effective majority in parliament. There is also the continuing debacle in Greece. The next tranche of official financial aid is not yet assured. Antonis Samaras, the new Greek prime minister, has gone to Berlin and Paris with his begging bowl, hoping to be rewarded with additional time in which to meet the deficit reduction targets. He will no doubt receive some superficial hand-outs from the Germans; but it is clear that there will be no meaningful change in the fiscal adjustment expected in Greece. How robust the Greek coalition government will prove when this becomes obvious is anybody’s guess. It is an added dimension of uncertainty in a highly uncertain environment.

With another round of gilt purchases underway and the ‘funding for lending scheme’ (FLS) still in its infancy, there is merit in the monetary policy stance being left unchanged this month, despite the balance of risks to both growth and inflation being on the downside. There is a small chance that the Draghi plan, which is now due to be announced at the 6th September ECB meeting, has a meaningful, long-lasting impact on investors’ risk appetite and bank funding conditions. A credible bond-buying programme could alter the balance of risks to inflation in the medium-term. There is an argument in holding fire until we have more information from the ECB.

There is also considerable uncertainty surrounding the magnitude of the monetary stimulus that the FLS will provide. While the scheme is little more than a collateral swap facility, allowing banks to receive treasury bills in exchange for illiquid securities and loans, its cost and size is directly linked to the amount of net lending to the ‘real economy’ that banks undertake. At its least effective, the scheme will simply provide a (large) funding subsidy for lenders, which they will use to boost profits and capital. This should lower the cost of funding that banks have to pay in the markets, making them more likely to lend over the longer-term. At its most effective, the FLS will actively encourage banks to increase/reduce their lending more/less than they otherwise might have done, and make credit available to borrowers who otherwise could not get a loan. While it should reduce the effective cost of credit to existing borrowers, it may also alleviate some of the quantity rationing that banks are currently imposing. Relative to the counterfactual, the expansion of private credit and broad money could be substantial. There is a good case for waiting to see how banks respond to the FLS in the weeks ahead, even though any conclusions will be tentative.

The likelihood is that additional monetary stimulus will be warranted later in the year, however. Notwithstanding the difficulties in looking through the highly volatile GDP data, the economy appears close to stagnation. Business surveys suggest output was expanding very slowly in the first half of this year. Recent reports suggest the pace of growth has moderated, and in the case of manufacturing they show an outright drop in activity. After four months of falling new orders, the July Purchasing Managers Index (PMI) survey pointed to the biggest fall in industrial production since March 2009. Meanwhile, service sector activity also appears to have faltered, leading to a decline in investment and hiring intentions since the spring.

The recent upward lurch in global energy and food prices suggests the central path for inflation may be somewhat higher in coming quarters than was likely a couple of months ago. Nevertheless, and to the extent that these moves primarily reflect temporary supply shocks, they are unlikely to have much information regarding medium-term inflation. If anything, global, particularly emerging world, growth forecasts have continued to fall in recent months. Domestic price pressures remain fairly limited despite what appear to be extensive effective supply failures. ‘Supply-side pessimists’ take these to be a permanent cost of the financial crisis, arguing that the apparent weakness in labour productivity should be considered a reduction in underlying productivity.

In this line of thinking, the output gap is currently relatively small.
Potential output may have been depressed by the financial crisis, but this could have as much to do with weak demand, a collapse in ‘animal spirits’ and banking dysfunction, as factors which will permanently depress potential output. This is a vital distinction – if persistently sluggish demand growth is itself feeding the rise in risk aversion and the unwillingness of banks to lend, potential output may be significantly affected by the path of demand. Doing too little now may contribute to a permanent fall in the sustainable level of UK activity. There is a strong case for policymakers erring on the side of doing too much in this environment even if the central case had inflation at the 2% target in the medium-term.

Comment by Anthony J Evans
(ESCAP Europe)
Vote: Raise Bank Rate by ¼ %.
Bias: No additional QE but Bank should be on standby with other monetary tools.

The two main pillars of the Bank of England’s inflation targeting regime are: 1) hitting a Consumer Price Index (CPI) target of 2%; and 2) communicating its decisions and justifications in a transparent way. It is currently failing at both. Most economists accept that they have adopted a de facto Nominal Gross Domestic Product (NGDP) target of sorts, but its failure to confront this issue is dramatically undermining its credibility.

Although there are reasons to suggest that CPI remains above target because of temporary or external factors, the inflation target should reflect them all. The Bank’s job is not to deliver 2% inflation on the domestically determined components of CPI alone. Ascertaining the breakdown is only helpful in as much as it allows people to make forecasts about the future path of CPI – on this point, the US Federal Reserve Bank of Atlanta has an index of ‘sticky prices’ which would be interesting to replicate for the UK. However, we have overshot the target for over two years by now, and inflation is creeping up once more, from 2.4% in June to 2.6% in July. If the Bank intends to retain the inflation-targeting regime, they need to signal that inflation remains a priority. If they are willing to tolerate above target inflation to temporarily hold up NGDP, they should communicate this. Until then, they’ve tied their own hands and should remain true to that.

Richard Fisher, President of the Federal Reserve Bank of Dallas, has recently talked about the threat of over prescribing ‘monetary Ritalin’ and it is important that the risks of low interest rates are investigated further. Low yields increase pension deficits and this has the potential to divert corporate money from much needed business expansion to cover the shortfall. In addition, it is no bad thing to permit moderate wealth transfers from people with tracker mortgages to those with tracker savings accounts. The main problem in the economy is not insufficient liquidity provisions by central banks, but a breakdown in effective intermediation – which is partly due to capital requirements and other regulatory shocks – and supply side problems.

As more time passes since the 2008 crisis, it becomes clearer that it is supply side factors hindering the recovery rather than inadequate aggregate demand. Fiscal and monetary policies have both been accommodating, but stimulating aggregate demand cannot capture lost output if the long-term growth rate has changed in the meantime. The official GDP forecasts from the Office for Budget Responsibility (OBR) have been shown to be hopelessly optimistic. Even so, this does not necessarily mean that the output gap is widening. In terms of a basic aggregate demand/aggregate supply model, policymakers are attempting to get back to a long run aggregate supply curve that has shifted. Doing so will increasingly deliver inflation rather than output growth. In addition, permanent ‘crisis’ rates of interest will make the economy more vulnerable to future shocks, and generate capital misallocations.

The Bank of England should concentrate on minimising the distortions caused by ultra-low interest rates, and recognise the limits of what they can do. Although future events may make emergency liquidity provisions necessary, that should not prevent attempts to return interest rates to their natural rate now.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; complete the latest £50bn QE stimulus.

The Office for National Statistics (ONS) have revised their estimate of GDP in 2012 Q2, as expected, from a fall of 0.7% to a fall of 0.5%, reflecting less negative estimates for production and construction. After allowing for the extra bank holiday for the Queen’s Jubilee, underlying GDP was probably flat in the second quarter. Nevertheless, there has been much speculation that the ONS is underestimating GDP, even after this upward revision, because of the seeming buoyancy of the labour market figures. However, a fairly quick inspection of the employment data suggests that not all is positive. In the second quarter, the number of full-time employees was down compared with a year earlier whilst part-time employees and the self-employed, who may or may not be fully occupied, increased. In addition, the number of part-time employees who worked part-time because they could not get full-time jobs has increased. Furthermore, a recent survey from the Chartered Institute of Personnel and Development (CIPD) suggested that one in three firms were holding onto more labour than they needed in order to retain skills but that, ominously, there would be redundancies if the economy did not pick up.

Surveys of business activity have also been quoted in support of the ‘ONS is underestimating GDP’ school and, indeed, many surveys until fairly recently had been modestly upbeat. However, the latest Markit Purchasing Managers Index (PMI) surveys for July were discouraging. They suggested that manufacturing was indeed declining whilst there was very little growth in services and construction. The ONS may revise GDP data, indeed they are almost certain to revise the GDP data, but their picture of a stagnant economy, at best, looks credible.

Under these circumstances the Bank of England looks set to maintain its very accommodative monetary policy for months, if not years, to come. This remains the broadly correct policy, notwithstanding the unexpected pick-up in July’s inflation figures. However, they are unlikely to make any further moves before November for at least two reasons. Firstly, the current £50bn of QE stimulus will not be completed until end-October and, secondly, the Bank appears to be prepared to wait a few months before assessing the impact on borrowing costs and lending of the Funding for Lending Scheme (FLS). The Bank seems, albeit cautiously, to have high hopes for the FLS. Indeed in the August Monetary Policy Committee (MPC) Minutes they wrote of the FLS that “in response a number of banks had already announced reductions in the rates on certain mortgages and small-business loans.” On balance, the Bank’s ‘wait and see’ mode seems eminently sensible. The MPC does however seem to be hostile to any further Bank Rate cut. The June Minutes claimed “a reduction of Bank Rate below 0.5% might squeeze some lenders’ interest margins to such an extent that they became even less able to extend new credit.”

Suffice it to say that the Eurozone crisis rumbles on. However, and despite the blood-curdling and apocalyptic warnings about the economic effects of a ‘Grexit’ and accompanying ‘contagion’, the probability of a Greek exit rises by the week. It is impossible to say if and/or when Greece will leave the currency union but surely there is at least a 50:50 chance that the country will have departed from the Eurozone by the end of the year. Overall, I continue to support very accommodative monetary policy. However, the time to consider a further tranche of QE is November at the earliest. Bank Rate should be left at its present ½%; there is little point in cutting it further.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate; no more QE but no withdrawal of QE.

Inflation has long since ceased to be an important determinant of monetary policy. However, and if it were, the outlook would recommend a rise in rates. The rate of price increase continues to be well above target and, although there has been some recent reduction, the outlook for energy and food prices suggests that annual increases in CPI above 3%, again, may not be far away.

In truth, though, inflation is now almost irrelevant. The key factor is growth. The UK double dip recession goes on. The Eurozone crisis continues its wayward and extended course. Either Greece or Finland may leave as soon as October. A Greek departure could herald a turning point, with a rapid transition to a Single European State, ongoing year-on-year fiscal transfers, and the eschewing of debt pooling. A Finnish departure could herald a wider breakup from the wealthier members and the disastrous consequences that would entail. The UK government estimates that a disorderly collapse of the Euro could mean a further 7% contraction in UK GDP and there may be a 35% subjective probability of such a disastrous contraction. It is no surprise that UK corporates are not investing their cash in such an environment.

Monetary policy cannot help here, any more. All that macroeconomic policymakers can usefully do is to return policy settings to neutral and thereby facilitate the maximum medium term growth rate. We must not forget that medium term growth is not maximised with interest rates of zero. Only six years ago, anyone proposing that this would be how to maximise growth would have been laughed out of office. The truth has not changed; only the willingness of policymakers to hear it.

It is supply-side policy that can make the difference here. Government consumption spending should be cut. The efficiency of government spending (i.e., public sector productivity) should be raised. There should be reforms to areas such as planning regulation. Beyond that, all that macroeconomic policy can do is not to impede. Government debt should not be excessive. Interest rates should be raised back towards the natural rate.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks.

The latest statistics on GDP, employment and unemployment, business surveys and most recently public sector borrowing have created an unending debate between supporters of ‘Plan A’ and those who want to see Plan A abandoned in favour of extra spending on infrastructure. Yet, there is no real controversy here. The truth is that worthwhile infrastructure projects with a good long-term return are always welcome. Traditionally, they were entered in the public accounts ‘below the line’ so recognising that they are: 1) temporary, and 2) to some degree self-financing in the context of the inter-temporal government budget constraint.

What ‘Plan A’ rules out is permanent extra spending and capital expenditure with no proper return. It therefore cannot be a ‘general stimulus’, which often seems to mean in practice that extra money is printed via QE whenever left-wing politicians demand it. The trouble is that such infrastructure spending would probably be going on anyway under existing plans. The main difficulty with infrastructure spending at present is that the coalition cannot agree on what is necessary. Witness the disputes over the HS2 rail link – which is clearly about to be dropped as the white elephant that it is – and the third runway at Heathrow.

The economy itself is growing weakly and the GDP figures are likely to be revised up to reflect this. There has been no ‘double-dip’ recession. This weak growth comes three years after the end of the recession proper and it is astonishing that people are still calling for continuously loose monetary policy. Macroeconomic theory and the models we have that fit the facts suggest that monetary policy moves lose their effects on output once they are well-anticipated and of long standing. Instead, if they affect anything, they affect prices.

In the present context, it seems that they are not affecting anything since as fast as QE money is printed it winds up in the Bank of England as bankers’ balances. Banks are unwilling to make extra loans except to non-risky borrowers (i.e., some large companies) who have no demand for it, enjoying surplus cash and with low investment plans. When it comes to small- and medium-sized enterprises (SMEs) the new capital regulations force large costs on banks if they lend.

However, while QE has not affected bank lending and therefore has failed to increase the money supply, and by implication has not reduced the cost of credit, it has succeeded in reducing the returns to savers. This has happened two ways. First, QE has added massively to demand for gilts, taking by now nearly 40% of available gilts, even after the large increase in public issue to meet its borrowing; this demand from the Bank must have driven down the yield to persuade institutions that would normally require gilts for their balance sheet ratios to part company with them. Secondly, QE has driven down the banks’ cost of funds and hence its offers of returns to savers.

This distortion of the savings market is further encouraged by the very low Bank Rate. Commercial banks can obtain funds from the Bank of England at this rate, and their bankers’ balances also attract a rate related to this. Thus, this is the rate at which the massive QE is available to the banks as a funding source. Yet, the banks will not lend it to extra (i.e., SME) borrowers because of other regulatory costs. Hence what this QE and low Bank Rate do is to depress what they offer to savers, and build up bank profit margins on existing business.

So we now have a monetary policy that is not boosting output via increased lending and lower lending rates, but is depressing returns to savers, and with it the cost of funds to the government. As I have noted in previous SMPC comments, this is essentially what ‘financial repression’ does in developing countries via controls designed to force savings resources cheaply to government. Here the repression is occurring through the new controls on banking, combined with the massive printing of government-backed money.
The government has begun to realise that its new banking regulations are causing these effects and its latest gambit has been the new incentives for lending scheme, under which ‘extra lending’ is rewarded by the government/Bank with a subsidy to the cost of bank funds. There is no reason to believe this bureaucratic scheme will work to expand lending, as opposed to expanding ‘extra lending’ as lending that would have occurred anyway will be diverted into the scheme.

Unfortunately, the only way to reverse the malign effects of the new bank regulations is to reverse the regulations themselves. Furthermore, to force the banks to compete and not to continue as an effective cartel, with only a few players, the government should force the break-up of RBS and Lloyds into several competing units; it should not hang on to its stakes in their present form and build up their profits for a share sale. It would be better to have less capital return and a growing economy with a healthy credit supply. Alas, in the present political climate both in and outside the coalition, these actions are not likely. So the economy is stuck with a distorted savings market; a controlled credit supply, and an impotent monetary policy.

My recommendations for monetary policy are, first, for bank regulations to be greatly eased and for the banks to be broken up. However, and second, whether this is done or not (as seems more likely), interest rates should be raised and QE reversed to remove the distortion from the savings market. So the recommendation is for a rise in Bank Rate to 1% with a bias to raise rates further. In addition, QE should be reversed by £25 billion per month until liquidated.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate; no immediate increase in QE.
Bias: To raise Bank Rate; avoid regulatory shocks; maintain QE on standby.

Perhaps the best analogy for the current British economy can be found in Samuel Taylor Coleridge’s ‘Rime of the Ancient Mariner, published in 1798:
“Day after day, day after day
We stuck, nor breath nor motion;
As idle as a painted ship
Upon a painted ocean”.

Certainly, there has been nothing in the UK economic releases of the past month to change one’s view as to the appropriate conduct of UK monetary policy, even if there remain the well-established inconsistencies between the weakness of the ONS GDP statistics and the stronger trend shown by the labour market data. The ONS has published a paper dealing with this issue, The Productivity Conundrum, Interpreting the Recent Behaviour of the Economy, by Joe Grice, which was released alongside the GDP figures published on 24th August, albeit with somewhat inconclusive results. We are also promised an ONS conference on the subject this autumn. A long-shot suggestion is that there might be glitches in the new software introduced when the ONS switched from its ancient Heath-Robinson methods of calculating the national accounts to its new fully automated system last year. The possibility of a programming error would certainly be consistent with the unfortunate recent experiences of financial institutions such as Knight Capital Group and the Royal Bank of Scotland.

Meanwhile, the uptick in CPI inflation from 2.4% in June to 2.6% in July and the rise in ‘double-core’ retail price inflation – which excludes mortgage rates and housing depreciation and is the most historically consistent inflation measure – from 3% to 3.3% must be regarded as a disappointment, especially as US inflation eased from 1.7% to 1.4% between the same two months, Chinese inflation fell from 2.2% to 1.8% between June and July, and Eurozone inflation was unaltered at 2.4%. Recent trade figures, and the most recent public sector finances release also suggest that the two key financial balances of the current account balance of payments and the budget deficit are deteriorating, rather than improving.

On a more positive note, the growth of M4ex broad money seems to have recently stabilised in the 3% to 3½% range – it was 3.5% in the year to June – and annual UK house price inflation was positive at 2.3% in the years to both May and June according to the ONS index. The national growth rate was held back by the 11.9% drop in Northern Irish house prices, however, which probably had more to do with the property collapse in the Republic of Ireland than mainland UK conditions. English house prices increased by 2.8% in the year to June, Welsh prices were unchanged, and Scottish prices eased by 1%. The reduction in producer output price inflation from 2% in June to 1.7% in July, the drop in core producer inflation (excluding food, beverages, tobacco and petroleum products) from 1.7% to 1.3%, and the 2.4% decline in producer input costs since July 2011 also suggest that the upwards blip in CPI inflation in July is likely to be reversed. The double whammy of the Royal Jubilee and the Olympics has complicated the interpretation of some recent figures. However, the Jubilee-affected manufacturing output figures in June, which were down 2.9% on the month and dropped 4.3% on the year, were not as weak as the financial markets had feared, while the 2.8% increase in the volume of retail sales in the year to July, when the value increased by 3.1%, was also stronger than anticipated.

The Bank of England has estimated that the Jubilee shaved some 0.5 percentage points off national output in the second quarter, suggesting that the underlying figure was flat. Some of this undershooting is likely to be clawed back in the third quarter: Bank officials have also suggested that any Olympics effects in the third quarter are likely to be small. Unfortunately, while the UK growth rate may enjoy a ‘dead cat bounce’ in 2012 Q3, the survey evidence from overseas is less positive. The Munich based CES Ifo world economic climate indicator, published on 16th August, fell in the third quarter, after two successive increases. The decline was due to both unfavourable assessments of the current economic situation and a less positive six-month economic outlook. The Ifo survey results were particularly downbeat for Western Europe and North America. In Asia, confidence was held back by the poor current situation, but there was also some optimism that matters would improve over the next six months.

One factor that has not helped either business confidence or the real economy has been the recent rise in the price of a barrel of Brent crude oil from a temporary low point of US$89.2 on 21st June to US$112.6 on 28th August. This development has partly resulted from the increasingly effective sanctions on Iran, but there have also been output losses in South Sudan, Syria and Yemen while North Sea production has been cut by heavy maintenance schedules and a strike in Norway. This has offset a marked increase in Saudi Arabian production and strong production growth in the US and Canada. The increased oil price should, correspondingly, be regarded as a genuine supply shock, rather than a wider indicator of global economic activity. Nevertheless, dearer energy costs will act as a drag on global recovery, regardless of their cause.

For at least three decades time series statisticians have been using statistical techniques in an attempt to distinguish between demand-side shocks, and supply-side ones. The essential distinction is that demand side shocks are considered to be ‘transitory’ in their effects, while supply side effects are considered to be ‘permanent’. There is also quite compelling evidence for a wide range of developed economies that supply-side shocks were at least as common and powerful as demand side ones before the ‘Great Recession’. This makes it all the more surprising that the current period of weak output, which has now persisted for roughly four years, is widely treated as being purely a demand-side problem and one that would respond to naïve 1960s style Keynesian remedies. Furthermore, it is perverse to treat the current difficulties as a failure of capitalism when one of the most obvious features of the 21st century has been the huge increase in the socialisation ratios of most of the worst-hit leading economies, and the noticeably better performance of countries such as Germany, Canada, Australia and Switzerland where this did not happen. The latest figures from the Organisation for Economic Co-operation and Development (OECD) show that the ratio of general government outlays to the market-price measure of GDP rose from 38.8% in 2000 to 43.2% in 2011 in the OECD area as a whole, but increased from 36.5% to 49.1% in Britain and 33.9% to 41.7% in the US. There is long-standing evidence that increases in the government spending ratio induce a slowdown in the rate of increase in GDP per capita. Moreover, there is some statistical evidence for the OECD in aggregate that, once the government spending ratio exceeds around 38%, or so, all further increases in the government spending are reflected one-for-one in the ratio of the budget deficit to GDP.

As far as the September Bank Rate decision is concerned, the continuing uncertainties in Continental Europe – which represents a gross failure of the Continent’s political class and not of capitalism – warrant a tactical hold. However, the medium-term aim should be to get Bank Rate into the 2% to 3% range at which point it may re-engage with the money market rates that determine borrowing costs, while desisting from ill-considered financial regulatory initiatives that unduly hamper the credit- and money-creation processes. Once the current tranche is completed, additional QE should be kept on standby in case there is a renewed threat of a banking meltdown caused by events in Continental Europe. However, QE should be reserved for lender of last resort purposes and not employed as an instrument of day to day monetary policy. Pace the Bank’s recent discussion paper on the subject – The Distributional Effects of Asset Purchases, 12th July 2012 – QE has created huge and morally totally unjustifiable windfall losses and gains for individual savers and borrowers even if the aggregate effects for a theoretical large and diversified national portfolio might cancel out. It also seems rather strange, from a political-economy perspective, that Bank of England officials are just about the last group in the country to still enjoy retail price index linked pensions. If any group should have their pensions unconditionally valorised at the CPI inflation target of 2%, surely it ought to be the people whose actions largely determine inflation in the first place?

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

It is becoming increasingly obvious that the Bank of England has lost control of UK retail borrowing costs. During the three years-plus that Bank Rate has been set at ½%, the average interest rate paid on banks’ and building societies’ notice deposit accounts has risen from a low of 0.17% in February 2009 to 1.83% in July 2012. Admittedly, the quoted monthly rates have bounced around, but the average for 2012 is 1.41%. This is a measure of the average cost of retail funds to the banking sector; the marginal cost is closer to 3%. On the other side of the balance sheet, Santander UK has recently announced a 50 basis point increase in its standard variable mortgage rate, to 4.74% from October. Clearly, the level of Bank Rate has played no role in the evolution of market rates for the past three years. The MPC’s consideration of a cut in Bank Rate is perverse and farcical in this context. As and when the UK economic news flow permits, Bank Rate should be raised in order to reconnect it to the structure of market rates. However, with UK activity indicators currently erratic and weak, now is not a good time to do this.

It is important not to lose sight of the beneficial purpose of raising Bank Rate, at least to approximate a zero real rate, and preferably a modestly positive one. The UK is subject to mounting inflationary risks. Some of these risks are visible and obvious; others are as yet latent. Unconventional monetary policy is associated with a much wider range of inflation outcomes than conventional monetary policy because unconventional interventions tend to be poorly calibrated. As the official Bank of England and Debt Management Office holdings of conventional government bonds approach 50% of the total in issue, it is time to wonder where the tipping point for inflationary expectations lies. The willingness of overseas investors to piggy-back on the Bank’s Asset Purchase Programme will one day evaporate and be replaced by a fearful rush for the exits because of Sterling depreciation risk. The loss of the sovereign’s coveted AAA-rated status cannot be far away now and this too could be a catalyst for overseas selling of UK government bonds.

Regardless of how soon this nightmare scenario arrives, there is plenty of inflationary concern that is already visible. Over the past five years, the UK has demonstrated a greater vulnerability to global inflation than other large European countries. Retail price inflation averaged 5.2% in 2011 and CPI inflation 4.5%. Inflation exceeded the year-ahead forecasts made by the Bank of England for the third year in succession. Factors influencing the pass-through of foreign pricing to domestic pricing include the lack of indigenous competition to imports; an oligopolistic distribution system, especially in food retailing and domestic electricity and gas provision; and a dramatic upward revision to clothing and footwear price inflation. Sterling has been fairly stable in terms of its trade-weighted index over the past three years, but economic weakness poses a renewed threat to the ‘safe haven’ status of its fixed interest market. The flexibility of Sterling to depreciate means that global pricing pressures have the potential for magnification, given that the UK is an effective price-taker in many sectors. Long after the Sterling depreciation of 2008, import price inflation of 5% or so has persisted.

The sluggishness of the UK economic recovery has reopened the debate regarding the potential medium-term growth rate. The Bank of England and the OBR routinely assume that the medium-term growth rate of the economy lies in the region of 2% to 2.5% per year, but in a credit-constrained world, these growth rates may be no longer attainable. The shocking manner in which the economic recovery has petered out since the summer of 2010 underlines the centrality of the role of credit, in its broadest sense, in healthy economic development. To the extent that cheap credit fostered the creation of excess capacity in the distributive and financial services sectors, for example, not only was their growth rate unsustainable but their peak level of activity was also artificial. Post-slump, the viable economic size of these industries may remain below their prior peaks for an indefinite period. This may already be reflected in stagnant productivity and rising unit labour cost inflation. After examining the behaviour of forty-four economic sub-categories, our conclusion is that the prevailing rate of sustainable economic growth may be as low as 1%. In these circumstances, economic stimulus whether monetary or fiscal, is liable to deliver an adverse mix of inflation and real activity.

The view of the Bank of England, reflected in the economic consensus (e.g., Barclays) is that an abatement of energy and commodity price inflation will allow the UK CPI to return to its target rate of 2% per annum and possibly fall beneath it during 2013. However, this has been the official view consistently and incorrectly for the past three years or so, regardless of the external realities. As ex-MPC member Andrew Sentance has pointed out, global inflationary pressures have strengthened since 2008 and 2009 and the UK is susceptible to them. Global goods deflation has been replaced by moderate inflation. The improvement in the non-food and energy inflation rate in 2011 and 2012 has been associated with a particularly weak sequence of economic outturns. Supposing that there is some recovery reflex, aided by the various policy stimulus initiatives, the Bank of England cannot rely on a stagnant economy to deliver its inflation objective, any more than it can rely on a sequence of good harvests to deliver low food price inflation. For some years now, domestically generated private sector inflation has departed from its stable low trend during 1993 to 2008, and there is evidence of a return to an inflationary mentality, reflected in term inflation expectations of the general public.

If the Bank of England was taking its inflation mandate seriously, it would have raised Bank Rate to 2% or more during the past three years. It has not and it now cannot.

Comment by Trevor Williams
(Lloyds Bank Wholesale Markets)
Vote: Hold Bank Rate; maintain.
Bias: To ease further via QE, with wider range of collateral.

It always seemed likely that the much-publicised very weak provisional GDP figures for the second quarter, which were published on 25th July and registered a fall of 0.7% on the first quarter, would be revised higher. The figures published subsequently, for retail sales but especially for employment, suggested that an upward revision was inevitable. In the event, the revised data published on 24th August showed a revision to a decline of 0.5%, a 0.2% better outcome though still a fall.

One of the most puzzling aspects of the performance of the UK economy in recent years has been the dichotomy between output and employment growth. While the level of UK output has reportedly contracted by around 4.5% since the onset of the downturn in mid-2008, despite rising public sector job losses, total employment is back to where it was prior to the onset of the 2008 recession. The divergence between output and employment has been particularly stark in recent quarters: while the level of GDP has contracted by a cumulative 1.4% since the third quarter of last year, the total number of employed has risen by 1.4% – its strongest three quarter gain since the third quarter of 1997. Although less pronounced, there is a similar divergence between the level of GDP and hours worked.

We estimate that, using employment trends alone, the underlying economy expanded by 0.2% in the second quarter; a similar expansion may take place in 2012 Q3, though the headline numbers might be flattering for the pick-up. Our survey data, from the monthly Lloyds Bank Economic Bulletin, also suggests that there is still underlying growth in the economy, albeit low. Trade data are implying that the rebalancing that had shown promising signs might be faltering.

Despite distortions, the Bank of England is right in my view to have eased policy via QE and other credit easing measures. Given continuing market volatility it is likely to remain vigilant, mindful of headwinds from Europe. I would therefore keep policy on hold, with Bank Rate at ½% and QE at its current rate.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Wholesale Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to

Sunday, July 29, 2012
Shadow MPC warns on UK's sustainable growth rate
Posted by David Smith at 07:00 PM
Category: Independently-submitted research

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 10th July, the Shadow Monetary Policy Committee (SMPC) decided by seven votes to two that Britain’s Bank Rate should be held at ½% on Thursday 2nd August.

Both dissenters wanted to raise Bank Rate by ½%. There was a range of views with respect to the efficacy, as well as the desirability, of the additional £50bn of quantitative easing (QE) announced on 5th July. Two shadow committee members supported this move, another pair thought that QE would work better if the range of assets was extended to include more private debt, one did not want to see the extra £50bn implemented, and four were reasonably agnostic on the issue, while advocating QE in a lender of last resort situation.

More generally, there was a widespread view on the SMPC that, under the current unusual circumstances, small changes to Bank Rate, had the power of a rifle, and QE was the equivalent of a large bomb, but financial regulation had a destructive potential akin to that of a tactical nuclear weapon. The committee argued that the policy inconsistency between over aggressive financial regulation and the need to stimulate money and credit creation – to get the real economy moving – was more than cancelling out the stimulatory effects of the ½% Bank Rate and £375bn of QE.

There was also a strong consensus that the tax-and-spend policies pursued in the first decade of the 21st century – when combined with serious policy errors since the 2010 election, such as the VAT hike – meant that the sustainable growth rate of the UK economy was now little more than 1% per annum.

Minutes of the meeting of 10th July 2012

Attendance: Philip Booth (IEA-Observer), Tim Congdon, Andrew Lilico, Kent Matthews (Secretary), David B Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.
Apologies: Roger Bootle, Jamie Dannhauser, Anthony J Evans, Ruth Lea, Patrick Minford, David H Smith (Sunday Times observer).
Chairman’s Comment

The Chairman, David B Smith, began the meeting by saying that the Office for National Statistics (ONS) had published a rebased set of national accounts with the volume figures expressed in chained 2009 prices, rather than the previous 2008 price basis, on 28th June. Unlike last year’s catastrophic move to the new ESA-2010 definitions, this year’s rebasing had proceeded more smoothly and long back runs of the new data were available on the ONS website without the six month delay that occurred in 2011. However, the data had been published originally with a number of errors that were not disclosed until well into July. Anyone who had downloaded the ONS data on its first release would be well advised to check that it remained accurate.

A cursory examination, which involved running the Beacon Economic Forecasting (BEF) model with scaled pseudo-2008 price figures, suggested that there had been some changes to the composition of the expenditure measure of national income. In particular, household consumption was now believed to be weaker and private investment stronger than had been reported previously. There had also been a marked upward revision to the growth rate of real general government consumption in the year to 2012 Q1 from 1.9% to 3%.

These data changes slightly altered the terms of the current economic debate and also pulled the rug from under Labour’s claims that vicious spending cuts were undermining the recovery. However, the figures for the growth of overall gross domestic product (GDP) remained pretty much the same. The updated data produced a forecast of average GDP growth in 2012 of 0.4% using the BEF model. This was a smidgen higher than the projection using the old official data set but the difference was not significant.

The chairman then added that he had been shocked and surprised by the London Inter-Bank Offered Rate (LIBOR) scandal because he had always naively considered this to be an accurately measured free-market rate throughout his long City career. However, corporate borrowers with rates linked to LIBOR had gained from the downwards suppression of the true rate, just as large wholesale depositors had lost out. Furthermore, it was not clear that high frequency gyrations in LIBOR, which largely self-cancelled over the term of a normal deposit or loan, had had major adverse consequences for anyone other than financial speculators who were caught out on the wrong side of derivatives transactions. None of this justified the appalling behaviour of the banks involved. There were likely to be further scandals yet to be revealed. Concern had recently been expressed about the broadly similar way in which the quoted price of oil was determined, for example. Another important issue was what the Bank of England was doing at the time either to permit, or to be unaware of, such misbehaviour. The Chairman then called upon Akos Valentinyi to give his assessment of the economic situation.

UK Economic Situation

Akos Valentinyi then produced a hand-out of reference charts and commenced his presentation with a discussion of inflation trends in the UK. While recent months have shown a downturn, even Consumer Price Index (CPI) inflation excluding energy had shown an upward trend on a longer term perspective. Therefore, it was too early to say that inflation was definitely on a downward trend. Goods price inflation had been highly volatile but services inflation had been less volatile and consistently above CPI inflation. Producer price inflation still indicated some upside risk as did the Bank of England inflation expectations survey.

Aggregate demand remained weak with both household consumption and investment dragging down growth. Spending on consumer durables had risen but, again, there was little to suggest a sustained positive trend. The investment figures continued to show weakness with only equipment investment showing signs of unusual activity, although the latter may result from the extension of wind farms. The rebalancing of household balance sheets was evident in the decline in the ratio of personal debt to income and, also, in the rise in the savings ratio.

Growth was being driven by activity in the service sector but services growth remained anaemic. The decomposition of service sector growth showed weakness in all areas. Manufacturing productivity had risen as a result of the output drop not being as great as the contraction in employment. Britain’s terms of trade had continued to decline. This deterioration could be interpreted as a negative productivity shock, which exacerbated the decline in real disposable income. Yet, the rate of unemployment remained below the peak of the early 1990s recession. A simple plot of the change in the rate of unemployment against the growth rate confirmed that Okun’s Law still prevailed. The implication was that real GDP growth in the region of 2% was necessary to stop unemployment from rising.

In summary, the demand side of the economy remained weak in the opinion of Akos Valentinyi. There might have been some good news with respect to durables spending but the supply-side was also debilitated. The balance between weak demand – but even weaker supply – suggested that the longer-term risks to inflation were on the upside.

Discussion

The Chairman thanked Akos Valentinyi for his presentation before throwing open the meeting for discussion. David B Smith added that while the latest ONS figures showed that government consumption expenditure was up 3% year-on-year in the first quarter, general government fixed capital formation was down almost 33% year-on-year, and that both figures were now noticeably adrift – but in opposite directions – from the post-Budget projections of the Office for Budget Responsibility (OBR). The Chairman then asked for comments and questions from the committee.

Andrew Lilico asked whether the exclusion of monetary developments in the presentation was deliberate and how did Professor Valentinyi see quantitative easing (QE) working on the economy. Akos Valentinyi said that there had been no major changes in the pattern of credit flows. Given the weakness of household demand and the rebuilding of balance sheets, QE would have had little force. He suggested that there might be a threshold effect before QE started to work so that only after a particular level has been breached, would QE begin to operate. He added that, in an open economy, QE could leak out in capital flows to the overseas sector and not have any direct effects on home demand.

Tim Congdon said that he found the lack of discussion of monetary developments very disappointing. He also disagreed with Akos Valentinyi’s pessimism on inflation. The recent collapse in oil and other energy prices implied a sharp fall in inflation measures later in 2012 and in early 2013. By the end of this year, all-items CPI inflation would be lower than CPI inflation excluding energy. Nevertheless, he doubted that output was substantially below its trend level, largely because the UK’s trend growth rate of output was now only around 1%.

Kent Matthews said that no amount of QE would have any real effects if there was indeed as little spare capacity as Tim Congdon suggested. Peter Warburton added that the output gap should not be seen as a domestic constraint. Rather world inflation was related to a global output gap and its consequences for the UK were amplified or diminished according to the weakness or strength of sterling. Andrew Lilico said that the most recent tranche of QE had been driven by the Euro crisis. The function of QE was to push money into the economy. However, with low capacity growth, a low output gap and loss of inflation target policy credibility, the policy had lost its traction. The Euro crisis could be viewed as an adverse supply-side shock.

Tim Congdon said that QE was indeed necessary at the outset of the crisis and that things would have been worse in its absence. David B Smith said that the official push towards ever greater financial regulation was so severely restrictive in its monetary and macroeconomic consequences that a great deal of QE was needed simply to offset its negative effects. The logical course was no regulatory overkill and no QE. It was crazy to try to offset the collateral damage done by one set of policy-induced distortions with another damaging set of interventions. This was reminiscent of the policy blunders of US President Carter and Britain’s second Wilson administration in the 1970s, where distortions were piled upon distortions and the authorities ended up chasing their own tails. It took Ronald Reagan and Margaret Thatcher to cut through this Gordian knot the last time round. However, he saw little prospect of current politicians being up to the task required. Kent Matthews said that this argument was reminiscent of the Lipsey-Lancaster theory of the second-best, where an initial distortion caused by a market failure was corrected by a counter-balancing policy distortion. Peter Warburton said that QE was a third or fourth best option. He said that gilt purchases were only one type of QE intervention.

Another type was to swap out existing QE for more risky assets, at fair value, held on commercial banks’ balance sheets. The Bank of England needed to take more risk in order to break the deadlock. Tim Congdon said that the separation of activity between the Bank of England, Debt Management Office (DMO) and HM Treasury had created inconsistency in policy.

David B Smith concluded the discussion by suggesting that the stance of bank regulators can be best understood by applying public choice theory to regulatory bureacracies. Over-regulation made it less likely that there would be politically embarassing bank failures and a few big banks centred on London were easier to supervise than numerous small ones scattered across the country. In addition, complex regulations allowed officials to maximise their bureaucratic empires and better enjoy the fruits of office. This was not an argument for zero regulation. Rather, he was suggesting that there was a tipping point beyond which regulation did more harm than good to society, and that we were now well past that point. Tim Congdon added that, as there was unanimous agreement on the SMPC that regulation was making things worse, a common statement on the implementation of Basle III and other regulation should be included in the policy recommendation. The Chairman then called on the committee to cast their votes and make their comments on monetary policy. These votes are listed in alphabetical order. The vote of Ruth Lea was cast in absentia on 17th July, because she had been unable to attend the SMPC gathering.

Comment by Philip Booth
(Institute of Economic Affairs)
Vote: Hold Bank Rate.
Bias: Do not implement the round of QE recently announced.

Philip Booth said that there were considerable supply side risks. The Eurozone crisis should not be allowed to dominate monetary policy. He said that falling inflation was resulting in less negative real interest rates and therefore there was no need to tighten and raise Bank Rate in the short term. He said that he was satisfied with the status quo and that latest round of £50bn QE should not be implemented.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: Continue with QE as announced.

Tim Congdon said that the funding for lending scheme announced in the Mansion House speech was potentially important. There could be higher growth of the quantity of money, due to both the third exercise in QE and the funding for lending scheme in late 2012 and early 2013. He said that interest rates should remain on hold for the time being and QE continue as planned. QE, which was currently organized solely by the Bank of England, should be replaced by a proper policy of debt management, coordinated between the Bank, the Treasury and the Debt Management Office. The main purpose of debt management policy should be to maintain stable growth of the quantity of money. However, another important consideration was to ensure that banks and other institutions active in the money market had an abundant stock of liquid assets (such as Treasury bills) to trade.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: No change in Bank Rate; continue with latest announced QE stimulus.

The Bank’s latest £50bn tranche of QE, announced at the July MPC meeting, was wholly unsurprising. Faced with a struggling economy, the recent downgrade by the International Monetary Fund (IMF) to its UK GDP growth forecasts was only to be expected; the Bank, rightly, continued to pursue its very stimulatory monetary policy. The damaging uncertainties created by the on-going Eurozone crisis show no signs of abating as the Eurozone’s political leaders continue to avoid the painful and necessary measures required to ‘solve’ the Euro’s intrinsic problems. The Euro crisis blew up in early 2010 and a permanent solution is almost as remote as it ever has been – even after the latest summit. Regulatory pressures on the banks continue to act in a counter-cyclical manner, restricting the banks’ ability to lend.

Meanwhile there was no need to be concerned about inflation. June’s CPI inflation rate fell to 2.4%, better than expected, and earnings growth remains extraordinarily subdued. It is now quite possible that the Bank will meet the 2% inflation target by the end of the year, which vindicates its ‘wait and see’ policy and refusal to tighten monetary policy even though CPI inflation has been above target since 2010. As CPI inflation falls to target then the painful squeeze on real incomes should be eliminated, which in turn should support consumer expenditure.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To raise rates.

Andrew Lilico said that it was not the job of monetary policy to offset regulatory errors. In the current situation, there was little monetary policy could do. An extreme monetary stimulus had been carried on for longer than necessary. Some normalisation of monetary policy should be aimed at. The rate of interest needed to revert to a Wicksellian norm – i.e. a real rate of something around 2% and there had to be a reconnection of the policy rate to market rates. A return to an equilibrium growth rate could not be obtained with Bank Rate so low. A rise was appropriate at this stage as a step towards the normalisation of monetary policy.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To raise; QE to be used only in the event of another Euro crisis flare up.

Kent Matthews said that he was impressed by Tim Congdon’s comments that there was little spare capacity in the economy and that capacity growth was in the order of 1% a year. If this was the case, then QE would be ineffective. He said that he was also optimistic about the funding for lending scheme and that it did have the potential to kick start bank lending to the growth sectors that will capacity build. His argument for raising the rate of interest was somewhat different to Andrew Lilico’s. While agreeing that monetary policy had to revert to some norm meant that rates had to rise, he felt that the Euro crisis might carry on for far longer than people currently suspect. Interest rates at the current position left no room for monetary policy in the event of another flare up of the Euro crisis. Currently, interest rates had nowhere to go in the event of a crisis. Interest rates would have to move closer towards a level where real interest rates were positive, so that in the event of a crisis the Bank could cut rates and deploy QE as a countermeasure. He said that interest rates should start to rise in small steps. While he felt that QE should be held in reserve for a bad day, to not implement the announced policy would only signal what some market participants fear – i.e., that the Bank does not know what it is doing.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate. No additional QE
Bias: To raise Bank Rate, once the Euro-zone situation clarifies.

David B Smith said that policy should be geared towards boosting the long term rate of growth using deregulation, tax reform and other supply-side friendly measures immediately and a rolling back of the excessive size of the state as soon as that becomes practical. The massive increase in the governmental sector between 2000 and 2010 had led to the mother of all supply withdrawals where the UK was concerned. This was not a situation that could be corrected by injecting ever more nominal demand into the economy. Britain’s small open economy meant that the main role of monetary policy was to differentiate UK inflation from world inflation via changes in the external value of sterling, which had been reasonably strong recently. The cut in the oil price from around $125 for a barrel of Brent crude to $100 – which now seems to be the new Saudi Arabian goal – will be dis-inflationary in the short term but also result in a positive surprise to global output in 2013.

Regulatory policy had been totally perverse and business cycle-exacerbating where money and credit creation were concerned. Monetary policy had attempted to offset the negative effects of regulation but without success. Higher capital and liquidity ratios should have been imposed in the boom not in the recession. QE was not a silver bullet. The only remaining argument for it now was to offset regulatory mistakes that should not have happened in the first place. Private-sector agents were not spending and investing because they faced hugely excessive regulatory uncertainty, tax unpredictability, and political risk. Politicians and bureaucrats needed to stop making matters worse and cease their confidence-sapping anti-business rhetoric. The economy required a predictable and stable banking system. Competition in the banking system could be brought in by employing anti-monopoly legislation to break-up the bigger banks, perhaps into their original constituents that existed before the clearing bank mergers of the late 1960s. This would reduce the ‘too big to fail’ problem without requiring the wholesale socialisation of the banking system that current policies were engendering.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate; no further QE.
Bias: To tighten.

Akos Valentinyi repeated that it was too early to say that inflation was on a sustained downward path. There remained significant inflation risks and expectations of inflation on the Bank of England’s own survey continued to point to an upward path. Low unemployment in the current stage of the recession could be interpreted as a positive inflation surprise. He said that there was no need for interest rates to rise immediately but his bias was for a rise in the near future. He said that QE should be put on hold for the moment.

Comment by Peter Warburton
(Economic