Following its most recent quarterly gathering on 17th January, the Shadow Monetary Policy Committee (SMPC) voted unanimously that UK Bank Rate should be held at ½% on Thursday 9th February. The main reason why SMPC members again voted without any dissension to hold the official interest rate in February was their concern about the potential adverse consequences of the crisis in the euro-zone for UK banks and exporters. Indeed, more time was devoted to a discussion of the situation in the euro-zone at the SMPC meeting than it was to British policy issues.

The general view was that the UK monetary authorities were in the position of doctors attempting to treat a patient with a life threatening medical condition that was incapable of diagnosis. Any aggressive treatment was more likely to prove fatal than to provide a cure. However, relying on a spontaneous recovery did not necessarily provide much hope either.

Two things that the SMPC generally agreed on were that a Greek default was unlikely to be averted and that there was a serious inconsistency in British monetary policy between the official hard-line approach to financial regulation and the need to maintain the supplies of money and credit to the private sector in order to sustain job-creating activity and the tax base.

The official intention to raise bank capital and liquidity requirements represented a perverse, business-cycle exacerbating, regulatory shock. The UK monetary authorities would be better advised to re-instate the Special Liquidity Scheme, whose premature withdrawal had badly damaged the credit creation process, if they wanted to succour Britain’s economic recovery.

Attendance: Philip Booth (IEA-Observer), Roger Bootle, Jamie Dannhauser,
Anthony J Evans, Andrew Lilico, Kent Matthews (Secretary), Patrick Minford,
David B Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.

Apologies: Tim Congdon, John Greenwood, Ruth Lea, David H Smith (Sunday
Times observer), Mike Wickens.

Chairman’s Comment

The Chairman started by saying that Gordon Pepper had confirmed his intention
to stand down from the SMPC in January 2012 in order to make way for the
new younger members of the committee who had recently been recruited. The
Chairman expressed his sincere thanks to Gordon Pepper for his consistent
loyal service to the SMPC since its foundation in July 1997. He added that
Gordon Pepper would be remembered among his numerous other contributions
for his pioneering advocacy of Quantitative Easing (QE) where he was well
ahead of the consensus and the Bank of England in understanding the need
for such measures. The Chairman then called upon Trevor Williams to give his
assessment of the global and domestic monetary situation.

UK Economic Situation

Trevor Williams said that he would reverse the usual order and discuss the
domestic monetary situation first and then go on to analyse the global scene. He
referred to his prepared charts on the monetary situation. The domestic scene
was set by events that had weakened global growth in 2011. The euro-zone
crisis, the deepening credit crunch, faltering trade and confidence effects were
joined by spending cuts in the US, tightened monetary policy in the emerging
economies and continued rising oil and commodity prices. The present year had
started with weak growth compounded by political risks from the Middle East,
regulatory risks for banks in advanced economies, and sovereign risk and bank
default risk. The only positive sign was the overweight holdings of cash on the
balance sheets of large companies. However, the exposure to a potential euro-
zone collapse was the major threat facing the British economy.

For the UK, the contraction in credit growth posed a major obstacle to recovery.
While credit availability had improved a little, it was still insufficient to meet
the latent demand from small companies. Defaults were rising and spreads
remained too tight. Survey evidence suggested that the UK was currently in
recession. The Lloyds Business Barometer indicated that the probability of a
renewed recession was well above 50%.

Secured borrowing by households had remained flat and unsecured borrowing
had picked up only marginally. Total personal borrowing had peaked but high
debt levels were holding back the recovery as household sector de-leveraging
continued. Net repayments dominated the actions of the corporate sector, with
credit growth having remained negative since mid-2009. The company sector
financial surplus had continued to rise while investment had declined. Overall,
the weakness in broad money growth signalled interest rates would remain low
for the foreseeable future. QE had boosted nominal income growth but had
demonstrated little ability to stimulate real GDP. However, underlying inflation
pressure was likely to be subdued although the inflation target was not likely to
be met until 2013.

The current downturn may not be as deep as the 1930s but it appeared to be
more protracted. The forecast for GDP had greater downside risk.

World Economy

Prospects for the world economy depended on whether the expected Greek
default was orderly or disorderly, according to Trevor Williams. The baseline
assumption was that there would be a Greek default. A 50% haircut was
expected around the turn of the year. If the default was orderly, contagion could
be avoided. However, the world would be adversely impacted by a disorderly
default. Structural shifts within the euro-zone had opened up wide gaps in
competitiveness between Germany and many of the other members, so any new currencies would face significant depreciation risk. A euro-zone break-up would impact on the UK through a liquidity squeeze, a tightening of the credit market, a contraction in domestic spending and an appreciation of sterling.

Globally, credit conditions were tightening and capital markets were under
pressure with widening emerging market bond spreads. A global recovery had
been underway at different speeds for the emerging markets and the developed
markets but with signs that growth was faltering in 2012. The quicker the euro-
zone crisis was resolved the better for the world economy.

Discussion

The Chairman thanked Trevor Williams for his presentation before asking both
Roger Bootle and Patrick Minford to make their respective comments forthwith,
since he knew that both had to leave by 6pm and time was pressing. As there
were ten members present, the Chairman also ruled that the last person to
physically join the meeting (Patrick Minford) would have his views recorded but
his vote discounted. Roger Bootle’s comment and vote appears with the other
votes below while Patrick Minford’s comments follow immediately.

Patrick Minford started by stating that monetary policy was in suspense while
the euro crisis continued and that voting for a policy was a pointless exercise.
That meant his immediate rate recommendation could only have been for a
hold where the 9th February decision was concerned. Unfortunately, the euro
crisis might continue for some time and QE was not having any effect other than
filling the government’s coffers by financing gilt sales. Meanwhile, regulatory
noises of a super-Basle nature had scared the banks into not lending. This was
similar to a situation of financial repression which was affecting small companies
particularly badly. Patrick Minford said that it was appropriate to be tough on the
commercial banks in a boom but not in a slump. He called for the reversal of
the current drive towards excessive bank regulation from the Financial Services
Authority and the Vickers Report. Patrick Minford then left the gathering.

The Chairman then opened up the meeting for general discussion. He proposed
that, rather than concentrate on the purely domestic situation, the meeting
should apply its monetary expertise to discussing the situation in Continental
Europe, since the uncertainties in the euro-zone dominated all other factors
and he strongly suspected that everybody present would be voting for a Bank
Rate ‘hold’ in any case. He suggested that they should begin with a discussion
about the technical feasibility of the break-up of a currency union, particularly as
Akos Valentinyi, as a Hungarian, knew a lot more than most people about the
collapse of the currency union between Hungary and Austria after World War 1
and Ukraine and Russia after the collapse of the Soviet Union. Akos Valentinyi
commented that the integration of financial markets made it difficult to compare
the break-up of the euro with the historical precedent of over-stamping a former
imperial currency to create a new national one. Peter Warburton added that
the web of interconnectedness went deeper than people imagined, particularly
through the leverage created by derivatives contracts.

Andrew Lilico said that the British banks had been instructed to make
contingency plans in case of a euro-area break-up. Trevor Williams said that Greek banks were effectively bankrupt with the haemorrhage of deposits from
Greece. He said that the draw-down of euro deposits in Greece matched the rise
in euro deposits in Germany. Andrew Lilico said that he was concerned with the
cascade effect of a Greek exit on the UK money supply. David B Smith said that,
under such extreme circumstances, the government should stabilise the stock
of bank deposits by allowing the budget deficit to be directly monetised until
the crisis was over. The UK budget deficit was so large that direct monetisation
would be a powerful weapon under these specific circumstances. Jamie
Dannhauser said that the Bank of England could switch from being a liquidity
provider to being a funder - like the ECB - by buying bonds from the commercial
banks.

The discussion went on to include the implications for bank balance sheets
of rating downgrades of government bonds. David B Smith said that financial
regulators almost universally demanded that banks hold government bonds on
alleged prudential grounds. However, there was now a greater probability of
major losses on sovereign debt than there was on lending to households and
businesses. This meant that such officially imposed balance sheet constraints
served no socially useful purpose and mainly served to allow fiscally profligate
governments to crowd out potential private-sector borrowers without having
to pay the normal interest rate penalty. David B Smith added that the banking
sector (and pension funds) would suffer large capital losses if real interest rates
simply returned to more normal levels, or inflation premiums rose, causing
nominal bond yields to rise and capital values to fall. However, such losses
would happen far more dramatically if governments substantially defaulted by
haircutting their debt obligations.

Jamie Dannhauser added that the difficulty of measuring financial services
and the possible overweighting of bank services in the official measure of GDP
in the base year of 2008 may have been giving a false picture of where the
economy currently was situated. Trevor Williams said that the political climate
had created perverse policy reactions that lead to credit tightening when the
crying economic need was for a loosening. He said that regulators had to accept
that the current situation was partly of their own making through the creation of
perverse incentives. Further tightening of the regulatory framework at this stage
would make things worse not better.

David B Smith concluded the discussion by suggesting that the uncertainties
discussed in the meeting were such that the committee were in the position
of a panel of doctors confronted with a patient with a life-threatening but
undiagnosable condition. His concern was not so much that the patient would
not recover if left well alone, but that ill-advised medical interventions carried
out by quack doctors would definitely prove fatal. The sight of politicians and
regulators crowding round the British economy with their metaphorical leaches,
bleeding cups, and trepanning drills did not inspire confidence, to put it mildly.
The Chairman then called on the committee to cast their votes and make their
comments on monetary policy. Kent Matthews suggested that they should
expand on their views on unconventional monetary policy since no one was
calling for a rise in interest rates.

Comment by Roger Bootle

(Capital Economics)
Vote: Hold Bank Rate.
Bias: Increase Quantitative Easing and carry on increasing it as necessary.

Before he left the meeting, Roger Bootle had stated that he largely agreed with
the assessment of Trevor Williams. The global economy was approaching an
existential crisis. Greece and possibly Portugal would have to exit the euro. The
worst of all outcomes for the world economy was for the euro crisis to drag on. A quick break-up would create immense damage in the short run but the recovery would be faster and, correspondingly, the better option for the world economy.

The potential for a banking crisis that was several times worse than the Lehman
one could not be excluded. One ray of sunshine was that inflation would fall
below 2% by the end of this year. Those in work would benefit from this. The
housing sector could still create problems and a weak economy would continue
for two or more years. Since inflation expectations were down, QE could be
used more effectively. He therefore voted to maintain the rate of interest and to
increase QE

Comment by Jamie Dannhauser

(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: Aggressive QE as the euro-zone situation worsens.

Jamie Dannhauser said that QE had been the correct policy response at the
beginning of the crisis and that it remained the correct response now. QE had
to be used to offset the effects of tighter conditions in the bank funding markets.
Greece was likely to exit the euro-zone within twelve months and could well be
followed by Portugal, in his opinion. The responsibility of the British government
was to insulate the UK banks from the seemingly inevitable break up. Unless
conditions in financial markets improved markedly, additional asset purchases
could be needed soon. If the euro area situation worsened, the Bank of England,
possibly in co-ordination with HM Treasury, should expand its QE programme
dramatically, going beyond gilts to bank debt (including covered bonds and
ABS) and potentially even riskier assets. In the event of a disorderly Greek exit
from monetary union, preventing a rapid appreciation of sterling would also be
important.

Comment by Anthony Evans

(ESCP Europe)
Vote: Hold Bank Rate.
Bias: Use QE to stabilise money supply to target nominal GDP.

Anthony Evans said that the problem facing the British monetary authorities
was the necessity to make policy decisions based on predictions of what was
going to happen to the euro-zone. Policy should not be based on pre-empting
disaster, although the Bank of England should be on standby to respond to
clear signals of financial distress. He said that he was hesitant to engage in
further QE especially when inflation was above target and the money supply
was rising. Indeed, he did not think that QE was compatible with the Bank
of England’s attempt to keep popular inflation expectations at 2%, and that
forecasts of CPI returning to target by the end of 2012 constrained its impact.
The fact that inflation targets had been more honoured in their breaching than
their observance in recent quarters suggested a need to re-examine the whole
monetary regime. The policy focus should be to buttress the broad money
supply to prevent nominal GDP from falling.

Comment by Andrew Lilico

(Europe Economics)
Vote: Hold Bank Rate; hold QE.
Bias: To raise rates.

Andrew Lilico said that he was mystified as to the purpose of monetary policy
since there appeared to be no robust inflation target to speak off. The policy
discussion was about what to do in the case of a euro-zone collapse. Greek
default could occur in the next two months, in which case QE should not be
viewed as last resort lending. The Bank of England should not stop banks from
going bust. It was likely that monetary policy had gone as far as it could. We
may be close to the point where the interest rate had to revert to a Wicksellian norm - i.e. a real rate of something over 2%. The rate of interest could not stay
at the current level forever. The interest rate could remain where it was in the
short term. However, a rise was appropriate if the crisis remained unresolved.

Comment by Kent Matthews

(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To raise; QE to be used only if euro crisis signals danger of UK recession.

Kent Matthews said that the problem for monetary policy was the need to know
whether the recent contraction in output was permanent or temporary. The
credit crunch that followed the banking crisis had led to considerable capacity
destruction in the Bernanke-Gertler sense. However, a permanent contraction
in output meant that GDP would not grow back to a ‘potential’ level defined by
some pre-crisis trend but rather grow at the historic trend rate from the low level reached in 2008 and 2009. Maintaining interest rates at their current low level was playing fast and loose with longer term inflation expectations.

Admittedly, the Bank of England’s prediction that inflation would fall in 2012 looked plausible. However, there remained room for doubt as to whether inflation would reach the target by the year end. Part of the uncertainty was to do with where interest rates will be in the second half of this year. We would have a better idea of whether the economy was close to capacity, or if the Bank was correct in its assessment that there was sufficient capacity in the system to continue to exert downward pressure on inflation, towards the year end. If there was little spare capacity, monetary policy was not just ineffective, it was inappropriate. Currently, we did not know where the economy was.

QE was good at stopping a downturn in the economy from turning into a
disaster, in the opinion of Kent Matthews. However, there was little evidence that
QE worked to reverse the direction into an upturn. Therefore QE should be used
sparingly and held in reserve. He was also not as sanguine about the likelihood
of a quick resolution of the euro crisis. The crisis could carry on for another
year or longer. In which case, interest rates would need to signal a movement
towards a level where real interest rates were positive. There was always the
possibility that a Greek exit became a reality in the next few months. In which
case, QE could be deployed to counter the liquidity squeeze and the ensuing
asset price deflation. In the mean time, we had to wait and see.

Comment by David B Smith

(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate, until the euro-zone situation clarifies.

David B Smith said that the decade of extreme tax-and-spend policies in the
UK between 2000 and 2010 had generated the mother of all supply withdrawals
and that the Coalition were in a state of psychological denial about the scale
of the structural fiscal problem that they had inherited. As a result, there was
a danger that policy could over-stimulate home demand relative to the supply
base, leading to chronic inflation and a worsening trade gap. If European
monetary union genuinely could not be saved, a rapid break-up was the least
bad outcome, regardless of how much political ‘loss of face’ this caused. This
was unambiguously preferable to a crisis that dragged on for several years,
leading to chronic economic uncertainty and rising social and political tensions
across the Continent. The European Central Bank had argued that a major
cause of the euro crisis was the inconsistency between the relative fiscal rigour
that had been maintained in Germany since monetary union in 2000 and the far
more profligate policies that had been adopted elsewhere. He broadly agreed
with this view and suspected that Greece, Cyprus and Portugal would all have to
quit the euro-zone during the course of 2012. However, he was more sanguine about Spain and Ireland which could regain favourable supply-side flexibility if
they returned to their earlier more disciplined fiscal stances.

The problems within the euro-zone had distracted market attention from the
issues of the long-term viability of UK sovereign debt, in David B Smith’s view.
The Coalition had inherited a dreadful fiscal mess but it had also chickened out
of taking the measures needed to stabilise the fiscal situation in the long run
and to improve the supply-side of the British economy. He was also profoundly
concerned that the domestic financial regulators had got the bit between their
teeth and were attempting to gold plate the already excessively tight regulations
stemming from Basle III and the European Union. The solution to the ‘too big
to fail problem’ was to break up the large banking groups using the normal
tools of anti-monopoly policy, not to strangle money and credit creation through
excessive regulation. Public choice theory suggested that bureaucracies always
tended to over-regulate financial institutions – regardless of the social costs and
benefits involved – because this minimised the apparent risk of embarrassing
institutional failures, even if officials were half-asleep on the job as they had
been before the crisis, and also maximised the extent of the bureaucratic
empires concerned. Monetary policy in the immediate future should be to
hold Bank Rate and to stop M4ex from falling, using the full range of monetary
tools including QE when appropriate. However, he thought that QE was best
employed when the Central Bank had to act as a lender of last resort and was
not convinced that it was an appropriate implement for demand management
purposes on a day to day basis. One reason was that it probably was not as
effective as the Bank of England appeared to believe. Another was the political
moral hazard it engendered because it allowed fiscal profligacy to become a free
good where the political and bureaucratic interests were concerned.

Comment by Akos Valentinyi

(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To tighten, unless inflation eases sharply.

Akos Valentinyi said that there remained significant inflation risks. The Bank
of England had consistently under predicted inflation in the past three years.
As a result its credibility was weak. It was difficult to see how the euro-zone
crisis would play out. It could turn out to be worse than a sovereign debt crisis.
The imbalances in the euro-zone went well beyond fiscal policy. There were
deep structural problems. The exit of Greece and Portugal from the Euro was
possible. However, and until the uncertainty in the euro-zone was resolved, the
Bank of England’s priority should be the inflation target. The inflation figures
were more transparent and better understood that nominal income, given the
delays and uncertainty of the Office for National Statistics (ONS) figures. He said
that QE should be put on hold for the moment.

Comment by Peter Warburton

(Economic Perspectives Ltd)
Vote: Hold Bank Rate; no extension of QE; reinstate the Special Liquidity Scheme.
Bias: To raise Bank Rate before the end of 2012.

Peter Warburton said that, on a global basis, the pace of private sector credit
growth had not slowed, despite the numerous surveys showing a tightening
of credit conditions. Overall, there had been no deceleration of global credit
aggregates and hence no strong expectation that the global economy would
slide into anything worse than an inventory downturn. This was not shaping
up as a repeat of the experience of 2008 and 2009. The UK was perfectly
capable of generating 1% to 2% GDP growth in 2012, even after accepting
that the Euro crisis could knock growth back by an indeterminate amount. The
Bank of England had effectively killed off the wholesale money markets and it should support collateralised alternative to the moribund inter-bank market. It
was wrong to think that UK banks could be weaned off their dependence on
wholesale markets, including securitisations, completely. There was a need to
widen the range of eligible collateral to provide greater flexibility for the banking
sector in meeting its funding requirements.

QE had induced some positive effects but these were diminishing, in Peter
Warburton’s opinion. The case for additional QE was unconvincing. The road of
pre-commitment to emergency low levels of policy interest rates was ill-advised;
the US Federal Reserve’s recent willingness to do so should not be copied in the
UK. Rather, by revitalising the wholesale markets, the Bank of England should
be looking to re-engage Bank Rate with the structure of market interest rates
later in the year with at least one token Bank Rate increase.

Comment by Trevor Williams

(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: To loosen via QE.

Trevor Williams said that the rate of interest had to remain on hold until the
situation had normalised. European Central Bank type lending could be followed
by the Bank of England but QE was probably more workable in the UK context.
QE did have an effect on ten-year gilt rates and it also minimised defaults. He
said that he was sympathetic to those banks that had responded to regulation
by increasing reserves with the central bank, because they were fearful of being
caught short of capital. However, central banks had sent the wrong message to
the commercial banks and households creating a moral hazard problem of their
own making. QE could be deployed effectively in the context of the euro crisis.
He said that QE should be extended by £75bn from its current position and even
increased up to a total stock of £500bn in case of serious fallout from the euro
crisis.

Policy response

1. There was unanimity that Bank rate should remain on hold in February and
probably until the outcome of the euro crisis was clarified.

2. There was general acceptance that the euro crisis would come to a head
in the first half of 2012 with the likely exit of Greece from the euro-zone.
However, two members of the committee felt that the crisis could continue to
be unresolved for longer.

3. Several SMPC members indicated a bias to raise Bank Rate in the future,
while accepting that this was not appropriate at the moment when QE
was a superior monetary tool. However, there was a bias to get back to a
more ‘normal’ rate of interest as soon as this became practical.

Date of next meeting Tuesday, 17th April 2012.

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
TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is
technically a non-voting IEA observer but is awarded a vote on occasion to
ensure that exactly nine votes are always cast.

In its most recent monthly e-mail poll, completed on 3rd January, the Shadow Monetary Policy Committee (SMPC) voted unanimously that UK Bank Rate should be held at ½% when the official rate setters make their announcement on Thursday 12th January.

The overwhelming reason most SMPC members voted, in some cases reluctantly, to hold the official interest rate in January remained their grave concern over the potential adverse effects of the Euro-zone crisis on British banks and exporters.

Some ‘holds’ thought that the 4.8% consumer price inflation recorded in November was bad enough to have justified a Bank Rate increase under more normal circumstances. However, there was a widespread view on the shadow committee that the measures adopted by the Euro-zone authorities were insufficient to stabilise the situation in the Euro Area and that the UK would just have to live with that fact.

There were two further concerns shared by several SMPC members. One was that the British economy had suffered a supply-side withdrawal, so that the negative output gap relied upon to bear down on inflation was smaller than the authorities believed. The second concern was the inconsistency between the official hard-line approach to financial regulation and the need to maintain the supplies of money and credit to sustain private job-creating economic activity.

Raising capital requirements now was a classic example of a perverse, business-cycle exacerbating, regulatory shock. The authorities would do better to re-instate the Special Liquidity Scheme, whose brutal and premature withdrawal has badly damaged the credit creation process.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold Bank Rate.
Bias: Increase Quantitative Easing and carry on increasing it as necessary.

The economic position continues perilous. An outright fall in GDP is expected for this year with little sign of a revival on the horizon. The good news is that commodity prices have started to fall and inflation now looks likely to embark on a large and protracted drop. This may sow the seeds of economic recovery in due course. However, this remains a hope for the future rather than a current reality.

In addition, the fall in inflation gives welcome cover for the authorities to increase Quantitative Easing (QE) still more. They should carry on and complete the existing programme as soon as possible and immediately announce more, and still more, and yet more, as necessary. Moreover, with the turmoil in the Euro-zone there is a significant chance that the pound will be forced up much higher against the Euro. If this happens, it would worsen the UK position and undermine confidence. The Bank of England should be ready to do Quantitative Easing (QE) across the exchanges – i.e. buying foreign assets, and even to take a leaf out of the book of the Swiss National Bank, standing by for even more aggressive currency interventions.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: Additional QE; unless Euro-zone situation improves markedly.

The fate of the UK recovery hangs in the balance. There is now a good chance that real GDP declines in at least one quarter in 2012. This primarily reflects the weakness of demand in the Euro-zone economy, which is Britain’s main export destination. The Euro Area probably entered recession in late autumn, with output in some of the smaller periphery economies in decline since the summer. Italy is the first major European economy to tip back into recession; others will soon follow. Euro Area output is unlikely to start growing again until the second half of 2012 at the earliest.

Beyond Europe, recent economic data have been mixed. Consistent with the rebound in US broad money and business lending growth that begun in the first half of last year, there has recently been a pick-up in the underlying pace of domestic demand growth. The substantial decline in the real value of the dollar has improved US exporters’ price competitiveness and boosted output via import substitution. In the emerging world, recent data releases have suggested a moderation in the pace of economic expansion. China, which has been a major source of global demand growth at the margin, seems to be slowing sharply, as efforts to rein in its banking sector start to bite.

Even before one factors in the increasing likelihood of a disaster in Europe, there are sound reasons for believing that this year will be a difficult one for the world economy. Policy tightening to ward off inflation in the emerging economies implies weaker growth than in 2010 and 2011. While the temporary extension of the payroll tax cut in the US limits the immediate fiscal squeeze, policies worth 3% to 5% of GDP are set to be implemented in 2012/13 in order to bring down the US budget deficit. In aggregate, the advanced economies will be buffeted by the largest, co-ordinated fiscal consolidation in the post-war era.

Were these the only risks to the global growth outlook, the current stance of UK monetary policy might be considered appropriate. There would be certainly a strong argument for waiting to see how fast inflation falls back in the first half of this year in order to assess, with greater clarity, how weak underlying inflationary pressures actually are. However, with the spectre of banking disaster once again hanging over us, there are strong arguments for additional Bank of England asset purchases.

Commercial banks already appear to be responding to funding tensions by reducing the availability of credit and increasing its cost. Even before this tightening of monetary conditions has fed through to real activity, the UK economy appears to have stalled. Unless financial-market conditions improve markedly in coming weeks, an additional dose of QE will be needed. Given the ongoing disruption to medium-term bank funding markets, the government should consider inviting the Bank of England to purchase bank bonds alongside gilts. While the former may have a less immediate impact on broad money – e.g. because the Bank is purchasing debt directly from the banking sector – it would help assuage banks’ funding problems, thereby limiting the deleveraging process that already appears to be underway.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Hold Bank Rate; expand QE further if M4ex broad money declines.

The fate of the world economy, the prospects for financial markets, and the international framework for the decisions of the Monetary Policy Committee (MPC) in 2012 depend primarily on the answers to three big questions: Will the Euro-zone crisis be resolved in a timely and effective manner? Will the US economy maintain its recent better performance? And will the Chinese economy avoid a hard landing in 2012?

The answers to these questions are not all favourable. First, the outlook for the euro-area remains clouded by the failure to resolve the region’s sovereign debt problems at the Brussels summit on 8th & 9th December, and there is a possibility of another crescendo in the crisis during 2012. This will continue to cast a shadow over Euro-zone business and consumer confidence. Real GDP growth for the single currency area was only 0.2% quarter-on-quarter in the second and third quarters of 2011. The subdued growth was due to the drag from the crisis economies which offset stronger growth in Germany and France. The survey data so far available – such as the Purchasing Managers Index (PMI) which remained below 50 for the three months September-November – indicates that the Euro-area economies are almost certain to have shifted to recession in the final quarter of last year. Another decline in economic activity is likely in 2012 Q1 followed by very low growth for the balance of the year. This, together with a weakening Euro, implies adverse market conditions for UK exporters.

Second, in the US the recent improvement in performance following the soft patch last summer has been only partial, with the overall economy likely to be held back in 2012 by many of the same headwinds that eroded performance in 2011. One example is that the traditional macro-economic tools of fiscal and monetary stimulus proved impotent when confronted with the greater power of private sector deleveraging. Thus, the fiscal stimulus passed in December 2010 – which extended the Bush tax cuts, lengthened unemployment benefits and reduced the payroll tax – and the second programme of QE conducted by the Federal Reserve between November 2010 and June 2011 both failed to revive the economy. Although lower inflation should help revive real consumer incomes, 2012 is likely to be another year of sub-par growth.

Third, the Chinese economy remains excessively dependent on external demand and hence acutely vulnerable to the deepening downturn in Europe. This means that China’s overall growth rate this year seems likely to be lower than in 2010 or early 2011, even though domestic monetary and fiscal stimulus will almost certainly be employed in 2012.

Turning to the factors driving the UK economy, balance sheet repair and the erosion of household income by higher than expected inflation were the two main headwinds holding back the economy in 2010 and last year. While balance sheet repair is likely to continue to be a major preoccupation of both the household and financial sectors for several more years, inflation is likely to fall significantly in 2012. Nevertheless, continued deleveraging and weak real income growth will prevent a sudden snap-back to pre-crisis economic growth rates.

Official views, as expressed in the Office for Budget Responsibility’s (OBR) Fiscal and Economic Outlook and the Chancellor’s Autumn Statement, have been very gloomy about the economic prospects for 2012 and 2013. On the positive side, both documents have at last displayed a welcome sense of reality in contrast to the previous tendency in Whitehall to persistently overestimate growth prospects and hence over-commit to government expenditure. On the negative side, the framework that the OBR uses to forecast growth depends on two concepts – the output gap in the economy, and the underlying growth of productivity – that are both extremely hard to quantify. Both of these have been problematic recently. The amount of excess capacity is inherently a nebulous concept, especially in a service economy. The OBR has argued that productivity growth has taken a permanent adverse hit because of the recession and will take many years to recover. On this basis, the OBR is forecasting only 0.7% real GDP growth in 2012 and 2.1% in 2013.

However, one can reach the same conclusion more directly. Much recent research has shown that growth is significantly impaired in the aftermath of a financial crisis. The reason is that financial crises damage balance sheets across the economy, and it takes a long time for the household and financial sectors to repair them. These are precisely the two sectors that became most over-indebted during the credit bubble of 2003 to 2008. Consequently I would say that essentially the official Whitehall view has at last come broadly into line with my forecast of sub-par, 1.0% real GDP growth in 2012.

On the inflation front, commodity prices were pushed up strongly in 2009 and 2010 on the back of the recovery in the emerging economies, especially natural resource-importing economies such as China and India. The feed-through to consumer prices in very open economies such as the UK was rapid, exacerbated by weak sterling and higher VAT and fuel duties. However, this recent episode of inflation was essentially a one off event rather than the start of a sustained, continuing inflation. In 2012, the recession in the Euro-zone together with weak monetary growth in the US and the UK over the past two years will mean that these one off effects will largely fall away. This means that rising inflation will be replaced by a deceleration. Annual Consumer Price Index (CPI) inflation is expected to fall to 2.4% for this year as a whole, enabling real incomes to increase marginally – a considerable improvement over 2011. Against this only slowly improving background, Bank Rate should be kept at its current ½% level. The Bank of England should also be prepared to extend again its programme of asset purchases to ensure that M4ex monetary growth remains positive, but in low single digits.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate and no more QE as yet.
Bias: Towards more QE.

The increase in GDP in the third quarter was misleadingly buoyant. The revised 0.6% rise was driven almost entirely by a sizeable increase in inventories. There was some pick-up in fixed capital formation and a modest rise in General Government consumption, but household consumption was flat (and 1% lower than a year earlier) whilst the balance on net exports, very disappointingly, deteriorated. The much needed rebalancing of the economy from domestic to external demand, ‘export-led growth’, hit the buffers reflecting renewed economic difficulties in the Euro-zone. Recent trade data confirm that exports of goods and services to the EU fell in 2011 Q3.

The December MPC minutes made a very telling point. They said that “around three-quarters of the cumulative increase in GDP since the trough in the second quarter of 2009” was attributable to government spending growth and an increase in inventories and “private final demand had been subdued”. Given the outlook for public sector spending and the extent of stock-building since 2010 Q2, neither of these growth drivers is likely to boost growth in future to the extent that they have done in recent quarters.

Under these circumstances the gloomy forecasts from the OBR, the Bank of England and the Organisation for Economic Co-operation and Development (OECD) are entirely reasonable. The OBR, for example, projected a modest GDP fall in 2011 Q4 and virtually flat growth in the first half of 2012 as their central case in November, cautioning that there was roughly a one-in-three chance that the UK would fall back into recession over the next three quarters. However, much depends on the Euro-zone’s performance. The OBR assumed that the bloc would muddle through and not implode. It said, with admirable constraint, “…the possibility of a more disorderly outcome represents a significant risk on the downside to our forecast, but one that is impossible to quantify in a meaningful way given the range of potential outcomes.”

Suffice to say the Euro-zone’s political leaders failed, yet again, to deliver anything approaching a feasible package to ‘save’ the Euro-zone at their December Summit. One senses that the world is growing tired of Europe’s confidence-wrecking muddle and would like some resolution, whichever way, sooner rather than later. The OECD recently stated “…imbalances within the Euro area, which reflect deep-seated fiscal, financial and structural problems, have not been adequately resolved. Above all, confidence has dropped sharply as scepticism has grown that euro area policy makers can deal effectively with the key challenges they face.” There is, in other words, an increasing feeling that today’s Euro-zone’s leaders are incapable of sorting out the mess.

Mme Lagarde also chipped in recently, warning of a 1930s-style depression if the problems of the Euro-zone were not dealt with. She made it clear that “…the core of the crisis at the moment…is obviously the European countries and in particular the countries of the Euro-zone”. In addition, the Obama administration has expressed its concern that, without swift and decisive action from Europe, the region’s debt crisis could damage the fragile US recovery and the president’s re-election efforts. One suspects that the world will have to wait some time for ‘swift and decisive action’ from Europe. In the meantime, the Euro-zone economy is heading back into recession, damaging British growth prospects.

Unsurprisingly, the labour market is weakening and, with earnings growth subdued, there are no signs of a ‘wage-price spiral’. Prices inflation surely will moderate in 2012. Under these circumstances, there is no justification for any change in interest rates for the foreseeable future. Concerning further QE, there is no need for any announcement at the 12th January MPC meeting. However, further QE may well be needed if the economy slumps back into recession.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate; hold QE.
Bias: To raise rates rapidly if Euro does not collapse within four months.

UK index-linked gilt yields are highly correlated with long-term economic growth. Their message has for some time been that the UK will struggle to grow at above 1% over the next decade. If that does happen, then households will be unable to service their debts and there will be widespread bankruptcies, unless inflation rises substantially. Current official policy appears to be to try to keep households clinging on, through maintaining policy interest rates at approximately zero, even if that comes at the expense of inflation and significant further deterioration in the value of the pound.

I have been an advocate and supporter of this policy up to now. Nevertheless, it cannot be right to maintain such a policy for more than an emergency period. In 2007, the economy clearly needed a very significant adjustment. There is a proper role for macroeconomic policy in attempting to smooth major economic adjustments just enough that they do not produce so much distress as to undermine social order. Policy can also act so as to limit overshooting. It seems clear that the UK economy has not overshot by any means – policy has almost certainly intervened at a very early stage and at a very large magnitude, so that it retarded the process of adjustment, rather than prevented overshooting. Thus far, we have undershot.

It is arguable that policy has smoothed what might otherwise have been such a large adjustment that it would have damaged orderly transition – perhaps through creating (more) investor panic or (more) liquidity problems or even (more) social disorder. Nevertheless, even this motivation has its limits. How long is it morally defensible to protect those that over-indulged and that made mistakes at the expense of those that were more prudent and restrained? A policy that can be perfectly correct if implemented over a year or two years might be the wrong policy if it must be repeated for ten years.

We are very close, now, to the point at which demand management has done all it can, and should leave the fray. The proposition is that there should be a rapid normalisation in interest rates – perhaps to 3.5% over a four- or five-month period. Unfortunately, the timing of the Euro-zone crisis makes that inapposite at present. However, the Euro-zone crisis has gone on for some time. Even so, a resolution may be enforced by around March, when the Greeks are likely to run out of money. So, it could be appropriate to wait until then. However, and if the Euro has not collapsed by April, it will be time to assume it will not. The need then would be to press ahead with what must eventually be done – that is unless the path of inflating away debts is being seriously offered as a ‘policy’? If the Euro does indeed collapse, then we are into dark times. QE will probably not be the correct instrument at that point – we may need to print money to directly fund government spending, rather than second-hand debt. However, that lies ahead. For now, again we wait.

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

The recent European Union (EU) summit on the Euro-zone’s problems changed nothing. It merely reinstated the Stability and Growth Pact, with new pious intentions and unenforceable ‘penalties’. Looking back over the period since the Euro was introduced in 1999, it is clear that the great ‘benefit’ to the southern European countries of joining the Euro – i.e. German-style low interest rates, which enabled much less to be spent on servicing huge sovereign debts – was illusionary. The illusion was that somehow the Euro-zone was more than the sum of its parts and that the implied solidarity would create a de facto bail-out for any country in trouble. Hence, the continued existence of Germanic interest rates for these countries for a decade.

It took the banking crisis to destroy the illusion, forcing Germany to protect itself against these implicit demands. Now, interest rates on the sovereign members of the Euro-zone reflect their true sovereign risk. The problem for each sovereign country is, however, that it cannot control either its currency’s value or the rate at which it prints money and inflates. These controls are available only if your currency is floating on the exchanges. So what exactly are the benefits of being part of the Euro-zone? Currently, there is only the cost of being unable to run your economy according to your own needs as the business cycle fluctuates. This cost-benefit logic is likely to become increasingly apparent to the citizens of all these southern countries as the grim austerity programmes mandated by the new Fiscal Agreement bite ever deeper. Their governments will struggle to maintain legitimacy as they implement these programmes; and leaving the Euro will rise up the political agenda.

Some commentators – such as the former MPC member, Willem Buiter, who is now employed by Citigroup – have tried to frighten us with the stories of the disaster that will occur if the Euro-zone breaks up. Such tales have little credibility: currency zones have been breaking up for centuries with little more than temporary disruption. Most countries left gold in the 1930s, with beneficial effects as this enabled each country to pursue easier money. In 1870 the Latin Monetary Union (the first ‘Euro-zone’) broke up. The Soviet currency bloc broke up with the demise of the Soviet Union. The Asian Crisis of 1988 forced most Asian countries off their dollar pegs: these countries bounced back in the early 1990s.

The UK economy will be adversely affected by the slow growth in the Euro-zone in prospect for 2012. This slow growth will continue until there is some certainty about which countries will stay in. However, this will not arrive until, perhaps, 2013 as the European elite responsible for the Euro will not lightly let it break up. The dissolution will be forced on it by messy national politics. However, a far more important external factor for the UK is the strength of the recovery of the US economy, which has been pallid and weak in job creation hitherto. Again politics is much of the reason. President Obama is unsupportive of the private sector and the market economy. His measures – not least ‘Obamacare’ but also his encouragement of union power – are proving toxic to private investment plans. Another factor is the stand-off in Congress over how to reduce the US budget deficit. Nevertheless, these issues will be resolved by the November 2012 Presidential election and the US should then start to come out of its torpor. It never pays to underestimate the resilience of the US economy.

During 2011, the emerging market countries have had to tighten their monetary policies to combat inflation. This has led to a deceleration of their recent fast growth. Instead of world growth of around the 4% mark in 2011, it now will probably turn out closer to 3%. However, this deceleration has eased up the supply situation in commodities and oil so that their prices have come off their peaks. Meanwhile, technology has been devoted to reducing the world’s dependence on them.

Overall, 2012 looks like being a year of slow growth worldwide, again a bit over the 3% mark. But this will not be a bad thing: it will allow inflation to subside in the emerging market countries and it will allow the balance of commodity net supply to be restored. The world trading system has held up, which is probably the most important development. It was the spread of protectionism in the 1930s that helped create the Great Depression. Against this background, the prospects for the UK are for more slow growth. However, this will not be a bad thing if this background leads to good supply-side policies, as there are signs it may. We have seen the public sector being brought back under control, with the dispute over public pensions now resolved and agreement reached on substantial cuts in public sector wage costs overall. There is a grittier realism around over education and the NHS. The UK private sector has been through a revolution in its practices since 1979. We now may be seeing the public sector being brought finally into that revolution.

The one area where a lack of logic prevails is over banking. Popular outrage at bankers has spilled over into a badly thought out plan for splitting the banks into retail and investment bodies. This will raise costs without reducing the probability of future crises. Whether split or not, the banking and financial system is tied irretrievably into a complex inter nexus, which is what forces the need for fire fighting by the Bank of England and the Treasury. The right way to limit banking risk is that of the latest Basel agreement – under which banks must post higher capital matching their risk profile. This will happen here too. However, the Vickers Report demands absurdly high posting compared with Basel III, whose requirements were already upped from Basel II. Fortunately, the government have gauged correctly the need to centralise these crisis and stability functions in the Bank where they always and rightfully belonged until Mr Brown created his Tripartite system that functioned so badly in the banking crisis. This UK repression of banking serves the economy ill and is one cause of slow growth in productivity. This is a major industry, after all, and also a key input into the rest of our economy.

Finally, what of monetary policy? The Bank has taken serious risks with its credibility in allowing inflation to rise to over 5%. It may get away with it and inflation looks likely to fall back – though not as much as the Bank optimistically once again forecasts. Essentially, the ongoing banking crisis, now reignited by the Euro-zone crisis, has kept monetary conditions tight for those small business and personal borrowers dependent on the banks. The government has been able to dispose of all or most of its debt issue to the Bank through QE; the counterpart money created has simply been re-deposited in the Bank of England by commercial banks nervous of aggressive lending. Thus, financial repression is effectively limiting credit to the private sector while keeping the cost of public finance as low as possible. If it is assumed that all the debt in 2011-12 is soaked up by QE, as it was in 2010-11, the reduction in public debt held outside the banking system is over 20% of GDP. Thus the repression of banking is contributing tax revenue of some 0.6% of GDP (20% times 3% interest saved) on top of the direct bank levy.

The Euro-zone crisis is likely to continue for the foreseeable future and most European banks are hardly able to borrow from the world wholesale money markets – US banks, for example, have reduced greatly their lending to them. As a result, they have borrowed recently nearly 500 billion Euros from the ECB. With this monetary tightness added to the effects of financial repression, there is no scope for any UK tightening moves at present. The return to a more normal monetary policy must await the ending of the Euro’s crisis and the release of the banking system from its regulatory reign of terror. The corresponding vote is for no change in interest rates, with no bias. Liquidity injections and possibly QE may be needed to protect UK banks against the banking spill-over consequences from the Euro’s crisis.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate, until the Euro-zone situation clarifies; keep more QE on standby for lender of last resort purposes.

Britain’s Office for National Statistics (ONS) released a mass of new data dealing with the national accounts, balance of payments, and government accounts on 22nd December with significant revisions back to 2010 Q1. The subsequent Christmas and New Year holiday break that followed immediately afterwards – together with the simplistic way the media report data – means that this new information has not yet been absorbed into the UK economic debate. One striking change is that the deficit on the current account balance of payments deficit looks as if it will have been at least £20bn higher last year than is suggested by the December 2011 consensus forecast compiled by HM Treasury, which shows a deficit of £18.4bn. The other thing that commentators appear to have missed is that the cumulative effect of the revisions has been to revise the volume of non-oil GDP in 2011 Q3 upwards by 0.6%. This suggests that there was somewhat less of a negative output gap – for those, such as the Bank of England and OBR, who have such concepts at the heart of their forecasting frameworks – than was believed previously.

The other important aspect of the new ONS data is that the official statisticians have, at long last, published a back run of the new volume data for the national accounts back to 1955 Q1. This represents the first time these figures have been available since the switchover from the old 2006-based ESA 1995 national accounts to the new and noticeably different 2008-chained ESA 2010 figures on 5th October 2011. The belated provision of this data should allow economic forecasters, including those working in the Bank and the OBR, to start re-building their statistical models using the new ONS figures. However, the ONS data bank remains a nightmare to use and some crucial series still do not appear to be available before 1995 Q1 or later. Furthermore, the individual ONS statisticians appear to have been allowed to set up their historic data in their own way. This means that there is little consistency and some series are far harder to download than others.

In a year, in which the Euro-zone’s political class have failed totally to respond adequately to unfolding events, the official UK borrowing forecasts had to be increased massively between the March and November 2011 OBR reports, and financial regulators threatened to bring about a new collapse in the supplies of money and credit through misguided pro-cyclical regulation, the competition for the wooden spoon award for the most outstanding piece of official economic incompetence during the course of 2011 has been unusually intense. However, and after due consideration, it seems appropriate to award it to the ONS for their decision to cease publication of all their established reports in August 2011, the closure of their old and clumsy – but functioning – data bank, its replacement by a series of balkanised excel spreadsheets, and the fact that having switched the national accounts to the new ESA 2010 basis, the relevant figures were not available until late December 2011, almost six months later than has been the case in the past. This has meant that, at a time of maximum economic uncertainty, it has been almost impossible to model or forecast the UK economy in the normal way for a period of several quarters.

Looking ahead to 2012, there are two obvious sources of uncertainty. One is the late Harold MacMillan’s “events, dear boy, events” when asked what really worried him as Prime Minister. This includes the possibility of political turmoil in the Middle East or a major US confrontation with Iran causing a major shock to the world’s oil supply as well as the problems of the Euro-zone, and the political uncertainties associated with the forthcoming French and US Presidential elections, which could lead to different policies being adopted in both countries. The other major uncertainty, already been discussed, is the poor quality of the UK economic statistics which make it more difficult to apply objective forecasting methods than at any time for the past few decades.

However, another major unknown concerns the extent to which the current weakness of the UK economy – together with that of many other Western nations – reflects a supply withdrawal and how far it reflects a Keynesian demand deficiency. There is widespread evidence from panel data studies that adding 1 percentage point to the share of GDP absorbed by government consumption and welfare payments slows the sustainable growth of GDP per head by some 0.1 to 0.2 percentage points per annum. This does not seem a powerful effect from a superficial viewpoint. However, it becomes highly significant once it is realised that the state spending share rose by 14.1 percentage points in Britain between 2000 and 2010, by 8.6 percentage points in the US and by 5.8 percentage points in the OECD area as a whole. The negative effect of high public expenditure on growth revealed by panel data studies is a long-term relationship and one might expect the government spending ratio to rise in a recession. However, the average UK spending ratio between the two five-year periods 1996/2000 and 2006/2010 – a comparison that smoothes out the business cycle – still showed a rise of 8 percentage points, from 39.5% to 47.5%.This might be expected to slow the sustainable growth rate of real GDP per head by around 1 to1¼ percentage points.

In the post-neo-classical endogenous growth models widely employed in international growth studies, the effects of a large increase in the ratio of government consumption to national output would be expected to have two distinct effects. The first would be to produce a downwards shift in the sustainable level of national output, the second would be to induce a slower rate of growth. The 22nd December ONS figures for the volume of UK non-oil GDP back to 2005 Q1 allows some rough-and-ready calculations of the potential size of this effect. This has been done by statistically relating the logarithm of real non-oil GDP to two time trends; one fitted from 1995 Q1 to 2007 Q2 and the other from 2009 Q2 to 2011 Q3. Real non-oil GDP was 13.7% below the pre-2007 Q2 trend in the third quarter of 2011 but it was only 0.3% below the post 2009 Q2 trend. Furthermore, the slope of the pre-2007 Q2 trend was equivalent to a growth rate of 3¼% each year while the post 2009 Q2 trend was 2% each year, representing a growth deceleration of 1¼ percentage points. The small number of observations for the two periods means that the difference between the two trends represents only a crude order of magnitude. However, the scale of the difference by 2011 Q3 explains why there is so much uncertainty attached to measures of the output gap, and why supply shocks can be extremely important, even if there may be many other factors involved in addition.

The massive data problems already alluded to and the fact that there has not been time to rebuild the Beacon Economic Forecasting model from scratch using the new ONS data – a process that normally involves five or six weeks of data compilation and re-estimation – means that any New Year forecasts are now highly uncertain for purely technical reasons, in addition to the risks arising from MacMillan’s ‘events’. However, neither ‘chickening out’ of making any predictions nor hugging the consensus represent worthwhile activities. On the basis of the data for the first three quarters, it looks as if UK real GDP increased by an average of 0.9% last year. For what it is worth, the market-price measure of real GDP is then expected to expand by a relatively optimistic 1.7% this year – the consensus growth forecast is 0.6% for 2012 – 2.8% in 2013 and 2.4% in 2014. The annual increase in the CPI inflation measure is expected to ease from the 4.8% recorded in November 2011 to 2.3% in the final quarter of this year, and stick there in 2013 Q4, but rise to 3.3% in 2014 Q4. The official Bank Rate is presently almost irrelevant where the structure of money-market rates that determine wider borrowing costs is concerned. Bank Rate is expected to remain at ½% until the middle of this year before rising to average 0.9% in 2012 Q4, and some 2.5% to 2¾% in late 2013 and throughout 2014. The current account balance of payments deficit appears to have been around £41.6bn last year. This imbalance is forecast to be £43.4bn this year, £51.5bn next year, and £55.2bn in 2014. The Public Sector Net Borrowing measure of the UK budget deficit is predicted to be £130.3bn in fiscal 2011-12, £139.8bn in 2012-13 and £132.7bn in 2013-14, after which it should be on a much clearer downwards trend, however. Finally, claimant-count unemployment is expected to rise from the 1,598,400 reported for November 2011 to 1,691,000 in the fourth quarter of this year, but ease to 1,673,000 late next year, and 1,621,000 in the end quarter of 2014. If an economic ‘gold medal’ should be awarded for such a lack lustre year as 2011, it should probably go to ordinary private-sector employees and their bosses whose mature co-operation in accepting substantial cut backs in real take home pay, in return for maintaining employment, has helped to prevent the huge surges in joblessness observed in the downturns of the early 1980s and the early 1990s.

As far as UK monetary policy is concerned, the latest figures show that the annual growth of the preferred M4ex broad money definition was 2.6% in the year to November 2011 while retail deposits and cash (M2) increased by 2.9%. These are not exactly ‘boom-boom Britain’ figures but they do not suggest a US 1930s style banking-sector meltdown either. The main risk now is that misguided financial regulation leads to a fall in commercial bank lending to the private sector and the broad money stock. The Bank of England published an important discussion paper on 20th December, Instruments of Macro-prudential Policy, which will need to be studied carefully before commenting further. The general issues of principle involved are that: first, the regulatory authorities should always bear in mind the macroeconomic consequences of the re-organisation of commercial-bank balance sheets induced by financial regulation; and, second, the regulatory and monetary officials concerned do not work at cross purposes, something that is supposed to be ensured by common members of the Financial Policy Committee (FPC) and the MPC. As far as the 12th January rate decision specifically is concerned, the international and domestic and international uncertainties are such that another hold appears to be the ‘least-bad’ decision.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To tighten, unless inflation eases sharply.

The Euro-zone crisis has not been resolved. The meeting of the EU leaders in December 2011 did not accomplish a breakthrough. They simply agreed to take the rules, which they had ignored in the past, more seriously in the future. Furthermore, the details of what they agreed, has not been worked out yet. It is even unclear at the moment whether the new agreement will be part of a new Treaty or not. This increases uncertainty about economic policy in the Euro-zone. Until this uncertainty is partially or fully resolved, the recovery in the Euro-zone will be fragile. This will slow down the recovery of the British economy.

Inflation is a serious concern. The annualized monthly inflation measured with the CPI was 4.8% in November, and it has been above 4% in every month since the beginning of 2011. We can get a better idea about inflation dynamics if we calculate a three-month moving average. Nine out of the twelve CPI categories had higher annualized monthly inflation in November 2011 than they had a year earlier. Inflation shows no signs of slowing down at the more disaggregated level. Inflation of alcohol, household equipments, transport and housing (including water and fuel) all accelerated by more than 2 percentage points between November 2010 and last November. The longer the current pattern prevails the more likely it is that inflationary expectations will lose their anchor.

Given the uncertainty in the Euro-zone a ‘wait-and-see’ approach is appropriate at the moment despite the inflationary pressure in the British economy. Bank Rate should be held in January. However, I would signal tightening. If there are no clear signs of easing inflationary pressure in the near future, a rise in Bank Rate could be necessary.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; no extension of QE; reinstate Special Liquidity Scheme. Bias: Raise Bank Rate.

Discussions regarding UK monetary policy have been overshadowed by developments in the Euro area. The Bank of England has adopted a fearful attitude towards the European banking threat which has sent ripples of despair throughout the economy. This is a counterproductive stance and one which is unjustified by the nature of the threat. The disintegration of the Euro remains a highly improbable outcome until the mechanisms and protocols for orderly departure from the Euro area have been devised and formally approved. Disorderly exit of Greece, or of any other country, would carry grave consequences for French and German banks through their colossal exposures to interest rate swap contracts. It is a reasonable assumption that the Euro area nations will not embark on a path of mutually assured destruction.

The best preparation for the eventuality of Euro disintegration is for the UK authorities to grant maximum flexibility of response to households, businesses and financial institutions. For households, the priority is to regenerate private sector employment growth through tax reform. For businesses, it is to press ahead urgently with the de-regulation of the UK economy. For banks, it is to undergird their operations through structural, un-stigmatised, liquidity support.

Over the past fifteen to eighteen months, UK residential construction activity and housing market turnover were among the biggest casualties of the Bank of England’s misguided urgency in withdrawing its emergency liquidity support from the banking system. As a result the UK banks’ customer funding gap, effectively its dependence on wholesale funds, has reduced from around £900bn at end-2008 to £275bn at end-June 2011. The banks have survived the brutal pace of withdrawal of the Special Liquidity Scheme only through a combination of deposit growth, loan shrinkage and new capital issuance. The forced contraction of bank lending to the private sector has superseded all other policies and initiatives, including the ½% Bank Rate and Project Merlin. Although this phase of contraction is drawing to a close, banks must accomplish £140bn of term refinancing in 2012, front-loaded to the first half of the year, and may struggle to do so in the context of Euro area banking woes. There is a strong case for the reintroduction of the Special Liquidity Scheme, to enable bank credit to flow more readily to the private sector after a year of enforced drought.

Consumer sentiment is back in the doldrums after a second successive year of real after-tax income compression. However, the end is in sight. The referred pain from the GDP slump in 2009 is working its way through the economy and 2012 should begin to see a remission. Affordability measures for first-time buyers have moved into attractive territory but the interest penalty associated with 90% loan-to-value mortgages remains a heavy disincentive. The scope for a fundamental improvement in housing market turnover arising from first-time buyers rests, to a significant extent, on the successful take-up of the new government scheme to support house builders, taking effect in the spring of 2012.

The recovery of the housing sector both in terms of residential construction and housing transactions remains an important barometer of the wider economy. After the largely self-inflicted setbacks of the past year or so, there are reasonable grounds for supposing that housing-related activity will stage a comeback in the context of cheap credit, more supportive government policies and yield-starved investors. The best hope for a resumption of economic recovery in 2012 lies in the removal of the constraints to bank lending growth to interest-rate sensitive sectors. This is not the moment to raise Bank Rate, although the reconnection of Bank Rate with the market interest rate structure cannot be postponed indefinitely. The Bank’s programme of gilt purchase appears to be suffering from the law of diminishing returns and should not be extended in its current form.

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 (Deloitte and 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), Gordon Pepper (Lombard Street Research and Cass Business School), 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 TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

The SMPC itself 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 deeper issues involved, distinguishes the SMPC from the similar exercises carried out by a number of publications. Because the committee casts exactly 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 consequence, the nine independent SMPC analyses should be regarded as being more significant than the precise vote. The latter is not intended as a forecast of what the Bank of England will do but a declaration of what the shadow committee believes it should do. The next quarterly SMPC gathering will take place on Monday 16th January and its minutes will be published on Sunday 5th February. The next two SMPC e-mail polls will be released on the Sundays of 4th March and 1st April, respectively.

In its most recent monthly e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one that Bank Rate should be held at ½% when the official rate setters make their announcement on Thursday 8th December.

The sole dissenting SMPC member wanted to raise Bank Rate to 1% immediately. The overwhelming reason why most SMPC members voted to hold in December remained their grave concern over the potential effects of the Euro-zone crisis for Britain’s exports and the UK banking sector.

Some ‘holds’ thought that Bank Rate was so far below the money market rates, which determined commercial bank lending costs, that it had little relevance to the wider economy. This meant that the main gain from holding Bank Rate was psychological. There was also a widespread concern that the supply side of the British economy was so arthritic that any fiscal or monetary stimulus would be largely dissipated in higher inflation rather than increased output.

The SMPC poll was carried out before the Chancellor’s 29th November Autumn Statement. However, committee members were given the opportunity to amend their contributions afterwards. A major concern, which was shared by many SMPC members, was the inconsistency between the official hard-line approach to financial regulation and the need to bolster the supplies of money and credit.

It was suggested that the main role of Quantitative Easing (QE) was to counter the adverse regulatory shocks that were being imposed on UK banks, both internationally and domestically, and that this represented a clear-cut policy inconsistency.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold Bank Rate.
Bias: Add another £75bn round of Quantitative Easing (QE).

The British economy is in a dire state. The signs are that domestic demand is pretty static if not falling a bit. Meanwhile, the position on the continent of Europe looks perilous. Nor is there any sign of anything on the horizon which could make things much better. About the best hope we have is that falling inflation will boost consumers’ real incomes – and, thereby, lead household consumption modestly higher – and that this factor will be intensified by a sharp fall of commodity prices.

The signs are now fairly clear that inflation has peaked, barring another upsurge of commodity prices. Inflation will probably fall sharply next year. Indeed, it will probably be below target by the end of 2012. There is a real prospect of deflation again becoming a realistic danger in 2013, if things do not improve markedly.

Accordingly, the Monetary Policy Committee (MPC) needs to relax policy considerably. It should complete its present bout of Quantitative Easing (QE) with all speed and then proceed to embark on another round of £75bn initially. However, and if the economy still looks as weak as currently, then the Bank should repeat the dose.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: Setting of interest rates and debt management policy (i.e. QE in present circumstances) to maintain low and stable growth of the quantity of money, broadly defined.

The effectiveness of QE – in other words, increases in the quantity of money, engineered deliberately by the state – has been called into question in recent newspaper articles, such as that in the Financial Times of 25th November by Professor Robert Skidelsky. The central proposition in the argument for QE during and since the Great Recession has been – or at any rate ought to have been – familiar from traditional monetary economics. This is that an increase in the quantity of money is associated with – and, indeed, usually causes – a proportionally similar increase in equilibrium national income and wealth. Nowadays, the quantity of money is dominated by bank deposits, which are more than thirty times larger than the note issue in the UK. The relationships between money, on the one hand, and national income and wealth, on the other, hold regardless of banks’ asset composition. Contrary to a widespread misunderstanding, the change in bank lending to the private sector is by itself neither here nor there. This is not to deny that new bank lending creates new bank deposits in the normal course of events. However, it is the deposits that matter to macroeconomic outcomes, not the loans.

The correctness of these remarks is confirmed by salient features of the Great Recession. Predominantly Keynesian economists might expect that the turmoil and confusion of the last few years would have destroyed the relationship between the supply of broad money and current-price national income. However, that is not so. In the five years to the third quarter of 2011, the increase in money Gross Domestic Product (GDP) measured at market prices was 13.8% (i.e., with a compound annual rate of increase of 2.6%), while the increase in the quantity of money (as measured by the M4ex measure) was 16.0% (i.e., with a compound annual rate of increase of 3.0%). The medium-term similarity of the rates of change of money and nominal expenditure has survived the Great Recession, just as it survived various bouts of macroeconomic instability in the 1970s and 1980s, and the happier Great Moderation in the fifteen years to 2007.

The point of emphasizing these facts is to assert that an acceleration in the rate of money growth – which can undoubtedly be delivered by sufficiently aggressive expansionary open market operations and/or by monetary financing of the budget deficit – can check emerging recessionary pressures. Inflation is going to fall in 2012, partly because of the easing in oil and gas prices since early 2011, partly because the effect of the early 2011 VAT increase will drop out of the annual comparison and party because of the high margin of slack in the UK economy. Given the widespread anxiety about the return of recession in 2012, the MPC’s decision to pursue another £75bn of QE should be endorsed. One would hope that it will lead to a burst of suitably positive money growth in the October 2011 to March 2012 period. The main caveat is that Britain’s banks remain under a regulatory cosh. Their shrinkage of risk assets may to a large extent offset the increase in their claims on the Bank of England and the government which is implied by QE.

The main criticism of official policy is one that has been stated many times and remains unchanged. The objective of QE is to increase the quantity of money and/or its growth rate, in order to counter the money stagnation/contraction attributable to the regulatory attack on the banks. The increase in the quantity of money is the variable that matters, not the location in terms of personalities and institutions, of the official decision to boost it. The simplest way of increasing money growth by far is for the government to stop selling long-dated gilts to non-banks, and to issue large quantities of Treasury bills and short-dated gilts with the intention that these will be acquired by the banks. The latter course would result in the creation of new money balances.

The enormous expansion of the Bank of England’s balance sheet since mid-2007 has led to administrative awkwardness and extensive misinterpretation. Liam Halligan has claimed in his Sunday Telegraph column, for example, that the increase in the monetary base – an increase which is clearly a by-product of QE – will result in rapid inflation and currency debauchery. The latest business surveys – which show a sharp loss of business confidence and clear declines in plans to raise prices – contradict these ‘forecasts’ although, to be fair, Halligan does not commit himself to a precise forecast of a particular inflation rate at any particular date. Ideally, an increase in the quantity of broad money can and should be organized without any significant effect on the monetary base.

The trouble is that the Bank of England – or at any rate its governor, Sir Mervyn King – believes that the Central Bank should have exclusive responsibility for monetary policy and, hence, for the specification of QE policy. It would be preferable if the Bank and HM Treasury – and also the Debt Management Office (DMO), to the extent that it has its own separate voice – worked together, with a view to achieving stable, moderate growth of the quantity of money. The management of the public debt undoubtedly has implications for the rate of money growth, or money contraction, and – willy-nilly – the central bank must always work with the finance ministry on the practicalities and tactics of debt issuance. An exaggerated sense of its own importance is one reason that the Bank of England has bungled so often in the last few disastrous years.

Thousands of words have already been written about the dysfunctionality of the Euro-zone, and there is no space here to rehash increasingly well-known analyses. Euro-zone sovereign debt and also, importantly, inter-bank claims between Euro-zone banks have become unsafe assets. There is little doubt that – if their assets were marked to market – virtually all the Euro-zone’s banks would now have deficiencies of capital. These deficiencies would take two forms, with equity capital either negative or far beneath the regulatory norms. Big Bang recapitalisation (i.e., a comprehensive and sudden imposed recapitalisation, compressed into a short period of time) would then be intensely deflationary and could plunge the Euro-zone economies into a second Great Recession, less than five years after the supposed end of the previous one. This would be a repetition of what happened to the East Asian economies in 1997, after Japan’s banks were told to recapitalise with undue haste, or to our own economy in 2009 after the bank-bashing of October 2008. Given that the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) both appear to favour a bank recapitalisation of the Big-Bang type, the risk of a second Great Recession is high.

However, a major recession in Europe can be easily avoided, if policy-makers use some common sense and do not insist on a Big-Bang recapitalisation. Frankly, the banks could not – in 2007 and earlier – have been expected to foresee either the Euro-zone’s disintegration or the traumatic effect on their solvency of that disintegration. Policy-makers must give the banks an extended period of time to recapitalise, with steady growth of the quantity of money as a key desideratum while that recapitalisation is taking place. In practice, early 2012 could be chaotic. We must envisage finance ministers in Euro-zone countries instructing the European Central Bank (ECB) governing council to expand its balance sheet rapidly in 2012, if a serious recession materializes. Unfortunately, a minor recession seems to be under way already. At this stage no one knows the eventual resolution of the huge row between Europe’s politicians and the ECB that seems imminent.

As long as the UK’s policy-makers keep the quantity of money growing at a reasonable rate (say, about 5% at an annual rate) in the next two or three quarters, the UK should be able to handle the side-effects of the Euro-zone recession without too much trouble. The British government’s efforts to curb the budget deficit are appropriate and desirable and – at last – there are signs that UK officialdom is rethinking its commitment to such expensive, growth-destroying follies as renewable energy and European Union (EU) social legislation.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: Additional QE; conditional on evolution of Euro-zone crisis.

At its October meeting, the MPC voted to extend its asset purchase programme by an additional £75bn. Gilts are to remain the asset of choice, with all purchases due to be completed by the end of February. The November Inflation Report suggests the Bank of England’s rate setters may soon vote to extend the programme beyond February. Given the downward revisions to the path of real GDP, and the Bank’s estimates of the effectiveness of QE, they seem to be shaping up for another £75bn to £100bn of QE, over and above the £275bn already announced. The MPC’s central forecast for inflation in the medium-term implied that there was a good chance that it would be below the 2% target. Three years from now, the MPC judged that there was a 40% chance that Consumer Price Index (CPI) inflation would be below 1%. These forecasts do not allow for the possibility of a disorderly default within the Euro-zone, since there is no realistic way in which MPC members could quantify the risk to the UK economy. However, there is little doubt that the MPC will take such a scenario into account in its policy choices. The magnitude of the risks may be unquantifiable. However, we do know that they are large and deflationary for the UK economy.

For the time being, the British economy is still growing, albeit at a rate noticeably below its underlying potential. The third quarter data point to sluggish growth once adjusted for the bounce-back from the weak second quarter caused by one-off events, such as the Royal Wedding. Indicators of activity in the final quarter of 2011 suggest softer foreign demand is hurting the manufacturing sector, although there still appears to be limited expansion in the service sector. The data does not yet point to a UK recession.

Over the next year, however, the UK economy is at risk, primarily because of events beyond its shores. The Euro-zone economy now appears to be in recession. Even if Continental leaders manage to cobble a plan together, economic conditions could get much worse in the next six months. Euro-zone growth risks are very much skewed to the downside. If anything, though, it is the risk of more significant disruption to bank funding markets that really threatens the British economy. Although UK lenders have so far suggested little impact on the supply of credit to domestic sectors, there are growing risks of a sharp tightening of monetary conditions. Broad money growth remains low. Were the £75bn of gilts to be purchased solely off UK non-bank investors, the direct effect would be to add around 5% to the stock of M4ex in three months. This represents a significant injection of money balances into the economy. Nevertheless, there could still be considerable downward pressure on the stocks of UK bank lending and broad money in the event of a worsening of the Euro-zone crisis. The MPC would be right to respond with further asset purchases.

The elevated rate of inflation may seem like an impediment to additional monetary ease. It should not be. Headline inflation is set to fall sharply in 2012. By year-end, it should already be below the 2% target and heading south. Risks to inflation in the medium-term are on the downside, even if the multitude of possible endings to the Euro-zone crisis means it is difficult to quantify those risks. By the middle of 2013, Britain will have had five years of little to no growth in broad money. Notwithstanding the effect of very low interest rates on the demand to hold money balances, it is very hard to argue that UK monetary conditions warrant anything other than an easing bias.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Hold Bank Rate; expand QE further if M4ex broad money declines.

British economic growth continues to stumble along at a sub-par rate, tracing out a trajectory well below its unsustainable pre-crisis path. The earlier growth path of 2.5% to 3.0% per annum in real GDP between 2000 and 2008 had been fuelled by excessive borrowing and lending, and has resulted in serious damage to the balance sheets of households and financial institutions. The result, in terms of spending and production, was an overemphasis on domestic activities, such as housing and consumption, at the expense of investment and exports. The ‘new normal’ for real GDP growth is turning out to be close to 1% per annum. This is far below estimates derived from simple extrapolations of past rates of growth of productivity and the growth of the labour force.

The main contributor to lower real GDP growth in 2011 has been the higher than expected inflation rate – basically a shift in the terms of trade – which has eroded real income growth for consumers. However, the underlying reason for the step down in the growth rate – and the inability to resume the previous growth path – is the huge pressure on banks, other financial institutions and households to repair their balance sheets. This process requires cutting consumption, raising corporate and household savings rates and using part of those savings to repay debt. Shifting real GDP growth back to its pre-crisis trajectory is not going to be achieved by short-term manipulation of monetary or fiscal policy.

On the monetary side, the best the authorities can do is to prevent outright deflationary conditions developing by maintaining monetary growth at positive rates. To avoid any contraction in the broad money supply (M4 or M4ex), the Bank of England has recently expanded its asset purchases or QE by £75bn. Nobody can be sure that the latest programme of asset purchases will ultimately be sufficient since the economy-wide deleveraging process may well continue for several more quarters – or even years. Accordingly, that would require further episodes of asset purchases by the Bank until private sector balance sheets had achieved a new equilibrium.

On the fiscal side, public sector current expenditure continues to rise, increasing by £8.5bn (+2.4% year-on-year) in the financial year to October compared with the same period in 2010. Net investment has, however, started to come under control, falling by £24.1bn in the financial year to October compared with the same period in 2011. At the time of the budget in March 2011, the coalition announced no less than one hundred and thirty-seven new initiatives to boost growth. However, the net impact of these measures will be limited due to the necessary, and inevitable, retrenchment that is going on in the private sector. The public is learning the painful lesson that the aftermath of a credit bubble can be very protracted.

Overseas, the Euro-zone leaders’ summit of 26th October produced three main policy proposals: a ‘voluntary’ bond exchange involving a 50% debt write-off of Greek government debt held by private institutions in exchange for Euro30bn from the member states, a Euro106bn recapitalisation of the area’s banks, and a proposed expansion in the size and scope of the European Financial Stability Fund (EFSF) rescue resources. These policies have been perceived to be inadequate, causing sovereign debt yields to rise in the aftermath of the summit. Furthermore, the ‘voluntary’ write-down of 50% of Greek government debt held by private sector institutions has undermined the validity of credit default swaps as a hedging instrument, and therefore potentially lowered demand for the bonds of other indebted economies such as Italy or Spain. More fundamentally, the summit proposals do nothing to improve the near-term competitiveness of the ‘olive belt’ economies, or to restore growth. Meanwhile, the on-going financial stress is progressively tightening credit conditions in Euro-area inter-bank funding markets, and will exacerbate the Euro-zone recession that appears to have begun in the fourth quarter. Taken together with the downward revisions of US growth expectations for 2012 – for example, by the members of the Federal Open Markets Committee (FOMC) – the international environment is likely to have an adverse impact on the UK economy in 2012.

Against this grim backdrop the Bank should keep base rates at their current low levels and be prepared to extend again the programme of asset purchases to ensure monetary growth remains positive.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate; no more QE as yet.
Bias: To do no more QE, but instead consider direct/primary purchase of government debt in the event of disorderly Euro-zone collapse. If there is not a Euro-zone collapse, bias is to raise UK rates.

The economic situation is difficult, and there are storm clouds in almost every direction. If there is disorderly collapse of the Euro-zone – a scenario to which a 30% to 40% probability should be attached – there could be a further 10% contraction in UK GDP, along with very serious further problems in the UK banking sector induced by multiple sovereign defaults and the collapse or nationalisation of much of the Euro-zone banking sector. If the UK economy drags along slowly for the next five years, but without Euro-zone collapse, UK households will default on their debts, bankrupting UK banks and dragging down the UK sovereign. If UK growth recovers and accelerates, there will be rapid rises in UK inflation, necessitating large rises in interest rates triggering a further recession in the UK. Almost all plausible scenarios from here onwards are bad.

The decision to re-start QE in the UK was at the same time too late, premature and inadequate. Too late, in that it should have been done from mid-2010 to early 2011, addressing the domestic slowdown of the period from September 2010 to June 2011. However, that boat has sailed. More QE now cannot undo the past. Premature, in that QE was actually re-introduced in response to the Euro-zone crisis and potential problems in the UK banking sector – which have not happened yet. However, further QE cannot prevent the Euro-zone crisis; neither can it stop the Euro-zone crisis, if it turns into a full-blown banking crisis, from sucking in the UK banks.

If the Euro does indeed collapse in a disorderly manner, QE – by which is meant purchases of government bonds in secondary markets – will no longer be the best mechanism of direct monetary injection. Instead, at that stage, the Bank of England should step up the scale by purchasing UK government bonds directly from the government. This would provide a more powerful monetary stimulus, and could potentially be combined with measures such as money-printing-funded income tax rebates sent directly to households. Such measures are obviously desperate. We would be in desperate times.

If the Euro does not collapse (and, arguably, even if it does), it would be desirable to escape from current zero interest rates. Setting interest rates at zero is obviously an emergency measure. More generally, setting interest rates below the Wicksellian natural rate should always be conceived of as a temporary measure. It is not good policy to hold interest rates systematically below the Wicksellian natural rate on a long-term basis. Doing so does not merely create inflation risks. Even if there is no inflation, real interest rates that are too low mean that there will be investment projects undertaken that are value-destroying, and will subsequently be exposed as ‘mal-investment’.

We are now approaching the third anniversary of zero interest rates in the UK. Such extended ‘emergency’ rates cannot indefinitely be regarded as temporary. At some stage, we must seek to normalise – otherwise the long-term growth of the economy will be damaged by excessively low rates, just as it would be by excessively high rates. Since it is more rapid long-term growth that the UK economy desperately needs, rather than a short-term boost, it would be desirable for the long-term health of the economy to seek to raise rates.

There is little to be gained, however, in raising rates when Euro-zone collapse might be only weeks away. For now, therefore, it is appropriate to vote to hold. Nevertheless, we should be seeking to raise rates at the earliest opportunity. The UK economy has got beyond the point at which policy accommodation on the interest rates side remains healthy. Monetary policy’s last role, here, is to maintain government liquidity if there is total meltdown in international sovereign bond markets. That is subject to the proviso that it can be done on a small scale, and temporarily, and is not used by the government as an excuse for not cutting spending enough in response.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again; QE should not be resumed.

The crisis in the Euro-zone worsens almost daily, with Greece, Portugal, Italy and now Spain facing interest rates that make their finances unsustainable. An attempt was made some weeks back to create a ‘big bazooka’ – i.e. a large amount in the EFSF – that would underwrite these countries’ financial difficulties. However, this attempt has collapsed with the problems now requiring far greater funds than Germany was willing to provide. Currently, the EFSF stands at Euro440bn but about half of this has already been used up on Greece. Banks that have lent to Greece have ‘voluntarily’ had their claims written down through a ‘haircut’ of 50%. The maturity of the EFSF loans to Greece has been lengthened to fifteen years, extendable to thirty, from the original seven-and-a-half years. The interest rate charged has been reduced to around 3.5%. However, the exact rate depends on the cost of funds to the EFSF, so this rate represents an agreed reduction in the EFSF spread to virtually zero. These terms have also been extended to Portugal and Ireland, the other countries currently receiving EFSF bail-out money. However, Greece looks unlikely to be able or willing to repay, even with all these adjustments. Italy, Spain and Portugal too look overwhelmed by the current situation. The austerity packages theoretically needed will almost certainly be rejected by voters. Meanwhile, the German electorate are also unlikely to countenance any further transfer of money from Germany to the rest of the Euro-zone.

This crisis situation looks set to rumble on for weeks, months and even years. Greece seems likely to leave the Euro first, perhaps early in the New Year. Efforts will then be redoubled to keep others inside. However, by the end of 2012 another victim – Portugal, probably – will have been claimed. It may not be until 2013 that Italy and Spain will leave the Euro. At this point, France too will look vulnerable and Germany may decide to restore the Deutschmark.

Accompanying this rumbling will be a huge German effort to beef up controls on every Euro-zone country’s economic policy. The Germans will not tolerate being caught like this again – did they not write a ‘no bail-out’ clause into the Maastricht Treaty and where did it get them? No teeth. Now, there will be teeth in abundance. How well will this new German economic empire go down with the satellites? Will being in the Euro seem worth it? All these developments seem to add up to the end of the Euro, rejected by the voters of all these countries because of its dreadful economic consequences. It would be really astonishing if democratic wishes were flouted on such a scale as to permit the sort of cross-country interference currently being proposed by Germany, France and the Commission.

Then there is the UK. It does seem that the Euro-zone ‘governance’ proposals will include tax proposals, such as the notorious financial transactions tax, which would put the City out of business overnight. Now these are supposed to be for the Euro-zone; but they will argue that, because of ‘competition’ from other tax jurisdictions in the EU, they must be ‘general’. They will argue that the Single Market mandates this and, under the Single Market agreement, the UK can be outvoted routinely by qualified majority voting. Such is the UK’s problem. Just like the ridiculous EU working time limits, we will be subjected via the Single Market to more highly damaging interference with our economy – this time taxation which will hit like an ‘Exocet’ missile into the heart of our economy. No wonder that our EU relations are climbing the UK political agenda fast. Even Liberal Democrats will not like these things ‘up ‘em’.

The grim reality of this poorly constructed EU economic edifice and the rumbling crisis will continue to have consequences for the world economy. The UK will probably detach itself to a large extent from it all over the next decade. People worry about ‘trade with the EU’; initially, attempts will be made for us to stay within the EU ‘customs union’ for this reason. However, as our economy moves more and more into services, where the EU has made no attempt to create a single market, the trade issue will become less and less relevant. Basically, the EU protects manufacturing with preferential prices, over world prices. But any of our manufacturing that needs such protection is not really worth having; we are better off moving into areas where we have ‘comparative advantage’ – i.e. those that are ‘competitive’ at world prices.

The Euro-zone crisis will have a dampening effect on growth, clearly, both via the reduction in our exports to a slowing area (for every 1% reduction of Euro-zone growth, UK growth could be reduced about 0.2%) and via the problems of the banking system, where the inter-bank market is once again frozen. However, the most important overseas factor for us is in the overall world economy. After all, our exporters can sell outside Europe, if there is growth elsewhere. Actually, the world is still growing fairly strongly (perhaps by 4% this year) and has endemic inflation. This inflation should now fall back as a result of the strenuous attempts to cool their economies being made by such leading emerging markets as China, India and Brazil. Commodity prices have fallen back, which is a good start. This should pave the way for better growth in 2012, with these countries able to resume a neutral monetary policy. The problems of the developed economies are related to the slow productivity growth that occurs when raw materials are in short supply and also to their banking-industry difficulties, which have been exacerbated by over-regulation. These adverse factors will not change soon. So the outlook is for continuing slow growth and difficult labour market conditions. However, the Euro-zone crisis is only a small part of these difficulties.

Furthermore, a determined effort by the coalition government to address the UK’s supply-side problems would pay off. Unfortunately, these ideas are mostly opposed by the Liberal-Democrat part of the coalition. But they would include abolition of the 50 pence tax rate, deregulation of hiring and firing, reductions in public sector union powers, road and airport infrastructure and most important of all in the present banking impasse a much lighter touch on banks during the slow growth period.

The most likely outlook for UK inflation is for a moderate fall to the 3% to 4% range, given that commodity prices are easing. Nevertheless, the Bank of England is still taking unacceptable risks with the control of inflation. It is highly vulnerable ‘on the up side’. Possible developments that could embed inflation further are: 1) a renewed commodity price spiral fuelled by new QE by the US Federal Reserve; 2) a breakdown of credibility in the UK inflation target regime, possibly as a result of political ‘loose talk’, and 3) a tightening of parts of the UK labour market leading to rising wage awards. At present, none of these look too threatening. Nevertheless, they are material risks. Why take them when monetary looseness is capable of achieving so little improvement in growth? Interest rates are at the zero bound; any QE goes straight into bank reserves; the UK’s growth rate is being determined by supply-side factors, including the effects of high raw material prices on capacity and productivity, mismatch in capital and labour market, and terms of trade effects on living standards from high raw material prices.

Everything we know about money and the economy suggests that efforts to use money to stimulate growth apart from in response to surprises (such as the banking crisis) are fully discounted by households and firms, and so have minimal effects on growth. As for the Euro-zone crisis, it merely means that there is just one more factor slowing UK growth over which we have no control. Our exporters need to divert their efforts away from the European Continent but this will take time. In terms of banking problems, we have already stuffed our banks full of reserves and if necessary we could give them yet more. However, that would be a specific response to a particular banking problem and need not be pre-empted by general monetary looseness.

For all these reasons, the Euro-zone crisis notwithstanding, it is time for the Bank to retreat from its highly exposed position on inflation risk. It needs to signal that it is doing so. Bank Rate should rise 0.5% (market rates are already around this level in fact); not much tightening would result but it would be a good signal. QE should not be extended unless it is needed to resolve bank reserve problems from the crisis. The bias would be for further, slower upward moves in rates and no further QE.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate, until the Euro-zone situation clarifies; keep QE on standby for lender of last resort purposes.

The British monetary and fiscal authorities appear to have found themselves in the position of shipwrecked mariners clinging to an overcrowded life raft. Any false move could lead to an immediate disaster but staying motionless will not provide long-term salvation. Meanwhile, an unpleasant-looking wall of water is heading for the raft from off Continental Europe, while the vital location-finding instruments have been destroyed through the incompetence of the official statisticians. This is not a hopeful prospect. The first priority has to be to prevent any individual member of the party from doing anything so stupid that it de-stabilises the situation. It is also too late to worry about whether the ship was sunk as a result of the gross incompetence of the previous ship’s captain, Gordon Brown, and whether a bolder initial response by midshipmen Cameron, Osborne and Clegg could have averted the peril. The situation is what it is and the only issue is how to get out of this mess.

There are at least four possible scenarios in which all could be easily lost. The first is if the government’s fiscal credibility gets destroyed as a result of the persistent overshoot of the official borrowing targets. The 29th November Pre-Budget Report and the accompanying forecasts from the Office for Budget Responsibility (OBR) indicate just how far the government’s fiscal retrenchment plans are already off course. In particular, the stock of public sector net debt, which encapsulates the totality of the upwards revisions to public sector borrowing is now expected to be £112bn (8.2%) higher in 2015-16 than was forecast at the time of the March 2011 Budget (see: OBR Economic and Fiscal Outlook, November 2011, Table 4.31, page 165). There is a real risk that the sovereign debt crisis that would probably have hit Britain in mid-2010, if the election outcome had been different, may have been postponed – but not averted – by the Coalition’s measures.

The second risk is that the government takes the political line of least resistance and tries to tax its way out of the fiscal mess, as it did earlier with its misguided decisions to increase VAT to 20%, raise National Insurance Contributions and implement Labour’s 50% higher income tax rate. Mr Osborne’s attempt to raise the tax burden in a recession, in order to fund government spending levels that could not reasonably be supported by the economy’s private sector, merits a Herbert Hoover award for supreme economic incompetence. However, it may be all that one should expect from a government of ‘wealth conservators’, who believe ‘nice’ people inherit money and look down on vulgar ‘wealth creators’ who wish to enrich themselves and society in general through their own efforts.

The third potential catastrophe scenario stems from the risks that misguided financial regulations will lead to a renewed downturn in the supplies of money and credit, either at a synchronised international level via the latest Basle accords, or domestically as a result of the UK financial regulators gold-plating international agreements and trying to introduce additional regulatory requirements of their own. The time for stepped up regulatory requirements was during the pre-2007 credit boom, as some of us were arguing at the time. To do so now, is simply perverse. Even phasing in the proposals over a long period, does not obviate the likelihood that commercial bankers will endeavour to contract their balance sheets in advance of new capital and liquidity requirements so that they are in the right place ‘when the whistle blows’. Public-choice theory suggests that government bureaucracies always try to over-regulate to a point well beyond the social optimum for two reasons. One is that it allows the expansion of well-paid bureaucratic empires, paid for by a covert tax on bank shareholders and customers. The second is that over-regulation reduces the risks of political embarrassment to the officials concerned, even if it has the pernicious hidden costs of reduced innovation and slower economic growth. It is simply dumb to indulge in round after round of QE to offset the effects of excessive and inappropriately timed pro-cyclical financial regulations. Traditional banking and finance economists understood many decades ago that the purpose of reserve asset requirements was to act as a safety net, which could be run down to zero if need be when the crisis hit. The same applies, mutatis mutandis, to capital requirements.

The fourth potential catastrophe is that developments in the Euro-zone become so adverse that they pose a major threat to the British economy, either because of the loss of export demand or contagion affecting British banks. The latter risk should be manageable if the Bank of England acts as efficiently as the Bank of Canada did when the neighbouring US banking system went into meltdown in September 2008. It must be hoped that recent institutional changes, including the establishment of the Bank of England’s Financial Policy Committee (FPC), will allow an appropriately rapid and effective response if UK banks are threatened by Continental defaults. The problem of exports is probably more intractable. However, British manufacturers should be shifting their efforts from slow-growing Continental markets to the faster growing rapidly industrialising nations, in any case.

While it is tempting to concentrate on the high-frequency gyrations in the financial markets where the crisis in the Euro-zone is concerned, the common currency area has been fundamentally blown apart by a low-frequency phenomenon. That is the difference between the relative fiscal conservatism with which the German public finances have been managed since 2000 and the large spending increases elsewhere in the Euro-zone. An important paper from the ECB dealing with this issue is ‘Towards Expenditure Rules and Fiscal Sanity in the Euro Area’ by Sebastian Hauptmeier, Jesus Sanchez Fuentes and Ludger Schuknecht (ECB Working Paper Series, No, 1266/November 2010). This argues that the tension between the tight government spending restraint in Germany, and the big spending policies of many peripheral Euro-zone members before the global financial crisis, was a major cause of the sovereign debt crisis. However, none of the countries concerned indulged in a public spending ‘bender’ of anything like the scale of the UK’s between 2000 and 2010. This is why the Coalition’s timorous attempts at improved spending discipline have simply been inadequate to the task in hand. Since May 2010, the government have erroneously behaved as if they were a new management acquiring a viable business, when they needed to act with the ruthlessness and despatch of receivers taking over a massively-indebted and near-bankrupt concern.

Finally, and in order to not needlessly rock the life raft, Bank Rate should be held in December and probably for the next few months. This is largely for psychological reasons, since banking lending costs are driven off money-market rates which have become detached from Bank Rate. QE remains a valid tool, which should be used without inhibition if the UK authorities have to act as a lender of last resort because of financial contagion from the Continent. However, it is not a cure all; it is grossly unfair to savers, especially those forced to buy annuities, and it lets the Chancellor too easily off the hook that he has got caught on because of the Coalition’s failure to exercise greater spending rigour. Meanwhile, Western governments have become so hooked on cheap credit that they have taken it for granted that they are entitled to borrow at ludicrously low nominal and real rates of interest. In the case of Italy, for example, a 7% bond yield does not look at all unreasonable for a country with 3.4% inflation even within the Euro-zone, and a huge funding task ahead of it. In normal times, one might expect a ten year government bond yield to equal inflation, plus a real rate of, say, 2½%, plus an extra 0.1 to 0.2 percentage points for each 1% of GDP accounted for by official debt sales. The financial markets are not being unreasonable in asking for higher bond yields from profligate governments. The politicians are being unreasonable – or delusional – to expect anything else. One very last comment, from a technical macroeconomic modelling and forecasting perspective, is that the UK Office for National Statistics (ONS) has made such a complete mess of the national accounts and its data bank that it is hard to see how the reliability of the latest Inflation Report and OBR forecasts can be anything other than seriously degraded as a consequence.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; no extension of QE; reinstate Special Liquidity Scheme. Bias: Raise Bank Rate once constraints on bank lending have been alleviated.

The Bank of England, far from being the saviour of the UK economy, is becoming its greatest liability. Warming to its expanded role in the wake of the global financial crisis, the Bank’s recent actions run the risk of condemning the country to a permanent state of crisis and emergency. Compounding its reluctance to respond to a persistently adverse inflationary trend, the Bank has followed a wayward US Federal Reserve in seeking to suppress interest rates across the yield curve for government bonds. However, the appropriate response to the threat of contraction in the market for wholesale funds prompted by the Euro area banking crisis is the provision of significant additional liquid funds (Treasury bills) to the UK banking system by the Bank of England, not the extension of the Asset Purchase Scheme for government debt.

Despite the repetition of the very same threat that plunged Northern Rock into darkness four years ago, the Bank remains adamant that it will close down its Special Liquidity Scheme (SLS) by January 2012 and is on course to do so. UK banks have been preparing for this withdrawal for the past two years. As a consequence, they have held back from net new customer lending and have reined back their unused credit facilities by 11.5% or £31.7bn in the past year. This enforced abstinence has robbed low interest rates of their expansionary vigour and denied to the UK economy even the temporary phase of rapid economic recovery that normally occurs following a slump.

Essentially, the Bank has adopted the position that the liquidity support for the banks should be temporary while the compression of interest rates, extending across the yield for government debt, should continue for a considerable period. This combination is wrong-headed and counterproductive. As Professor Ronald McKinnon of Stanford University has recently pointed out in the US context, the continuation of near-zero short-term interest rates poses a credit constraint on the banking system. Low interest rates only stimulate faster credit growth when inter-bank rates are comfortably above zero. Banks with good opportunities for lending to individuals and small and medium-sized enterprises (SMEs) typically do so through the extension of credit facilities. These credit lines, like an overdraft facility, can be drawn down when the borrower requires them. For the bank, this creates uncertainty in knowing what its cash positions will be. An illiquid bank would soon be in trouble if its customers decided to use up their credit lines in a synchronised fashion, as often happens during a temporary decline in economic activity.

If banks had ready access to wholesale funds through the inter-bank market then their fears of illiquidity would be allayed. They could cover unexpected liquidity shortfalls by borrowing from banks with excess reserves without needing to offer collateral. However, with an inter-bank rate close to zero, as now, strong banks with surplus reserves are unwilling to part with them for a derisory yield. Weaker banks, including those in which the government has a stake, cannot readily bid for funds at an interest rate significantly above the inter-bank rate without signalling that they might be in trouble.

The solution is to reverse the Bank’s position: to reinstate the SLS for an extended period, and to begin to raise Bank Rate from its unhelpful and unrealistic low level of 0.5%. The market-determined three-month interbank rate was 1.02% in October, while the average interest rate on bank and building society accounts with notice periods was 1.19%. The logical response to the Euro-area threat to UK wholesale market funding is to strengthen the offer of substitute liquidity facilities to UK banks, not to compress interest rates. Once Bank Rate has been raised to around 2%, the volume of commercial inter-bank lending will recover and the Bank’s special liquidity facilities can then be withdrawn safely. Until then, the UK banking system is hamstrung in its capacity to lend to creditworthy unencumbered individuals and businesses by the ongoing and sudden threat of a contraction in wholesale funding in the context of a moribund inter-bank market. The UK banking system’s vulnerability to shrinkage of wholesale funding is every bit as great as when the crisis first struck in 2007. This is a plumbing problem that the Bank of England could and should have solved without recourse to an expanded balance sheet or the indefinite extension of crisis-level interest rates. In keeping interest rates at emergency low levels, the Bank is perpetuating the emergency.

As discussed in last month’s minutes, the psychological impact of increasing Bank Rate in the prevailing economic climate would be clearly damaging. However, it is imperative that the Bank of England relaxes the liquidity constraint on the UK banking system to head off a further tightening of credit conditions. When bank lending growth has recovered from this arbitrary clampdown, Bank Rate should be raised to the region of 2% as part of the normalisation of UK money markets.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold Bank Rate and maintain QE.
Bias: To hold Bank Rate and be prepared to raise QE total to £400bn by end 2012.

Despite a recovery of 0.5% in UK GDP growth in 2011 Q3, the economy has steadily worsened. In fact, the slowdown started around this summer, when the US Federal Government’s credit rating was downgraded by the Standard and Poor’s agency from AAA to AA+, and the European debt crises went viral. Without increased stock building and a rise in government spending, the British economy would have contracted in the third quarter. As it was, national output was just 0.5% higher than in the same period of the year before.

The latest indication from our December ‘Business Barometer’, which has survey data for November, shows that the economic prospects index fell to its weakest level since January 2009. Although companies’ own trading prospects in the Barometer have remained more resilient, the overall data imply that quarterly growth will be flat in 2011 Q4 and the provisional projection is for a 0.3% contraction in 2012 Q1. Interestingly, the new OECD projections published on the same day predicted a marginal fall in quarterly growth in the fourth quarter of this year and a 0.15% contraction in Q1 2012 – meaning a technical recession. Using Lloyds Bank Corporate Market survey data to predict the probability of recession in the next two quarters suggest a recession risk of 50% - up from 30% last month.

With this backdrop, rates can only sensibly be left on hold. QE is putting money into the economy via the banking sector and so ends up providing some of the liquidity that is required to help stave off the threat from any spill-over effects of the debt crisis in Europe. Nevertheless, with the economic slowdown in Europe likely to get worse before it gets better, it would be sensible to plan for a worst case scenario whereby a Continental recession tips the UK into a deeper downturn. In that case, the UK authorities will have to be prepared to inject up a total of £400bn into the economy, a further £125bn more than announced so far.

Reversing this monetary easing will be a challenge when the time comes for it to be done. Clearly, the risks are of higher inflation if this policy injection is not managed carefully. But not doing anything in the near term runs the risk of pushing the economy into as deep a downturn as in 2009. Strong growth in the rest of the world will help the economy only when the UK can orient exports away from Europe to faster growth markets elsewhere.

In the meantime, the UK is trapped in the reality that 50% of its exports still go to an economic area that is undergoing a period of extreme volatility and financial and economic challenge. It is true that the UK economy would have faced a crisis despite the problems in the euro zone - and one should not blame the UK's slow growth on Europe. Blame should go to a lack of the right skills, productive capability and export industries that have reduced the ability to switch from reliance on domestic demand and debt to export-led growth. Not even a weak currency has reversed the adverse effects of these structural weaknesses, although it may have helped ameliorate them. When combined with Europe’s challenge, the UK economy is very vulnerable in the short term.

Over time, the authorities will have to continue to reduce long-term government debt levels, to free up capital for the private sector to meet the challenge of focusing on the supply side of the economy. Help with Research and Development (R&D) tax credits, reform of regulations, long-term infrastructure spending and more incentives for skills training and apprentices will help the economy. However, these are all for the long term. In the short term, the direction of the economy has already been determined.

Appendix: ‘E-mail from America’

Editorial Note: The SMPC member Anthony J Evans is currently on an academic sabbatical as the Fulbright Scholar in Residence at San Jose State University, California. He has not been contributing to the SMPC UK Bank Rate polls while he was away. However, it was thought that his close-up view of the US economic scene would be of general interest. This section has been named ‘E-mail from America’ with acknowledgements to the late BBC correspondent Alistair Cook’s ‘Letter from America’. Anthony J Evans will shortly be returning to Britain and this will be his final US e-mail.

It seems increasingly likely than one of the intellectual legacies of the US’s continued economic woes will be the rise of Nominal Gross Domestic Product (NGDP) targeting. Inflation targeting has come under immense scrutiny and the main argument in its favour – the Great Moderation – has now turned into the Great Recession. As ever, economic performance tends to determine the fate of economic theory. NGDP targeting is nothing new. It has a rich lineage in the history of economic thought, perhaps championed most famously by Bennett McCallum. However, one can also find strong hints of it in the works of FA Hayek. The issue I want to draw attention to is not the idea itself – which it is assumed readers will be familiar with – but the way that it is spreading within American discourse.

The resurrection of NGDP targeting can be accredited to Scott Sumner, the Bentley University economist, who blogs at www.themoneyillusion.com. Throughout the current crisis, he has made repeated and persuasive claims that the US Federal Reserve’s policy response in mid-2008 was contractionary and that a credible commitment to a level target for NGDP futures would be the best cure. It is possible to have reservations about his views. However, it is fascinating how they have gained traction. Sumner’s blog soon got the attention of prominent macroeconomists, across several different schools of thought. These schools included monetarists (e.g. Bill Woolsey), Keynesians (Paul Krugman and Brad De Long) and quasi-Austrians (Tyler Cowen). Several other bloggers, including Nick Rowe, David Beckworth, David Glasner and Lars Christenson (who has written an academic paper on the spread of this movement) have formed an epistemic community that has gained the label ‘market monetarism’. In contrast to the Public Choice attention to ‘interest groups’ an epistemic community is a knowledge-based group, typically international, formed around an intellectual commitment to certain policy ideas.

And they are becoming increasingly influential. Christina Romer recently endorsed NGDP targeting in a New York Times article and the Federal Reserve Open Market Committee have held an “interesting conversation” on the idea. Thinking in terms of NGDP targeting is instructive not only in terms of the implied policy responses, but also as an interpretation of history. The Bank of England has de facto abandoned its commitment to 2% inflation, so observers are wondering what is guiding their decisions. There’s a plausible argument that NGDP growth sheds some light. Not only did cash GDP grow at 5% in the decade prior to the credit crunch – indeed, it rarely changed by more than 0.5 percentage points either side – but the official forecasts of cash GDP project that this will continue through 2016.

When interest rates are low, and the quantity of base money is high, economists and policymakers have a habit of getting confused about the monetary stance. Expectations in the path of NGDP provide a solution, and suggest that keeping inflation expectations anchored to 2% is a bad idea. Ironically, the good news is that the British MPC seem incapable of delivering this, so it may not stay this way for long. An alternative way to infer the monetary stance is to look at Federal Reserve holdings of US Treasuries (as a share of the total market). Given that monetary policy takes place through open market operations, the degree to which the Federal Reserve is ‘moving’ that market can be taken as a sign of their monetary intentions. In a new working paper, Justin D. Rietz of San Jose State University uses ‘Freedom of Information Act’ requests to attempt to uncover this information. He found that from 2002 to 2007 the Fed’s holdings fell from 19.6% to 15.9%, and that the Federal Funds rate hit its lowest point a full eighteen months after the Fed’s market share began to fall. He uses this evidence to conclude that other holdings – namely foreign governments – were driving US short term interests rates, providing empirical support for the global savings glut hypothesis.

In the ongoing discussion about a new policy framework, defining the monetary stance may form a crucial part of the debate.

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 (Deloitte and 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), Gordon Pepper (Lombard Street Research and Cass Business School), 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 TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Following its latest quarterly gathering on 17th October, the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one that Bank Rate should be held at ½% when the official rate setters make their announcement on Thursday 10th November.

The dissenting SMPC member wanted to raise Bank Rate to 1% with immediate effect. The main reason most SMPC members voted to hold in November was concern over the potential adverse consequences of the turmoil in the Euro-zone for Britain’s exports and UK banks. Several of the holds thought that the UK inflation situation was bad enough to have justified a credibility-preserving rate hike in the absence of the uncertainties on the Continent.

There was also a near universal concern on the shadow committee that the supply side of the British economy was so arthritic that any monetary stimulus would be largely dissipated in higher inflation.

The other major worry was that heavy handed financial regulation and additional capital requirements, at a time when banks could not raise capital in the equity markets, could lead to a retrenchment in UK bank credit and broad money. From this perspective, the additional £75bn Quantitative Easing (QE) announced in October was trying to offset the perversely negative effects of a pro-cyclical regulatory stance with a direct cash injection into the economy.

The same analysis implies that the extra capital requirement imposed on the Continent’s banks by the 26th October Euro-zone Summit would also act as an adverse regulatory shock to the supplies of money and credit. This had the potential to seriously reduce activity in the zone as a whole.

Minutes of the Meeting of 17th October 2011

Attendance: Tim Congdon, Andrew Lilico, Patrick Minford, David Brian Smith
(Chairman), Peter Warburton, Trevor Williams.

Apologies: Philip Booth (IEA-Observer), Roger Bootle, Jamie Dannhauser,
Anthony J Evans, John Greenwood, Ruth Lea, Kent Matthews (Secretary),
Gordon Pepper, David Henry Smith (Sunday Times Observer), Akos Valentinyi,
Mike Wickens.

Chairman’s comments
David B Smith expressed his concern about the revamp of the Office for
National Statistics (ONS) website carried out in late August. He explained that
the ONS had taken a number of cost saving measures including the abrupt
cessation of many of its traditional publications. These titles included Financial
Statistics, the Economic and Labour Market Report and the Monthly Digest of
Statistics. This followed on from the earlier decision by the Bank of England to
cease publishing its monthly Bankstats publication as one coherent report. The
overall outcome of these changes was to reduce the accessibility of economic
and financial statistics and often to destroy the continuity of long runs of time
series data.

On the specific matter of the new ONS website, he was shocked by the radical
changes to format and procedure, including the separation of data tables
from the body of statistical press notices. Another extraordinary change has
resulted in the interspersal of data of different frequencies in downloaded
files. A discussion followed where there was unanimous criticism of the new
ONS site. Tim Congdon suggested that the old website should be reinstated
immediately and the new format reconsidered. Patrick Minford expressed
incredulity that the ONS had spent so much effort on creating a new format
when excellent examples exist elsewhere, such as the sites of the US Bureau of
Economic Analysis and the US Federal Reserve (FRED). (Editorial Note: Some
of these concerns have subsequently been recognised and partly addressed in
a ‘website update’ mounted on the ONS site on 23rd October.)

The chairman then asked Andrew Lilico to give his assessment of the global and
UK monetary background.

The Monetary Situation
The International Situation

Andrew Lilico began by reviewing global indicators for economic growth,
unemployment and broad money growth, observing that there was little evidence
to support the notion of a global economic crisis. While the leading indicators
compiled by the Organisation for Economic Co-operation and Development
(OECD) had weakened since the spring, these also failed to sound the alarm
over global recession. Andrew Lilico then highlighted the context of the Euro-
zone as the potential catalyst for a much weaker global outlook. He asked
the question, can the Euro be saved? In his presentation, he articulated three
different types of crises that afflicted the various countries. He described the
situation of Greece and Cyprus as unsalvageable. In Belgium, Spain and Ireland
he identified a crisis in the banking sector as the defining problem. In contrast,
Italy and Portugal suffer from a crisis of competitiveness, which had been a
significant factor in their weak pace of productivity and economic growth.

He argued that the solution for banking crisis countries was to disentangle the
state from the banking sector and impose debt-equity swaps on distressed
banks. This would involve bringing forward the European Commission ‘bail-
in’ proposals from 2013 to the present. His prescription sought to avoid bank
recapitalisation either by the banks independently or by the state. In the former
case, banks had a vested interest in conserving capital by shrinking their loan
book rather than diluting existing equity shareholders. The by-product would
be a potentially violent contraction in the Euro-zone money stock. Andrew
Lilico rejected as a solution any arrangement whereby Germany, France, etc.
became responsible for current debts in Italy, Spain, etc. This would rule out the
Eurobond proposal, the leveraged European Financial Stability Facility (EFSF)
or substantial purchases of government bonds of the PIIGS countries. He drew
a distinction between collective debt issuance in future and responsibility for
legacy debt.

In the case of countries suffering from a crisis of competitiveness, the solution
was to raise their economic growth rate to allow them to service their own debts.
He advocated the use of ‘Euro-zone only’ structural funds to improve the supply-
side characteristics of these countries. He reminded the gathering that Ireland
had received structural funds equivalent to 0.5% of GDP in the 1990s. Applying
the same rule of thumb to Italy and Portugal would imply structural funds of
€9bn. He considered that there might need to be double this level in the early
years to be credible but that this was not out of the question. The structural and
cohesion funds budget runs at €58bn per year. He reiterated that the key was
to boost investments that would have a lasting effect on the pace of economic
growth. In contrast, the cost of debt pooling for Germany and France could be as
high as €36bn per year on the assumption of a 100 basis points addition to their
borrowing costs.

The UK Economy

Andrew Lilico then focused on the long-term sustainable rate of growth in the
economy. The Bank of England was expecting a return to annual Gross
Domestic Product (GDP) growth of 2.3% in 2012 and the Office for Budget
Responsibility (OBR) had asserted a sustainable growth rate of 2.35%. He was
concerned that these estimates were too high. The UK economy seemed to
have stalled during the preceding nine months and measures of consumer
confidence had slipped back towards the weakest levels of last year. In his
research at Europe Economics, he had derived an estimate of the risk-free real
interest rate of 1.4% and of sustainable economic growth of 1.1% per annum. If
the sustainable growth rate was indeed this low, then the output gap was
negligible or negative and the Coalition’s targets for budget-deficit reduction
would not be met. Also, it would imply a vulnerability to rising inflation that was
inconsistent with an inflation target of 2%. Andrew Lilico observed that the
reported rates of the Consumer Price Index (CPI) and Retail Prices Index (RPI)
measures of inflation had trended steadily higher since 2001. This upward drift
broadly coincided with a slower pace of productivity growth. He also drew
attention to the plunging real yields on index-linked gilts as evidence of a
weakened supply-side potential. Regarding the Bank’s own inflation forecasts,
he recalled that in May 2010 the Monetary Policy Committee (MPC) had
assigned zero probability to an inflation outcome in September 2011 that was
higher than 3.5%. (Editorial Note: The September figures released on 18th
October showed annual CPI inflation at 5.2% and RPI inflation at 5.6%.)

Discussion
Supply-side uncertainties cramp monetary options

The Chairman thanked Andrew Lilico for his excellent presentation and opened
up the meeting to discussion.

There was a lot of concern expressed about the potential rate of UK economic
growth. David B Smith started the debate by stating that he accepted that the
real rate of interest should equal the rate of economic growth in Solow-style
steady-state growth models, as Andrew Lilico had suggested. However, Britain
had a small open economy and probably took its real bond yield from the world
outside – which theoretically reflected the much higher growth rate in the world
as a whole, including the newly industrialising countries (NICs) – rather than
purely domestically. Patrick Minford also claimed that the UK risk-free real rate
was derived from the global risk-free rate. He considered that the explanation
for poor potential economic growth in the UK was over-regulation in the banking
system and a falling rate of productivity growth. He failed to see how monetary
policy could help to raise the risk-free rate and feared that an expansionary
monetary policy would worsen the inflationary outlook. Peter Warburton argued
that two explanations were needed of the UK’s sluggish economic performance.
Even if one accepted the logic of a slower potential growth rate, there remained
the issue of the failure to recover the output level of 2008. A second explanation,
concerning the obsolescence of the capital stock was required to justify the
inability of the UK economy to make up lost ground.

Patrick Minford expressed the view that the term ‘balance-sheet recession’ was
inappropriate to describe the UK’s predicament. He believes that the negative
pressures on private-sector balance sheet were a symptom of an underlying
potential growth problem. David B Smith queried whether corporate balance
sheets were weak, pointing out the unusually strong cash flows and high liquidity
of large corporations in the UK and elsewhere and suggested that the real
problem was a collapse in entrepreneurial ‘animal spirits’. Animal spirits were
weak because of the uncertainties over future tax burdens associated with large
budget deficits, misguided regulatory shocks in the labour market as well as the
financial sector, and blood-curdling anti-market rhetoric by politicians who should
know better. Patrick Minford introduced the dimension of political risk (now
widely measured in available indices) which suggested a marked rise in the US
under President Obama.

A broader discussion ensued concerning the explanations for disappointing
recent economic performance in the UK and the US. Patrick Minford blamed
populist anti-business sentiment and President Obama’s distrustful attitudes
towards business. Tim Congdon added that policies had targeted the financial
sector and the oil and gas sector for tough regulatory interventions. He said that
these policies had serious consequences for the operations of heavy industries.
In addition, European Union labour market directives were perpetuating labour
market inefficiencies.

The report of the Vickers Commission on UK banking was also criticised for
its potential negative effects on the future supplies of money and credit. David
B Smith then noted that the burden of public spending had barely risen during
the present century in Germany – but had gone up massively in Britain and
the US – and suggested that this might help explain the relatively stronger
performance of the former. Andrew Lilico summarised his justification for
assuming a very low long-term potential growth rate in the UK. First, the large
increase in the proportionate share in government spending implied higher tax
rates in the future. Second, the rise in the government debt to GDP ratio had
reached levels that were deemed by Stephen G Cecchetti, MS Mohanty and
Fabrizio Zampolli as undesirable and probably unsustainable in their 5th August
2011 paper published by the Bank for International Settlements (BIS) The Real
Effects of Debt. Third, high levels of household indebtedness had already been
instrumental in reducing the pace of economic growth since 2002. Fourth, the
UK’s poor record in terms of productivity growth was in part a consequence
of transferring economic activity from the private to the public sector. Finally,
productivity growth in the UK’s public sector has been negative — if it had
matched private sector productivity growth in the decade to 2007, UK GDP
growth could have been 0.5% faster.

Trevor Williams introduced the dimension of slowing growth of the working
age population as a contributing factor to weakening economic growth. He
commented that the UK had consumed the benefits of its North Sea oil and
gas endowment rather than storing up wealth in a sovereign fund as Norway
had done. He also believed that excessive borrowing by the public sector
has crowded out private sector activities. Pro-cyclical economic policies
were responsible for imposing constraints on the banking system that were
aggravating the economic downturn.

Andrew Lilico questioned whether the Bank of England’s recent decision
to extend the Quantitative Easing (QE) programme was designed to offset
disappointing economic outcomes or to pre-empt the effects of a Euro-zone
banking crisis. Tim Congdon defended the decision to undertake an additional
£75bn of asset purchases as wholly justified in the context of very weak money
supply growth. He estimated that the Bank’s action would add about 5% to the
stock of broad money and would boost UK economic growth during the first half
of 2012. Peter Warburton expressed his concern that this latest intervention
would drive down the value of sterling. The Bank was providing an excellent
opportunity for overseas gilts holders to cash out their recent strong gains.
Patrick Minford agreed with the judgement that there was not much spare
capacity in the UK economy and then highlighted the inflation risk associated
with QE. He believed that the Bank model omitted a major channel of inflationary
transmission, namely the inflation expectations channel. A loss of inflation
credibility had allowed inflation expectations to become untethered, clearing the
way to divergent inflationary outturns in the future.

Patrick Minford opined that the Bank of England appeared to be willing to do
anything to stimulate growth. Tim Congdon countered that UK banks were
still not growing their risk assets and that the growth of broad money was
very weak. He supported the use of QE to provide a burst of money growth.
He reminded the committee that the impact of the original £200bn of QE had
been dented due to huge capital raising by the banks. Trevor Williams warned
that the process of capital raising by UK banks might not be over, citing the
implications of the Solvency II directive. He noted that there was a scramble to
secure US$ assets in Europe and that US banks had drastically reduced the
provision of US$ liquidity to European banks. Andrew Lilico wondered whether
the Bank of England should promise some future inflation in order to induce
corporate investment. Trevor Williams thought that it would have been better to
delay the QE decision until the November Monetary Policy Committee (MPC)
meeting. However, David B Smith said that recent major changes to the national
accounts almost certainly meant that the Bank’s forecasting model, like his
own, had been effectively rendered non-operational for the time being, and that
there was nothing to be gained from waiting for the November Inflation Report
projections. Tim Congdon also disagreed with Trevor Williams on the grounds
that it was better to counteract a monetary contraction as soon as possible and
he expected inflation to fall back considerably next year.

Andrew Lilico raised the issue of the fallout from a Euro-zone banking crisis
on UK banks and wondered what policy responses lay beyond QE. Former
MPC member Sushil Wadhaani had advocated a form of QE whereby people
were sent cheques. Another idea was for the banks to fund the government
budget deficit directly rather than through the purchase of gilts. Patrick Minford
suggested that the Bank of England was using a foreign crisis to excuse a
domestic monetary easing. He believed that UK monetary policy had been held
hostage by the Euro-zone crisis and that the Bank had panicked at the prospect
of a worsening demand outlook for UK exports. David B Smith was increasingly
concerned, in the light of QE2, that the overseas sector might judge the UK as
a high sovereign risk situation, provoking a further downwards adjustment of
sterling, higher inflation, and much higher official funding costs in the longer
term.

Votes

The Chairman then asked each of the other five SMPC members present to
make a vote on the appropriate monetary policy response. In addition, to the
votes cast at the gathering at the IEA, three votes were subsequently cast in
absentia by John Greenwood, Ruth Lea and Kent Matthews in order to ensure
that exactly nine votes were cast. These votes are included below and all nine
votes are listed alphabetically, in line with the customary SMPC practice.

Comment by Tim Congdon
(International Monetary Research)
Vote: No change in Bank Rate.
Bias: Easing through additional QE, conditional on monetary outcomes.

Tim Congdon stated that he endorsed the additional £75bn of QE that had been
announced and would support an extension of the programme, conditional on
the path of broad money growth being too low to support a proper recovery.
However, he believed that the same effect could have been achieved by
the government borrowing directly from the commercial banks. This would
have avoided the sizable increase in the Bank of England’s balance sheet.
Tim Congdon supported measures to boost the supply-side capability of the
economy as a means of restraining future inflationary pressures.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Expand QE further if M4ex broad money declines.

Economic growth in the UK, Europe and the United States, had disappointed
during the current economic recovery according to John Greenwood’s
submission in absentia. The downward revision to the second quarter UK
GDP growth figure to only plus 0.1% quarter-on-quarter had been just one
manifestation of this persistent weakness in growth in the developed world. The
recent deterioration in demand prospects associated with the sovereign debt
crisis in the Euro-zone, together with the steep falls in financial markets since
July, had prompted the Bank of England to implement a second programme of
asset purchases. This amounted to £75bn of gilt purchases to be conducted
over the four months October to January.

Two broad sets of factors explained the weakness of growth in Britain, according
to John Greenwood’s post-meeting submission. First, the relatively strong
growth of the period 2002 to 2008 had been artificial to a significant degree,
based on the rapid growth of money and credit, accompanied by a rising shares
of government and household consumption in GDP. Consumption was routinely
mistaken for prosperity. In this sense, the current period of slower growth was
largely a reaction to the earlier period of unwarranted consumption growth.
Second, the increase of debt on household and financial sector balance sheets,
and more recently on government balance sheets, had reached levels that
were clearly inhibiting growth. The Bank for International Settlements (BIS)
study by Stephen Cecchetti and others (cited by Andrew Lilico) showed that
over-indebtedness beyond well-defined thresholds in a variety of sectors –
household, non-financial business, or government – typically caused growth
to plunge in the aftermath of crisis. The reason – which was not spelled out
by Cecchetti et al – is that balance sheet repair or debt repayment necessarily
takes several years, and detracts from investment and other spending during
that period. Those who argued during the past two years that the UK recovery
would be strong and vibrant (either using the standard Zarnowitz argument
that deep recessions are followed by stronger than normal recoveries, or the
argument that economic agents would respond positively to abnormally low
interest rates) have therefore proven to be wide of the mark.

In this situation, there remained limited scope for either fiscal or monetary
stimulus. However, asset purchases by the central bank were justified to prevent
a monetary contraction. As demonstrated by the experience of Japan in 2001 to
2006, there was no link between QE and CPI inflation when the private sector
was deleveraging. On the contrary, deleveraging was inherently disinflationary
in John Greenwood’s view. The Bank of England needed, therefore, to have
no concern that QE would add to inflation unless and until broad money growth
accelerated, and there had been absolutely no sign of that so far this year.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: Hold Bank Rate; no change to new £75bn QE package.

In her vote in absentia, Ruth Lea stated that the MPC’s decision to authorise
a further £75bn of QE at the October meeting was something of a surprise in
terms of timing and magnitude. Even though the September MPC minutes had
indicated that more QE could be in the offing, market expectations had focussed
on November rather than October for action. Furthermore, the amount had been
more than expected. Expectations had been more in line with an extra £50bn.
Following the announcement, Sir Mervyn King had been in apocalyptic mood.
“This is the most serious financial crisis we have seen, at least since the 1930s,
if not ever” he had said. Given the deepening crisis in the Euro-zone which
could only be ‘solved’ by break-up or full fiscal union, neither of which appeared
likely in the foreseeable future, the Governor could not be accused of idle
scaremongering, in Ruth Lea’s view. More QE was probably the right decision.
The economy needed all the support it could get and, whilst the Chancellor
stuck to his fiscal retrenchment package – and rightly so, in her view - monetary
easing was an obvious alternative.

The Bank remained especially concerned about the state of the banking sector.
The October minutes had said “stresses had been particularly acute in bank
funding markets….while banks in the UK had made significant progress in
meeting their debt issuance targets for the year as a whole, there were limits
to how long they would be able to withstand elevated funding costs or closure
in the markets before lending to the domestic economy would be affected.”
Furthermore, and even though the objective of further QE had not been stated
explicitly in terms of supporting the banking system, it was reasonable to
conclude that one of the main reasons for the action, if not the main reason, was
to do just that. However, given the 2% inflation target, the Bank had probably
felt obliged to justify its actions in terms of ensuring the 2% CPI target was not
undershot.

The ONS had revised GDP growth for 2011 Q2 down to 0.1% in early October.
Household consumption had fallen by 0.8% and there had been a disappointing
deterioration in the net trade balance. Buoyant ‘export-led’ growth, which had
been a key part of the OBR’s March forecast, had not happened. Furthermore,
and given that the Euro-zone and the US, which were our major export markets,
were stuttering it was not likely to happen for some time. The economy had
almost flat-lined since autumn last year.

There was not much ONS evidence for real activity for 2011 Q3 available yet.
However, what there was, failed to inspire. Retail sales slipped in the quarter
and industrial production was disappointing in both July and August. Surveys
had been mixed. The most recent Markit/Chartered Institute of Purchasing and
Supply (CIPS) Purchasing Managers Index (PMI) surveys, for example, painted
a patchy picture. The manufacturing PMI was only 51.5 in September, the
services PMI picked up to 52.9, but the construction PMI fell to 50.1, suggesting
stagnation in the sector. The first estimate of 2011 Q3 GDP, which was due on
1st November, may only show an increase of around 0.2%.

Moreover, the labour market was clearly deteriorating. The International Labour
Office (ILO) measure of unemployment had increased by 114 thousand in the
three months to August, to reach a seventeen-year high. Inflation continued
to run well ahead of the Bank’s 2% target. September’s CPI inflation picked
up to 5.2% and RPI inflation, at 5.6%, was the highest since June 1991.
Nevertheless, it was reasonable to suppose that inflation would fall rapidly
next year. Earnings annual growth remained a very subdued 2.8% in the three
months to August, on the measure including bonuses, implying a major squeeze
on households’ incomes. This meant that there should be no change in interest
rates in November, with a bias to keeping interest rates at their present level,
and no change to the current programme of a further £75bn of QE agreed at the
October MPC meeting.

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

Andrew Lilico believed that the Bank of England had jumped the gun in its
QE announcement. He would have liked to hear more details of the ‘credit
easing’ proposed by Chancellor Osborne. He was concerned that such policies
contained a veiled signal that the UK banking system was under threat. He
would like the Bank of England to explore other forms of unconventional
monetary policy besides QE.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To raise Bank Rate; QE should be held in reserve.

The argument that the rise in inflation was temporary and would drop next
year was wearing thin, in the post-meeting view of Kent Matthews submitted in
absentia. Kent Matthews added that people were told that temporary factors,
which the Bank could not control, had been the main reason for inflation
reaching its three-year peak. Inflation would slow in the coming months, once
factors such as the January 2011 VAT increase fell out of the system, in the
official view. However, it was hard to accept the claim that inflation had nothing
to do with the Bank’s policy given the near 25% depreciation of sterling since
2007. The monetary authorities’ argument that inflation was driven by external
factors and that the domestic drivers, such as wage inflation, pointed to its
transient nature hinged strongly on what has happened to productive capacity.
If we were in a world of Keynesian excess capacity, the argument went that
demand deficiency would place downward pressure on inflation. Evidence for
the Keynesian scenario was ample. Firms were hoarding cash while interest
rates were near zero (i.e. the liquidity trap); investment intentions were weak
(i.e. low animal spirits); and conventional monetary policy was ineffective (i.e.
pushing on a string). The conclusion was that extraordinary direct measures
- such as QE and possibly fiscal policy - were the only escape from the
deteriorating economic situation and weakening world demand.

An alternative view was that excess capacity was much lower than the Bank
thought. The world economy had seen major capacity destruction from the
realisation of low marginal returns from excess investment, principally by
the Far-Eastern economies, and prospects for capacity building by the small
business sector in the Western economies had been stifled by the credit crunch
and credit rationing by the banks. In the UK, the growth in the government
sector, business unfriendly regulation and increased taxation had compounded
negative world shocks that had resulted in a contraction in productive capacity
and a weakening of underlying productivity. In this scenario, real wages needed
to fall, which was happening through the rise in prices in a world of nominal
wage frictions, and competitiveness to improve through a depreciation of the real
exchange rate. Consumer spending would remain muted with the realisation of
the decline in permanent income. Business investment would stay pessimistic
as long as the world economy remained sluggish and with no sign of positive
supply-side policies from the government. In this latter scenario, there was
little that monetary policy could do. QE could be deployed if the Euro-crisis
turned particularly nasty. However, this should be used to stop an asset-price
deflation from turning into a financial market melt-down not to stimulate domestic
demand.

If the first view was correct, inflation would indeed begin to fall by the middle
of next year and the credibility of the Bank could be restored with a smug ‘I
told you so’ response to the doubters. If the latter was proved correct, inflation
expectations would feed into domestic costs as firms began to hit capacity
constraints and the anti-inflation reputation of the Bank would be shot to
smithereens. Rebuilding reputation would then be long and painful. Quite clearly,
there was currently little the Bank could do in the face of the continuing Euro-
crisis and the uncertainty it was causing in the financial markets. Raising interest
rates now would do little to restore the Bank’s anti-inflation credibility and could
zap an already fragile financial market. There was nothing for it, but to do
nothing to Bank Rate and keep QE in reserve.

Comment by Patrick Minford
(Cardiff Business School)
Vote: Raise Bank Rate to 1%.
Bias: Raise Bank Rate; no further QE.

Patrick Minford stressed that the UK economy was hamstrung by fundamental
problems that could not be solved by a progressively easier monetary policy. He
remained worried that the recent addition to QE will have further adverse effects
on inflation. He believed that there had been a huge over-reaction by regulators
to the financial crisis to the detriment of the supply capability of the economy.
The diminished growth potential of the economy left the UK open to a worsening
inflationary scenario. He believed that tighter monetary policy was justified as
a response to inflationary concerns and that the structurally weak growth rate
should be addressed through deregulation and other means.

Comment by David B Smith
University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: Tighten, conditional on developments in the Euro-zone.

David B Smith was appalled by the explosion of public sector spending during
the present century in Britain and the US. This had provoked supply withdrawals
in both countries and was an unacknowledged cause of the Global Financial
Crash. The reason was that a supply contraction reduced the net present value
of assets, such as equities and property, where the current price reflected
the discounted stream of future returns - because these returns themselves
depended on the prospective growth rate. He added that the ‘big picture’
was that the size of the state had reached the point in the UK and US where
governments encountered the problems traditionally associated with financing
a major war. David B Smith added that the share of UK GDP absorbed by
government now substantially exceeded the peak costs of fighting World War I.
In the US under President Obama, government expenditures narrowly exceeded
the peak cost of World War II. In both cases, there had been a massive
diversion of resources from the private to the public sector and seriously
deleterious effects on the supply side. He viewed proposed regulations to oblige
private banks to hold more public debt as a form of ‘forced funding’ on wartime
lines and QE as being worryingly close to ‘resorting to the printing presses’.

Large Budget deficits crowded out private activity not only for the well
understood ‘Ricardian-equivalence’ reasons but also because private agents
faced uncertainty about their future tax liabilities. He advocated as a response
that the UK government should pre-announce that there would be no more tax
hikes for the duration of the parliament and that any future borrowing overshoots
would be tackled solely through spending cuts. His perspective on the recent
addition to QE was that the policy was unlikely to create any ‘added value’ with
bond yields already so low. However, he also believed that an active funding
policy was a valid tool to control monetary growth, provided that it was used
symmetrically in both directions. On a more optimistic note, he noted that there
had been a sharp drop in world non-oil commodity prices recently and reckoned
that there was some scope for the UK economy to recover next year. However,
there was now a powerful stagflationary bias in both the UK and US economies.
Traditional Keynesian demand measures would not be effective in the absence
of the supply-side improvements that could only be achieved through lower and
more predictable tax levies on the private sector and a bonfire of unnecessary
regulations. Unfortunately, he had serious doubts as to whether the present UK
coalition had either the desire or the will required to implement the necessary
reforms.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate.
Bias: Raise Bank Rate once economic outcomes improve.

Acknowledging the disappointment over recent UK economic performance,
Peter Warburton had dropped his longstanding call for a higher Bank Rate.
The failure of the Bank of England to raise the rate last year had undermined
the credibility of the inflation target regime and damaged perceptions of the
Bank’s independence from the political process. The ritual exchange of letters
between the Governor and the Chancellor was proof that this mechanism fell
short of proper accountability. The average cost of notice deposits at banks
and building societies rose from a low of 0.2% in 2009 to 1.4% in the autumn
of last year. It has since fallen back to 1%. This rate gave a better indication
of UK interest rates than Bank Rate, which remained largely irrelevant in the
post-crisis world. Bank Rate still had a residual totemic significance, however,
through its psychological impact on public attitudes. In today’s febrile economic
climate, it would be a mistake to inflict a Bank Rate rise. For the record, Peter
Warburton stated that he disapproved of the recent QE addition, believing that
this could give rise to a perverse response with regard to the policy imperative of
budget deficit reduction. Should further asset purchases be judged necessary,
he advocated the purchase of land and property assets which would support the
collateral of the banking system.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold Bank Rate.
Bias: Neutral; no more QE.

Trevor Williams echoed earlier comments regarding the impact of supply-side
constraints on inflation. He was concerned that the recent QE addition could
backfire and would have preferred it if the Bank had delayed the move. He
acknowledged that more UK bank recapitalisation could be required if the Euro-
zone system suffered an irrevocable breakdown. He also favoured measures
to support the supply-side capability of the economy, such as Research and
Development and capital investment tax credits for businesses.

Policy response

1. Eight out of the nine SMPC members concerned felt that Bank Rate should
be held on 6th November.

2. One Member of the shadow committee believed that an immediate 50 basis
points hike to 1% was more appropriate.

3. There was a widespread view on the SMPC that the supply side had been so
damaged by excessive government spending and regulation and high and
uncertain taxes that there was unlikely to be an elastic supply response to
any stimulatory measures taken by the authorities.

Date of next meeting

Monday 16th January, 2012.

Appendix: ‘E-Mail from America’

Editorial Note: The SMPC member Anthony J Evans is currently on an academic
sabbatical as the Fulbright Scholar in Residence at San Jose State University,
California. He will not be contributing to the SMPC UK Bank Rate polls while he
is away. However, it was thought that his occasional views on the US economic
scene would be of general interest. This section has been named ‘E-mail
from America’ with appropriate acknowledgements to the BBC’s late Alistair
Cooke, and his ‘Letter from America’. Anthony Evans’s first occasional e-mail
correspondence appears below.

The author recently attended a Monetary Policy workshop at the San Francisco
Federal Reserve, with panellists including the well-known US economists Glenn
Rudebusch, Eric Swanson, and Carl Walsh. It was focused on how the US
Federal Reserve’s response to the financial crisis has impacted on the way in
which we teach. However, three more general themes seemed to emerge.

Firstly, traditional forecasting techniques struggle with economic uncertainty.
The Bank of England’s ‘fan charts’ are an attempt to factor uncertainty into its
forecasts, but they rest on an assumption that the underlying distribution is
reasonably normal. When the person responsible for the San Francisco Federal
Reserve’s forecasts was asked to add a confidence interval his response was
that the distribution was probably ‘bi-modal’. In other words, we were not dealing
with probability theory but scenario analysis – we might expect an EU implosion
and minus 2% growth or a gradual recovery of plus 2% to 3% in national output.
However, these were two alternative futures and not merely gradations around a
most likely one.

A second insight was that unconventional monetary policy tools were having
negative unintended consequences. Consider ‘Operation Twist’ – the US
Federal Reserve’s attempt to change the composition of its bond holdings
in order to target long-term interest rates. This sort of decision should
be the province of a Debt Management Office, and severely blurred the
distinction between monetary and fiscal policy. It was yet another example of
unprecedented powers being granted to central banks without any exit strategy.
In addition, we lost an important signalling device by deliberately manipulating
the yield curve. The increase in discretionary powers and the loss of market
signals should not be neglected costs of policy.

Finally, US central bankers do not pay close attention to events in Europe. When
pressed on whether the US Federal Reserve would be assisting the European
Union sovereign debt crisis the response was along the lines of “Tim Geitner
offered some advice but it was not well received”. Those conducting stress
tests of US banks were happy to leave EU regulators to deal with their own
companies. The Federal Reserve believed that Europe needed to resolve its
own problems independent of any assistance other than dollar liquidity. One
might view this as an acknowledgment that they have their own problems to deal
with. However, the assumption that Europe could get its own house in order
might be viewed as heroic.

Either way, the use of new monetary tools at the zero lower bound made
this a compelling time to learn and teach economics. Whether or not it was a
good time to be a citizen of the countries that are employing these techniques
remained a more open question, however.

What is the SMPC?

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

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff
University, and its Chairman is David B Smith (University of Derby and Beacon
Economic Forecasting). Other members of the Committee include: Roger Bootle
(Deloitte and 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), Gordon Pepper (Lombard
Street Research and Cass Business School), 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 TSB Corporate Markets). Philip Booth (Cass Business School and IEA)
is technically a non-voting IEA observer but is awarded a vote on occasion to
ensure that exactly nine votes are always cast.

In its most recent e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by seven votes to two that Bank Rate should be held at its existing ½% when the official rate setters make their next announcement on Thursday 6th October. The two dissenting SMPC members wanted to raise Bank Rate by ½% to 1%.

The main reason why most SMPC members wished to hold Bank Rate in October was concern over the potential adverse consequences of the turmoil in the Euro-zone for Britain’s exports together with the potential risks to UK banks if their Continental counterparties were destabilised by a sovereign debt default.

Two of the holds regretted that Bank Rate had not been raised around the middle of last year, when there was the opportunity to do so. This would have allowed the Bank of England to achieve a greater psychological impact now with an overt rate cut, than is achievable with another hold.

A rate hike last year would have also strengthened sterling and meant that inflation would have been less of a concern than it has now become.

The main reasons that two SMPC members wanted to raise Bank Rate was a belief that the UK economy was weak for predominantly supply-side reasons – a number of the ‘holds’ shared this view to a greater or lesser extent – and that the sustained period of high and accelerating inflation had already destroyed so much of the Bank’s credibility that it risked the development of a wage-price spiral. There was a consensus that further Quantitative Easing (QE) should be on standby in case the situation in the Euro-zone worsened, but no great enthusiasm for implementing it immediately.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: More QE, possibly as early as November.

UK inflation is set to hit 5% in coming months. Over the medium-term, however, inflation is set to fall below the Bank’s 2% inflation target. Downside risks have increased markedly since the summer. The debacle in the Euro-zone continues. The meeting of international leaders at the International Monetary Fund (IMF) over the weekend of 24th/25th September suggests bold ideas are being placed on the table; but it is far from obvious that there is the political stomach for such action in the places where it is most needed – Berlin and Frankfurt. Since our last vote, the Fed announced a sequel to ‘Operation Twist’, buying $400bn of medium and long-dated US Treasuries (USTs) with the proceeds of sales of its short-dated USTs by mid-2012. Its actions may have some effect in pulling down the US yield curve; but it is hard to believe this will have much effect on US demand growth, given the limited boost it will offer to broad money and the state of US household balance sheets. Some 23% of mortgagors – around 12½% of all US households – now find themselves in negative equity.

The biggest worries for the UK are external. First, the rate of demand growth in Britain’s trading partners is set to be weak in coming quarters. A recession in the Euro-zone now looks increasingly probable. Second, there is a growing risk that UK banks are adversely affected by wider financial market developments. Bank stocks have taken a battering in recent weeks. The senior unsecured bank bond market in Europe has effectively been closed since mid-July. Marginal funding costs for UK banks have increased by 150 basis points (bps) since the end of May and by 50bps in the last month alone. To the extent this leads to even tighter credit supply in the UK, it poses downside risks to already weak monetary growth. The Bank’s latest Credit Conditions Survey, due to be released on the 28th September, could be particularly telling.

While considerable uncertainty persists about the degree of spare capacity in the economy, a good amount of slack should remain for some time. Recent developments suggest downward pressure on inflation from this source could be greater than previously anticipated over coming quarters. In the light of the gloomy outlook for global demand, commodity prices should decline further as we move into 2012. Brent crude oil at $105 per barrel looks particularly expensive. Moreover, it is hard to detect any real sign that recent upside inflation surprises are feeding through to wage settlements or medium-term inflation expectations. Headline Consumer Price Index (CPI) inflation could be below 2% by the end of next year. Unless there is a meaningful improvement in financial conditions, especially in bank funding markets, soon, additional Bank of England asset purchases will be desirable.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Hold Bank Rate, expand QE only if M4ex broad money declines.

The weakness of recent economic data releases among the developed economies, the on-going crisis in the Euro-zone, and the sharp declines in equity and commodity markets are all symptoms of a shared malaise: excessive indebtedness in the household, financial and government sectors. To gain proper perspective we need to step back for and consider some history. Looking across the world over the sixty-five years since the ‘Bretton Woods’ system of pegged currencies was implemented after World War II, there have been hundreds of recessions and dozens of more serious crises for individual economies, currencies and sovereign states, both among developed and emerging economies. In most cases, the underlying causes included the excessive growth of private-sector credit or government debt in the period prior to the crisis. These episodes were often – but not always – accompanied by excessively rapid growth of the quantity of money and hence inflation.

Time and again, the preferred solution by politicians and central bankers was either to spend their way out of these recessions, or to devalue the currency to regain competitiveness and enable growth to revive. In the case of private sector debt crises, this meant transferring, not paying down or restructuring, the debt from the banks or firms or households that had over-borrowed and overspent to the government through some kind of bail-out mechanism. The result has been a persistent rise in the ratios of public and private sector debt to GDP in one economy after another. In the US case, the combined debt-to-GDP ratio for the combined private and public sectors increased modestly from around 140% in the late 1950s to nearly 170% by 1980 (based on annual flow-of-funds data), but then soared over the next three decades to reach a peak of 375% in 2009. If the financial sector is excluded, US total sectoral debt was 268% of GDP in 2010. On the same basis, the UK’s total sectoral debt-to-GDP ratio increased from 203% in 1990 to 321% in 2010. Numerous countries in Europe have seen similar increases.

Since the credit crisis of 2008-09, the US and UK private sectors have de-leveraged modestly. However, this has been offset by the government leveraging up to finance fiscal spending stimulus, and to recapitalise the banks and other financial institutions. Since the depths of the recession in early 2009, US household debt has declined from 101% of GDP to 92%, while in the UK it has declined from 111% to 103%. At the same time, UK net government debt (excluding temporary financial interventions) has increased from 35% to 61.4% of GDP, or 151% including those interventions. In the US net government debt has risen to 74.8% of GDP. In their efforts to solve the 2008-09 crisis, politicians and policy-makers of US and European governments are grasping at the same old solutions again: borrow and spend more money in the hope that private sector growth will pick up, GDP will revive, and government tax revenues will recover. In the past, central banks stood ready to create the money needed to finance the spending. This Keynesian solution always seemed to work.

The problem is that there is a flaw in the Keynesian solution. It ignores the underlying deterioration in private and public sector balance sheets. The recovery formula was focused on flows of spending and only worked as long as private and government debt levels were relatively low in relation to annual incomes, or the debt could be devalued or forgiven. Now that both the private sector and governments are overburdened with debt and neither the US nor the UK nor the Euro-zone can overtly devalue, the mechanism is seizing up. On one side, households and firms are reluctant to borrow from banks and spend, while banks are unwilling to lend until they have repaired their balance sheets. On the other side, incontinent governments are looking less and less creditworthy – even to those who have funds to lend or invest. So the economic recovery is stalling, and investors are demanding bigger risk premiums (i.e. higher bond yields) for lending to financially weak governments.

In effect, the British, US and European governments have maxed out their credit cards. The Keynesian formula has reached the end of the road. It is time to turn to a different, more durable solution. For the UK this means that if a ‘quick solution’ is sought, it must come from accelerating balance sheet repair – for example through relieving households and banks of debt – not through additional fiscal spending or inflationary money creation. This implies no change in Bank Rate, and activating asset purchases only if the M4ex broad money continues to decline.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate and raise QE.

To state the obvious, the economic situation is dark and difficult. The British domestic recovery – albeit inflationary and unsustainable – appears to have been derailed by international events. British inflation remains high. The Bank of England’s credibility is totally gone. The government’s deficit reduction programme – always overly dependent on tax rises early and thus always at risk of experiencing slow growth early on – appears unlikely to deliver on its targets without further spending cuts. Some British banks are exposed to further downturns in the US, others to developments in the Euro-zone, yet others to a downturn in the East. Another banking crisis appears imminent, with the government forced to consider whether to cast even more good taxpayers’ money after bad in recapitalising the banks yet again.

The most severe and imminent issue is in the Euro-zone, where a Greek default appears imminent at the time of writing and certainly inevitable by March 2012. Euro-zone policy-makers appear resolved to continue in their apparent attempt to turn crisis into catastrophe, with ever-more exotic and expensive schemes – e.g. debt pooling, Eurobonds, a €2 trillion European Financial Stability Fund (EFSF), mass European Central Bank (ECB) purchases of distressed debt – that serve little purpose other than to undermine German popular confidence and which risk eventually inducing a German withdrawal. The longer a Greek default is delayed, the worse the banking sector contagion will ultimately be. Since the Euro can function only with large fiscal transfers between member states in the long-term and no such long-term transfers will be offered to Greece, the longer the pretence is upheld that the Euro can continue with Greece as a member, the greater the ultimate risk of disorderly collapse of the whole arrangement, dragging down the Single Market in the process and inducing a Euro-zone-wide recession on a scale unprecedented in modern Western democracies.

The disaster sketched above is by no means inevitable yet. Greece might default reasonably soon, exiting the Euro (presumably accompanied by Cyprus), and a longer-term solution for the Euro might be implemented with the loss of no more than a couple of other members, perhaps even none. Even if an EU collapse does occur, the slump scenario of a 20% to 25% first-year contraction in GDP even of countries such as Germany, recently put forward by the Union Bank of Switzerland (UBS), seems hysterical to put it bluntly. However, the scenario of Euro-zone and consequent European Union (EU) collapse, though not yet the most likely outcome, is definitely now on the table. Policy-makers should have contingency plans in place.

For the UK, the key contingency plans fall outside monetary policy, albeit within the Bank of England’s new remit. There must be no more bank bailouts, no more taxing of the poor to keep the rich wealthy. ‘Recapitalisation’ – a strategy that would have been immoral and economically destructive even had it worked in its own terms – has manifestly failed. The error must not be repeated, or else Britain risks going the way of Ireland. Governments must not recapitalise failed banks. Indeed, even the insistence on private sector recapitalisations to meet new higher capital adequacy thresholds is misplaced and risks making matters much worse. Capital exists as a buffer against a rainy day. Insisting that banks have adequate capital at the moment makes no more sense than insisting that a man must be wearing a dry raincoat during a storm.

Instead, if banks become distressed this time, then: if they are solvent and viable long-term, they should be provided with Bank of England funding (which is not a form of bailout); if they are insolvent but viable long-term, they should have bail-ins (swapping bank bonds for equity) imposed in Special Administration; if they are unviable, value-destroying entities, their assets should be sold off or wound up. To manage the risk of bank depositor runs, a Deposit Access Fund should be created with newly-created Bank of England money, servicing depositors, repaid from the assets of the banks. This will have short-term money supply implications, and thus is a clear monetary policy issue. QE should be held back for this purpose, for the purpose of offsetting any contraction in the money stock if British banks should actually collapse and – if push really comes to shove – standing ready to fund the British government’s deficit if bond markets panic totally.

QE should have been introduced more than a year ago, when many members of the Shadow MPC were calling for it. Not having done that can now be seen to have been a serious policy error. However, it should not now be introduced for purely UK domestic purposes. Doing so would be chasing the problem. If international events settle down quickly following a Greek default, then only a minor liquidity injection – no formal QE at all – might be sufficient. Complaints about slow British growth miss the point. The sustainable growth rate for the UK economy is currently very low – perhaps only 1% to1.5% per annum; it is potentially even lower. There is probably much less output gap than official government figures have suggested – after all, even the growth we have had has been associated with rising inflation. So growth is not ‘slow’ in the sense of being ‘slower than possible’. Growth is slow because potential growth is slow. That problem can only be addressed by raising the potential growth rate: household deleveraging; government spending reduction; increasing public sector productivity growth (through more use of quasi-markets) and increasing the pension age.

There are no instant solutions here. There is simply working the problem through. Monetary policy can only help so much. The main alternative strategy would be a form of ‘cleansing’ – raising rates rapidly back to some neutral level, forcing rapid deleveraging and rapid structural change. This is a much less stupid or unthinkable idea than is often implied, and if matters were to drag out into a Japanese-style quiescence, then cleansing might become attractive – a couple of years of minus 5% growth followed by 2% or 3% growth thereafter could be much more attractive than two decades of no growth at all, interspersed with occasional recession. Even now it is a judgement call that is becoming more balanced. However, we are not there yet. For now, we should await the storm. Hold interest rates. Hold QE. And hope…

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To raise Bank Rate; QE should be held in reserve.

The global stock markets have reacted with their usual alarm at recognising that the economic fundamentals are not as rosy as was originally thought. Capacity destruction coming from a mixture of over-investment, credit crunch, oil price rises and, in the case of the UK, a decade of tax and business-unfriendly regulatory policies have produced adverse supply-side effects that cannot be rectified by radical or unconventional monetary policy. Granted that a wave of asset price deflation, particularly that of bank stocks, following a sovereign debt default, could be averted by providing emergency liquidity to the money markets and through a further bout of QE; but all that QE can do is to arrest the natural decline in stock values that must eventually occur with the recognition that the returns from investment have diminished. However, nobody wants what should be a stock market correction to turn into a stock market melt-down. QE is not going to revive domestic demand at a time when households remain over-leveraged and investment pessimism dominates corporate expectations. Household and company borrowing were based on the expectation of positive returns on investment and productivity growth which looks naïve in retrospect. There is nothing for it but to recognise that households have to rebuild assets and repay debt and that could take some years. There is no magic bullet available to the government and any policy that can be done such as supply-side innovations will not yield immediate returns.

QE is an option, but one that should be held in reserve if (or when) the Greek default and inevitable exit from the Euro results in a deluge of asset price deflation. Until that happens, the Bank of England needs to focus on monetary policy. It is clear that the Bank is in no hurry to stem the rise in inflation. Inflation expectations have crept up and it appears that the policy of inflation targeting is all but abandoned. So, should we therefore recognise the inevitable and simply allow inflation to devalue the debt? Inflation will redistribute the burden of adjustment from borrowers to savers which is good news for the borrowers in the short term (government and indebted households). However, the long term damage in terms of the reputation loss to the Bank and the pain of disinflation and restoration of credibility that must inevitably follow, has to be weighed against the gains of the short-term fix. It is tempting to put off pain today for pain tomorrow. Even so, those of us who remember the inflationary 1970s and the hard path of credibility built during the 1980s would prefer pain now to a longer pain in the future. It’s a tough call asking for a rise in Bank Rate at time when financial markets are in such turmoil. If rates had been raised earlier, we could be talking about a cut in Bank Rate to help boost financial markets. However, and like a stopped clock that is always right twice in the day, rates have now to stay where they are until the financial storm has passed.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again; QE should not be resumed.

To read some of the pronouncements from Madame Christine Lagarde at the IMF and Olivier Blanchard, her chief economist, one could be forgiven for thinking the world was on the brink of recession. Yet world growth is likely to be around 4% this year, after over 5% last year, with an IMF forecast of another 4% in 2012. So, all the fuss is about the West and in particular the threat to it from the Euro-zone crisis. There has been a (deliberate) slowdown in the East and other emerging countries because monetary policy has been tightened in the face of serious world inflation, including 8.4% in India and 6.2% in China. This in turn has taken the sheen off manufacturing growth worldwide, assisted by the earthquake-related problems in Japan. Nevertheless, growth in these emerging market countries remains robust and will be allowed to rebuild as soon as world inflation drops back.

The underlying problem of the West-East imbalance that is driving slow western growth is an imbalance of productivity against a world shortage of raw materials. With eastern productivity growth fast, fuelled by inter-sectoral transfers of people and capital, supplies of raw materials are pre-empted by the East, and their prices driven up. This, in turn, undermines western productivity growth, which relies on ever-rising computer power and cheap raw materials. While it is hard to get exact estimates, western total factor productivity seems to have slowed down, capital installed on the assumption of low raw material prices has been written off – while estimates of excess capacity are likely to be revised down correspondingly – and investment in new projects and the uptake of new labour is being slowed by low marginal profitability. Another factor is the sharp decline in western terms of trade due to these high raw material prices; this has lowered permanent income. Similar things occurred in the oil and raw material crisis of the 1970s. At that time, western governments estimated excess capacity at high levels and called for large-scale coordinated stimulus in the face of the ‘oil producer surpluses’. However, this essentially Keynesian analysis turned out to be seriously wrong and precipitated massive world inflation.

It is incomprehensible that the IMF of all bodies should be demanding coordinated stimulus from western governments coping with sovereign debt problems. More understandable is the IMF’s demand that the Euro-zone come up with a plan to deal with its sovereign debt problems and the knock-on effects on banks. But is the Euro-zone crisis a threat that requires the UK to abandon inflation targets and fiscal stabilisation? Certainly not at this stage, at least. In aggregate, the Euro-zone is not growing any more slowly than the UK. A Greek and, say, Portuguese default accompanied by exit (no doubt temporary) from the Euro could actually restore some growth on the periphery. Bank problems have been well trailed and their sponsoring governments must be ready to support them, one would assume. Also, the ECB seems to have been licensed to be active in support operations of sovereign bonds) – even if German Board members are not happy, they cannot seem to stop it.

If UK growth is slow because of slow productivity and excess capacity, as is now generally being agreed, much lower than previously thought, then we are facing a ‘supply-side’ problem that cannot be cured by demand stimulus, whether fiscal or monetary. Additional fiscal stimulus is essentially out of the question now that the existing plans will most likely overshoot the Chancellor’s public sector borrowing targets. So what of monetary policy? It seems rather clear that the Bank of England has seriously underestimated UK inflationary pressure. This has come about in two main ways. First, they have overestimated excess capacity and firms have accordingly been pushing up prices faster than expected, with no dampening of the ‘pass-through’ of massive input price rises. Second, by treating sterling as an exogenous variable over which money has no power, the Bank has disregarded a major transmission channel of its policy. This has led to inflation breaching the 2% target for much longer and by bigger amounts than the Bank has successively forecast for the past two years; there seems no prospect of the Bank reaching its target in 2012 either. This breaching of the target has led to doubt about the Bank of England’s seriousness in pursuit of the target.

So far, wage settlements have been quiescent as the weak labour market - which now has a fair degree of competition and union power only in a beleaguered public sector - has pulled wage growth down. However, were inflation expectations to climb to 4%, which is a not incredible prospect, and should unemployment continue to be roughly level, then real wages would start to level off or rise a bit and nominal wages start to grow by 4% to 5%. With UK labour productivity growth stalling (or even negative) this would threaten to raise steady state inflation to around the same rate. Then we would go into 2013 with continued inflation of over twice the target. At this point, either the target will be abandoned or raised or there will have to be a drastic monetary tightening to get inflation back under control. As an election might then be approaching, it is too easy to see the target’s abandonment as the most likely course.

For all the discomfort of the UK economic prospect at present, the fact seems to be that there is little we can do about it without sacrificing control of inflation. Furthermore, even if inflation were to be sacrificed in this way, it could not alter the gloomy supply-side ‘fundamentals’ and might not have even have much of a temporary effect on growth. Therefore, any resumption of QE should be opposed. The Bank needs to signal its serious intention to bring down inflation by raising Bank Rate to 1% at once – with a bias to raise it again in due course. This will not have much short-run practical effect on costs of funds which are well above Bank Rate now. However, it would be a powerful signal in this environment. It is really about time that the Bank of England rediscovered its role as the guardian of the currency, and ceased to be its debaucher.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold Bank Rate.
Bias: To hold QE in reserve.

Other things being equal the effectiveness of fiscal policy depends critically on whether the consequential alteration in government borrowing is from banks or non-banks. Suppose that fiscal policy is eased by a cut in the rate of VAT, the government’s borrowing requirement will increase because of the loss of revenue. The additional funds can be obtained from either the banks, for example, by issuing treasury bills, or from non-banks, by issuing medium and long-dated gilt-edged stock. In the former case, banks’ liabilities rise in line with their assets. The private sector’s bank deposits rise and these can be spent either on goods and services or on assets. Money, that is, purchasing power, will be injected directly into the economy. In the latter case, the private sector’s holdings of assets, rather than money, will rise and the direct effect on economic activity will be much less. Easing fiscal policy is not really effective if the government replaces the lost finance by borrowing from non-banks.

How about the opposite case of fiscal policy being tightened? If the government uses the additional revenue to repay borrowing from banks, bank deposits will fall. There will be a direct impact on economic growth as less money is spent on goods and services. If the government uses the additional revenue to repay borrowing from non-banks, for example, by buying gilt-edged stock from non-banks, the sellers of the gilt-edged stock will receive bank deposits in return for their stock. Initially, however, much of the money is likely to be spent on assets, as the funds are reinvested. Asset prices will rise but the direct effect on economic activity will be delayed. Money normally stays in the system as one person passes it to another, rather like the ‘hot potato’ in the children’s game, in which case a direct effect will still occur but will be delayed whilst the money percolates through to being spent on goods and services.

QE is the name now given to government buying gilt-edged stock from non-banks. Since QE started in March 2009, money has been injected directly into the economy. However, only a small amount has stayed in the system. The bulk of it was absorbed by banks raising new capital and large companies issuing bonds the proceeds of which were used to repay bank borrowing. Such restructuring of balance sheets was highly desirable. Even so, most of the continuing impact of the money created by QE was lost.

If current fiscal tightening is not to slow economic activity, monetary growth must be adequate. QE is however not the only way in which the money supply may be boosted. Other things may not be equal. For example, after the UK borrowed from the IMF in 1976 and fiscal policy was tightened, confidence in sterling returned and the Bank of England intervened in the foreign exchange market to stop sterling from rising. The result was that the money supply was boosted by money flowing in from abroad. Further, after Geoffrey Howe’s budget in 1981 buoyant bank lending was the main offset to a dramatic fall in the central government borrowing requirement. Neither appears likely to occur this time. The conclusion is that additional QE may become vitally necessary during the coming months.

In February, it was argued that a distinction should be drawn between a jump in the price level caused by external factors and inflation and, further, that it was certainly the job of the MPC to stop the former from turning into the latter. Inflationary expectations must be stopped from rising. There is a strong case for the MPC standing firm and not easing in the face of trade union militancy and until there is clear evidence that inflation is falling back towards target.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: To ‘normalise’ Bank Rate in small steps until it reaches 2½%, while holding QE in reserve.

It has become increasingly hard to avoid the conclusion that both the fiscal and the monetary authorities in the US, Japan, the Euro-zone and Britain have largely lost their control over events. This can be seen from the widespread failure of the public finances to improve as intended, the continued weakness of output and international trade, and the failure of the attempts to bail out the weaker members of the Euro-zone to gain bond-market credibility. The seeds of the present crisis were sown by the remarkable expansion in the size of the state during the present century in countries such as Britain, where the government spending ratio went up by 14.4 percentage points of GDP between 2000 and 2010, and the US where the increase was 8.4 percentage points. The developed countries that have escaped most lightly from the post-2008 Global Financial Crash have, by-and-large, tended to be nations where the share of government spending was relatively low to start with in 2000 and has remained low subsequently – examples, would include Switzerland, Australia and Canada – or, alternatively, where spending has been falling noticeably as a share of GDP, Sweden would be the prime contender here.

Germany is especially significant. This is because it has broadly held its government spending ratio, which was 46.7 % of GDP last year, over a decade in which many other Euro-zone members have seen substantial increases from distinctly higher starting bases. People used to contrast Germany’s ‘Rhineland’ social-market capitalism with the more aggressively pro-capitalist approach of the US and Lady Thatcher’s Britain. However, Britain has had a higher government spending ratio than Germany since 2007. The British government spending ratio was 51.0% last year, according to the Organisation for Economic Co-operation and Development (OECD). The US, at 42.3%, is also catching up rapidly, having had a spending ratio 11.2 percentage points below that of Germany in 2000. The ‘old’ Bundesbank was as hostile to European Monetary Union (EMU) as it dared to be in public ahead of the event. Recent developments have confirmed the prescience of the EMU reservations that it was advancing in the late 1980s and early 1990s. One crucial concern, which was brushed aside by Continental politicians, was that it would not be possible to hold a monetary union together in the absence of a single over-arching legal authority. This was partly because central banks could only operate effectively if they had a clear legal right to regulate commercial banks’ activities. However, it was also because the Bundesbank anticipated the fiscal free-rider problem that would arise if irresponsible countries could borrow at better terms within the currency union than they would have been as stand-alone entities.

This is why the Maastricht criteria were introduced as a second-best solution to the problems posed by the absence of a unitary legal authority. These criteria, including the 3% of GDP government borrowing limit, were deliberately made simple for political-economy reasons. The mainly German officials concerned wanted the convergence criteria to be so simple that a media furore would be provoked if the fiscal limits were breached. The intention was to embarrass the politicians into responsible fiscal behaviour. The officials who designed the fiscal criteria were well aware of the case for automatic stabilisers and cyclical swings in the deficit. They just did not want to allow the politicians ‘wriggle room’ to get out of the Maastricht commitments. However, the fatal weakness of the criteria is that they did not include a limit on the acceptable ratio of government spending to GDP. If that had been set somewhere around 40% to 45%, it would still have been too high from the perspective of maximising social welfare but it is unlikely that the present crisis would have escalated to the extent that it has.

It is in nobody’s interest to have your neighbour’s house on fire. The events in the Euro-zone pose a major threat to the UK, because it is our largest export market and because of the risk of financial contagion affecting UK banks. However, it is hard to see a resolution that can be implemented from a political viewpoint. The most likely long-term outcome seems to be a process of the EU’s political class attempting to postpone the inevitable, followed by one or more sovereign defaults, ending up in the probable Balkanisation of EMU. In pure logic, it should be possible to move towards the single legal authority for the Euro-zone, which was a necessary condition for a stable monetary union in the Bundesbank’s eyes. This appears to be the path that the EU elites wish to adopt. Indeed, such people are trying to use the crisis to ratchet up fiscal and political integration several more notches. The stumbling block is that the German people – who never wanted EMU in the first place – will not wear it, and will probably bring down any government that takes this path. Fundamentally, the Germans are being asked to accept open-ended taxation without representation, while the more fiscally-challenged Euro-zone members are asking for representation without taxation. This prospect is untenable as well as unjust and the situation in Continental Europe is only likely to deteriorate. This imposes a massive constraint on policy makers in the UK, because of its potential adverse fall out effects.

Another background concern is the growing evidence that the UK’s fiscal position is not coming right as rapidly as Mr Osborne had intended, despite a recent £5.9bn downwards revision to estimated Public Sector Net Borrowing in 2010-11. It has been argued previously that the Coalition would not achieve its borrowing targets as a result of the adverse ‘Laffer-curve’ effects arising from the hikes in VAT and employers’ National Insurance Contributions. (Editorial Note: see also Chapter 2 of the recent IEA publication Sharper Axes, Lower Taxes: Big Steps to a Smaller State, edited by Philip Booth.) However, the questions that now arise are how long the UK can maintain fiscal credibility, if its borrowing plans are not achieved, and what will be the consequences if fiscal credibility is lost, especially where debt servicing costs are concerned? The 29th November Autumn Statement and the new Office for Budget Responsibility (OBR) forecasts released alongside it will be important here. It is fortunate for Britain that financial markets can only concentrate on one thing at a time and that they are currently pre-occupied with the Euro-zone. The danger point for Britain is likely to come when – or if – there is a resolution to the Euro-zone crisis and the financial markets’ attention becomes directed elsewhere.

The 2011 Q3 Bank of England Quarterly Bulletin has an article on the effects of the earlier QE operation, which may be intended to soften up public opinion for a further tranche of QE (see: The United Kingdom’s Quantitative Easing Policy: Design, Operation and Impact, by Michael Joyce, Matthew Tong, and Robert Woods). The article uses a variety of techniques to assess the effects of the £200bn QE implemented earlier and suggests that QE may have raised GDP by 1½% to 2% and increased inflation by some ¾ to 1½ percentage points, while admitting that a high margin of uncertainty is attached to these estimates. These are rather stronger gains from QE than the author found in his article on the subject published in the June 2010 IEA Economic Affairs. However, another thing that comes out of the Bank’s research is the poor output/inflation mix that has accompanied QE, although this probably applies to other potential stimulatory measures also. Between one third and one half of any boost to money GDP from QE seems to have been dissipated in higher inflation. This suggests that there are supply-side constraints present, and not just a simple deficiency in demand. Moreover, bond yields have recently fallen so low that it is hard to see that QE would be anything other than otiose at present.

The Office for National Statistics (ONS) will be introducing major changes to the methodology used to compile the national accounts on 5th October, after this note has gone to print. Past form suggests that these revisions might be large enough to alter views about the current situation and the future outlook. Recent data show a downbeat picture of sluggish home demand, stubborn inflation and disappointing figures for the government accounts and international trade. The annual increase in the ‘double-core’ Retail Price Index (RPI) – which excludes all housing costs – went from 5.5% to 5.7% between July and August, while target CPI inflation accelerated from 4.4% to 4.5%. The RPIX ‘old’ target measure and the all-items RPI showed inflation rising from 5% in July to 5.3% and 5.2%, respectively, in August. This suggests that Bank Rate remains too low from a strategic perspective and should have been raised some time ago.

Finally, the issue of whether a low Bank Rate stimulates the economy or not is more open than most people assume and essentially a quantitative one. A low Bank Rate compared to other countries lowers sterling and increases export competitiveness. However, it also leads to higher inflation, reduced living standards and increased precautionary savings. These two sets of factors counterbalance each other. It is only if one knows the relative sizes of the effects involved that it is possible to estimate which will dominate. The evidence suggests that the demand for imports into the UK is now largely insensitive to the exchange rate and that exports are only weakly sensitive. Furthermore, a lower pound appears to be eventually completely reflected in a raised price level, reduced living standards and less home demand. The higher inflation that appears during the adjustment period also has adverse effects on activity for both supply-side and demand-side reasons. The MPC has taken another view of the quantitative effects concerned – which it is entitled to do – but it would be useful to have a fuller debate on the subject. Meanwhile, the uncertainties are such that holding Bank Rate for purely tactical reasons seems the most appropriate policy decision where October is concerned. Raising rates now will bring little immediate benefit and could have a nasty impact on shaky confidence. The pity is that we are not starting from a 2½% Bank Rate already, as some of us have long advocated. Then there could have been a modest cut from a more sensible base and a greater psychological impact on ‘animal spirits’ than yet another business-as usual ‘hold’ decision.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: Neutral.

There have been few new macroeconomic figures coming available since last month. This means that there has been very little change in sentiment concerning the evolution of the economies of Britain and the other industrialised countries. Recovery in the industrialized countries is weak, and so it is also in the UK. One new piece of information, which has become available, is the August inflation data. Inflation is a cause for serious concern. The annual monthly inflation rate measured with the CPI reached 4.5% in August, and it has been above 4% in every month since the beginning of the year. We can get a better idea about inflation dynamics if we calculate a three-month moving average of the CPI. Nine out of the twelve CPI categories have higher annualised monthly inflation in August than they did in December 2010. Inflation shows no signs of slowing down at the more disaggregated level. It is picking up speed and it does so in more and more CPI categories. The inflation in the prices of alcohol, clothing, household equipments, and housing has risen by more than 2 percentage point since December 2010. The longer the current pattern prevails, the more likely it is that expectations of future inflation lose their anchor. Then inflation will speed up further.

The key question remains the same as in previous months; is the weak growth of the British economy and the leading seven industrialised countries (G-7) primarily due to: 1) weak demand and the associated negative output gap; or 2) supply constraints in a situation in which the output gap is close to zero? If demand is weak, then observed inflation is temporary, and there is no need for monetary tightening. If supply is inadequate, then inflation is not temporary and without monetary tightening, it will not get back to its target. In particular, if there is spare capacity resulting from weak demand, monetary stimulus could help to lift the economy out of recession. Current output-gap estimates suggest there is a significant negative output gap. That would indicate the existence of spare capacity and no need for monetary tightening as a corollary. On the other hand, survey evidence suggests that capacity utilisation is not particularly low in the UK suggesting that there is little excess capacity. This would imply a need for monetary tightening. However, there were several factors prior to the crisis that would distort estimates of the margin of available capacity. In particular, the long period of time in which government expenditure grew rapidly makes it particularly hard to estimate the output gap during the present period, when there is very little room to increase government expenditures. Therefore, it is more likely that there is little or no excess capacity in the British economy at the moment. Hence monetary policy should be tightened by means of a ½% rise in Bank Rate. This increase would signal that the UK monetary-policy makers take inflation seriously, and would keep inflation expectations anchored. However, there is no requirement to signal further tightening. Thus, there is no bias where future rate changes in November and beyond are concerned.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: Hold Bank Rate and stand by to ease via QE but only if there is a recession.

Financial markets are in turmoil at present. Evidence of tepid growth in the advanced economies and growing indications that Greece will default is leading to renewed volatility. After a very difficult August, September has turned out to be worse. The greater volume of trading, as people returned from holiday, has not brought the calm that was expected, but a greater storm. Now, the focus is on what the ECB and the politicians in Europe can do to manage the impact of any default by Greece, in terms of financial markets support for affected banks and a long term solution that answers the question of what might happen after Greece to the members at risk from a similar outcome.

The reason why this is so very important to the UK is the implied direct economic impact of disruption to key export markets, and the impact (direct and indirect) on our banking sector. This has added to pressure to keep interest rates low and perhaps to embark on further QE, as a consequence. There is little domestic economic reason for QE2 at present. This is because the economy is growing, albeit by just 0.7% in the year to 2011 Q2. There is little that interest rates or QE can do to speed up the recovery pace. For one thing, there is a process of deleveraging underway in the private sector, amongst households and companies. Of necessity, this is a slow process. No matter how low interest rates are consumers and business will not be encouraged to spend more than at present. Savings are being built up and financial balance sheets are being strengthened. Paradoxically, low interest rates are inimical to this as they mean savers are getting little or nothing on their money in nominal terms and, indeed, returns are falling in real, inflation adjusted, terms.

Yet another effect keeping down the pace of economic recovery in the real economy is the high rate of price inflation. This is eroding the real spending power of households as wages are well below price inflation, which is running at 5.2% on the RPI and 4.5% on the CPI basis. Lower real wages may help corporate profitability. However, they are serving to keep a lid on real household income growth, which is experiencing one of its worst performances for decades. On some measures, this represents the longest run of negative income growth since the 1920s. Hence, the problem is that high price inflation is exerting a negative effect on real incomes and so spending and the rate of growth. It has helped nominal GDP but not volume growth. This is why QE is not yet appropriate, especially since price inflation is higher now than when it was last enacted. Of course, if the economy started to contract that would be a different scenario. However, and at present, it is growing at the sort of rate that is to be expected from a debt-constrained economy at this point in a recovery phase that could last for up to eight years.

Of course, there was also the shock from higher oil prices earlier in the year. This oil price shock, together with the impact of the Tsunami and nuclear meltdown in Japan, as well as the crisis in the Middle East, also need to be taken into account. These events have all conspired to weaken global growth and so UK exports. Slower manufacturing activity has flowed from this and this has weakened the overall rate of growth in 2011. However, with spare capacity likely to have been damaged by the long period of weak investment spending, the trend rate of growth of the UK economy is likely to be down to some 1% to 2% a year for some time to come. In this context, Bank Rate should remain at ½% at the moment. In addition, QE should only be used if the economy enters recession, perhaps as a result of Euro-zone issues. With inflation still high, monetary policy should not be loosened. This is because it will only artificially boost asset prices which will fall back once the QE is stopped.

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 (Deloitte and 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), Gordon Pepper (Lombard Street Research and Cass Business School), 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 TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

In its most recent e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by a knife-edged five votes to four that Bank Rate should be raised when the official rate setters meet on 8th September. All five members who voted for an increase wanted to raise Bank Rate by ½% to 1%.

There were two main reasons why a narrow majority of the SMPC wished to see a Bank Rate increase in September. The first was the suspicion that Britain’s weak growth and limited job creation were predominantly supply-side problems caused by excessive government spending, populist political interventions and perverse regulatory shocks, which could not be alleviated by a lax monetary policy.

There was also concern that the UK monetary framework risked losing popular credibility if the persistent overshoots of the inflation target continued to be ignored. One risk associated with the current policy mix, in the view of the SMPC hawks, was that it could embed a ‘stagflationary’ bias into the UK economy, which could only be countered by painful measures in the longer run.

The reason that four SMPC members wanted to hold Bank Rate was a belief that the UK economy was weak for predominantly demand-side reasons, and that the recent data suggested that activity was palpably faltering.

Both hawks and doves agreed, however, that the present crisis in the Euro-zone posed a serious risk to Britain because of the damage it might do to our export markets and to UK banks’ capital and reserves if there was a chain of defaults. There was a consensus that Quantitative Easing (QE) might need to be revived if the situation in the Euro-zone got out of hand.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and keep QE at present level.
Bias: Neutral, except in case of Euro-zone disaster.

Over the last month, investors’ risk appetite seems to have deteriorated markedly. Equity markets have been on a roller-coaster ride, bank shares in particular. Most notably, dislocation in bank-funding markets has become more acute. Lenders in Europe’s periphery and beyond have found it more difficult to roll-over short-term funding. US money market funds, key providers of short-term finance to European banks, reportedly cut their exposure to Spanish and Italian banks to practically zero in July. Data from the US Federal Reserve suggest their difficulties may have intensified in August, with US offices of foreign institutions losing over $100bn of deposits in the last month. This could help to explain the extra premium that European banks are now paying to swap Euros into dollars.

The major UK banks have been insulated from these tensions somewhat. Furthermore, sizeable term-debt issuance in the first half of this year means they are relatively well placed to cope with disruption in funding markets. They are not, however, completely unscathed by recent developments. The risk premia on UK banks’ Credit Default Swaps (CDS) have risen sharply. To the extent that these are a proxy for lenders’ marginal funding costs, and that market disruption is not short-lived, there could be further upward pressure on banks’ lending rates.

Tighter than expected monetary conditions are one downside growth risk that may be materialising. The other is the timing of the global slowdown. Next year was always going to be a difficult one for the world economy, with the advanced economies undertaking the largest, co-ordinated fiscal consolidation in the post-war period. Weak monetary growth in the West and inflation-fighting in the East meant there would be little demand offset. Although there is scant reason to expect the magnitude of the growth slowdown to be any greater, recent data suggest it may already have started. Indicators of manufacturing activity in Asia, for instance, far from rebounding after the Japanese disasters, have softened further in 2011 Q3.

The chances of a renewed UK recession would still appear slim; but the recovery could remain subdued until the second half of next year. UK export prospects are less bright than anticipated a few months ago; and there are concerns for UK consumer demand given the soon-to-be-felt energy price hikes. Despite this, the case for more Quantitative Easing (QE) at this stage is hard to make. Consumer Price Index (CPI) inflation could hit 5% in coming months and there is considerable uncertainty about how consumers and firms will react to such a prolonged period of upside-inflation surprises. It is also important that one gets a clearer picture of global developments: to assess how much of the apparent weakness of the world economy is due to Japan-related supply-chain disruption and the spike in oil prices; and how much reflects more persistent factors.

Looming over any forecast of the UK economy is the debacle in the Euro-zone. The ‘unmentionable and unimaginable’ risks, which Mervyn King spoke about, cannot be quantified. It is unclear how one factors in such a low-probability tail-risk with such damaging consequences to forward-looking monetary policy. The best one can do is to build in an expectation of very weak European Area output growth and ongoing disruption to parts of the funding markets. If the crisis in Europe were to intensify significantly from here, the Bank of England has to stand ready to deploy whichever tools it deems necessary to shield the UK banking sector.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate and to keep further QE in reserve.

Economic growth is faltering. The revised estimate of second quarter GDP from the Office for National Statistics (ONS) suggested a modest 0.2% quarterly increase, which implied the economy had barely grown since the third quarter of 2010. The ONS, perhaps encouraged by HM Treasury, offered many reasons - one is tempted to use the word ‘excuses’ - for the weak figure. These included the Royal Wedding, the sale of Olympic tickets and the weather (an old favourite). Whilst it can be expected that the third quarter may ‘bounce back’ a tad, the omens for growth in the near-term do not look encouraging.

The last set of labour market data was also disappointing. Unemployment on the International Labour Office (ILO) definition was up 38,000 in the second quarter and the unemployment rate inched up to 7.9%. Higher unemployment can only undermine consumer sentiment and, on cue, the Nationwide’s consumer confidence index, released the following day, slipped further.

But the really worrying economic developments in recent weeks have concerned Britain’s main export markets. It is on these markets, and the potential for ‘export led growth’ as projected by the Office for Budget Responsibility (OBR) in March, that so much of Britain’s near-term prospects depend. The recovery in the US, one of Britain’s biggest export markets, is running out of steam to a worrying extent. The Euro-zone is not just experiencing an existential crisis, its ‘powerhouses’ look to be faltering too. After buoyant first quarter GDP figures for Germany and France, the second quarter data were especially disappointing. A measly 0.1% quarterly increase was recorded for Germany whilst France flat-lined. Granted that the quarterly patterns may be distorted by the effects of rogue seasonal factors over the winter, the underlying trends are not encouraging. Recent business surveys have been almost uniformly pessimistic.

CPI inflation was 4.4% in July and looks set to reach 5%, before declining. The Monetary Policy Committee (MPC) is clearly resigned to this probability. However, it has, rightly in my view, resisted the temptation to raise rates and undermine the economy further. Given all the downside risks, not least of all the increasing probability of a car crash in the Euro-zone, my vote is for no change in interest rates, with a bias to keeping interest rates at their present level. Further QE should be kept in reserve.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again; QE should not be resumed.

The world has been through a sharp recovery from the Great Recession. However, this immediately triggered a return of the commodity price peak that itself was, in turn, the underlying reason for the slowdown that precipitated recent US house price falls, mortgage losses and bank losses on property. The renewed upturn in commodity prices was, therefore, the underlying reason for the whole crisis. The available supply of world raw materials cannot accommodate world growth on its recent scale. We will have to see how much growth it can tolerate as monetary policy continues to tighten and brings down world inflation from its current 5% or so. Inflation has now become worryingly embedded in a number of major economies, as the July CPI figures reveal. These show that annual inflation was: 3.6% in the US; 4.4% in Britain, 2.5% in the Euro-zone, 6.5% in China, 8.6% in India, and 9.7% in Argentina.

It seems likely that economic growth in the developed countries will continue to be slow. Commodity prices will continue to be kept high by the continuing fast growth of productivity and GDP in the emerging market economies. This will go on restraining western growth, in turn. Commodities are in short supply after the massive world growth of the 1990s and the 2000s. Their shortage remains the underlying factor limiting world productivity growth, especially in the developed world which relies on innovation rather than the transfer of people from low- to high-productivity sectors to power its productivity growth. It is hard to innovate when raw materials are so costly. This is because raw materials are complementary to many new products – for example, the rare earths which are widely required as parts in electronic products and now in seriously short supply. Furthermore these high commodity prices act to reduce developed country real living standards directly.

The instinct of many leading macroeconomic commentators – for example, recent statements by Professor Kenneth Rogoff – is to demand ‘a final bullet’ to jumpstart growth again. In his case he wants inflation to be raised for a long stretch to eliminate ‘asset deflation’. However this misses the point about supply limitation. After all, it is unlikely that the world economy could be ‘short of demand’ as such people claim, over a long period. The International Monetary Fund (IMF) is predicting 4% world growth for 2011; this hardly rates as ‘slow’. It is developed countries that are growing slowly; clearly not because of some global demand shortage. If it were a local shortage of demand, how come that record fiscal deficits combined with near-zero interest rates do not revive it? How come that QE stimulated a huge flow of money into emerging markets via the carry trade and hence a sharp world inflation?

In short, it is rather astonishing that so many macro commentators have forgotten the basic lessons of macroeconomics: that repeated ‘stimuli’ only create inflation once economies have settled down after major shocks. It is one thing to inject money in the immediate aftermath of an emergency like the 2008 Lehman collapse; it must be quite another to keep on doing so long after the initial injection has worked to revive the patient from the emergency. Fortunately most developed-country central banks have been more prudent than this. Indeed, while central bank interest rates have remained close to zero in most countries, the interest rates charged by banks have been much higher. In addition, there is plenty of evidence that banks are still lending slowly, and charging high commitment fees in addition to the overt interest rate charged on loans. This tightening has been enhanced by the recent crisis in the Euro-zone, which has made it much harder for most European banks exposed to the crisis to raise money to lend. Furthermore the aggressive printing of money via QE has ended in the UK and now also in the US. Finally the European Central Bank (ECB) has raised its lending rate to 1.5%.

In these circumstances the Bank of England has decided to take no action at all on interest rates and not to restart QE. Some are now urging it on to more QE because growth is weak. This is true. However, QE will not change the facts of supply. Instead it will embed inflation in the UK via a falling exchange rate and rising inflation expectations. The anchor of the inflation target regime is its credibility; this has been seriously undermined by the Bank’s weakness in the face of persistent inflation.

It has now become routine for commentators to stress the dangers to growth of the Euro-zone crisis, of weak jobs growth in the US, or tightening monetary policy among key emerging market economies. Indeed, all this is true. However, it does not alter the necessary monetary stance because these are the result of supply problems. The implication is that an easy monetary policy will have little effect on growth but will create inflation through the undermining of the target regime. That regime sets inflation as the unique target; only if it is satisfied can the Bank pay attention to growth. Yet the Bank is ignoring this. True, it tells us that if it tightened it could create ‘deflation’; tell that to the marines when inflation is climbing to 5%!

In conclusion, my view is that the Bank should return to its inflation-targeting regime. Under present information, and if it does not start to tighten policy soon, it will undermine the prospect of inflation falling that it constantly predicts, simply because people will stop believing that it will ever act to ensure this. This scepticism will be reinforced by the prospect that growth will remain weak, which is now the dominant probability. If the Bank has covertly switched to a growth targeting regime, then it is likely not only to avoid raising interest rates indefinitely but also to embark on more rounds of QE. It is hard to imagine a more certain way of creating renewed and embedded future inflation. Therefore, I reiterate my call for a rise in interest rates, of ½% with a bias towards further increases subsequently. QE should not be resumed.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold Bank Rate.
Bias: To hold QE in reserve.

The author of this submission has been monitoring the behaviour of the money supply for more than forty years. This experience shows that the current stance of monetary policy should be judged by whether the supply of money is greater or less than the demand for money. Further, the stance during the last year or so is a powerful indication of whether the economy is developing expansionary or recessionary tendencies. In the former case the current stance should not be easy. In the latter case it should not be tight.

About this time last year, it was possible to argue that the negative growth of the stock of money that was occurring in real terms was not necessarily an indication of shortage of supply, because the demand for money was possibly falling even faster. The explanation of this unusual situation was that the demand for money as a home for savings had collapsed due to the abysmally low rates of interest on bank deposits. This was, however, an argument that would not be tenable for very long. The fall in the stock of savings money in the economy could not go on forever. It would eventually come to an end. When it did, monetary policy would be too tight if sluggish monetary growth continued. This has now happened.

During the first three quarters of the past year the conclusion that monetary policy was not too tight was supported by the behaviour of the stock market. If the supply of money is inadequate expenditure on goods and services falls as does expenditure on financial assets. Because financial markets react much more quickly than the real economy the effect on asset prices comes first. The equity market has, for example, always fallen prior to a recession. The fact that it was not falling until recently suggested that monetary growth was adequate and that a second leg of the recession was not imminent. That has now changed.

Elaborating, when unexpected bad news occurs the reaction of the equity market depends on the amount of money about. If there is a lot people will bargain hunt, taking advantage of falling prices, and the market will tend to bounce back. If there is little there will be less bargain hunting and the fall in the market is more likely to continue. One thing is clear at the moment. The existing stock of money being held as a home for savings is very low because of the fall in the savings demand for money during past months. This suggests that bargain hunters will have little ammunition. An important conclusion for investors is that the market is likely to be susceptible to further bouts of bad news (but see below about QE).

Reverting to the main theme, policy needs easing. Fiscal policy, which is one of the main drivers of monetary growth, is out of play because of the debt overhang. Interest rates cannot be used either because they have been lowered as much as they can be. Only two types of measure remain, namely, supply-side and direct action to boost the money supply. Without any question all types of supply-side measures to boost economic growth should be employed. The trouble is that they are slow acting and can take several years to have a full impact.

Bank lending is another of the main drivers of monetary growth. (After Geoffrey Howe’s budget in 1981 buoyant bank lending was the main offset to the dramatic fall in the central government borrowing requirement.) The difficulty here is illustrated only too clearly by the behaviour of one of the UK’s largest banks which is charging an absurd APR of 19% for personal overdrafts even when credit worthiness is impeccable. Even then, credit is not freely available. Banks have to strengthen their balance sheets before they will again lend freely. So, bank lending to boost the money supply is not in play either. Another way in which the money supply can be boosted is for the Bank of England to intervene in the foreign exchange market to stop sterling from rising if it becomes firm. This process was the main offset in 1976, after the IMF had insisted that the UK should tighten fiscal policy. This depends on sterling becoming stronger, which may be wishful thinking.

QE remains. In my judgement, the case for case for additional QE is stronger than it has been for more than a year. Nevertheless, it should still be only held it in reserve, for three reasons. Firstly, it would be wise to wait until there is definite evidence that inflation in the UK is falling, particularly as QE2 in the US was one of the causes of the damaging rise in commodity prices as people switched out of dollars into commodities. Secondly, the case for additional QE is nothing like as strong as it was in the winter of late 2008 and early 2009 and our knowledge is insufficient to attempt to fine tune the economy. Thirdly, it takes time to repay debt and restore balance sheets and there is a case for wanting sluggish economic growth rather than rapid recovery.

Finally, after a financial bubble bursts, asset prices fall and a downward spiral starts symmetrically with the previous upward spiral. The process becomes asymmetrical during the downswing when the value of asset prices falls to a level at which the value of collateral in general is no longer sufficient to cover the bank loans being secured. Borrowers then become forced sellers of assets. The laws of supply and demand then reverse with a fall in prices forcing more selling rather than encouraging buying. Confidence in markets becomes shot to hell. QE’s most important role is to stop the forced selling and avoid the asymmetry.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%.
Bias: To ‘normalise’ Bank Rate in small steps until it reaches 2½%.

The international financial markets had a severe fit of the collywobbles during August. However, it is still not clear whether this was primarily the result of erratic trading in thin summer-holiday markets or the harbinger of something nasty affecting the global economy. The FTSE World Share Price Index measured in local currency dropped by 12.6% between 1st August and its low point on 10th August but had recovered by 5.5% by 30th August, the latest available figure, to give a net decline of 7.8% since the start of the month. The US Standard and Poor’s composite index of US Share prices was 5.8% down on its level on 1st August on 30th August, while the British FTSE All-Share index was down by 9%. Possibly surprisingly, neither short-term money market rates nor the trade-weighted exchange rates for the major currencies showed any major changes beyond the usual wobbles through the course of August as a whole. This was despite occasional marked movements within the month, especially where the Swiss Franc was concerned. There was, however, a noticeable easing in government bond yields. The US ten-year yield fell from 2.75% to 2.18% between 1st and 30th August, while the equivalent UK and German yields eased from 2.82% to 2.50% and from 2.47% to 2.15%, respectively. In theory, lower bond yields, after allowing for inflation, should boost equity valuations because they lower the rate at which future profits are discounted. This clearly did not happen in August 2011.

Hypothesising without data is always a dangerous activity. However, one plausible explanation of what is happening in the developed economies is a collapse in the ‘animal spirits’ of businessmen and entrepreneurs caused by a sharp increase in the perceived political uncertainty of doing business, recruiting or investing in new plant and equipment. The initial increase in uncertainty resulted from the collapse of Lehman Brothers on 15th September 2008, after which businessmen became obsessed with avoiding counter-party risk. This reaction caused a collapse in trade credit, supply chains and intermediate demand. However, this initial panic had burned itself out by 2009 Q2 – when industrial production in the aggregate OECD area was 15.9% down on its peak a year earlier – and by the first quarter of this year industrial output was 13% up on its trough. The problem now is that misguided political and regulatory initiatives, and the threat of large populist-inspired increases in the taxes levied on wealth creation, have increased business uncertainty to the point that the entrepreneurial classes are again withdrawing into their shells. This, politically-induced, increase in uncertainty explains why businesses are de-gearing, sitting on abnormally high levels of liquid assets, and have become reluctant to recruit workers and invest in long-term assets.

This situation cannot be cured by monetary stimulus or conventional Keynesian fiscal stimuli, if that is interpreted to mean further increases in public spending as distinct from supply-side friendly tax cuts. Indeed, the first thing that the fiscal authorities need to do is to convince economic agents that they will not be clobbered by even higher taxes every time that the official projections for public borrowing are overshot. The next thing that the political class needs to do is stop engaging in lynch-mob rhetoric against wealth creators, something that US President Obama, some UK Liberal-Democrats and many Continental politicians are unduly prone to do. Such rhetoric undermines confidence and leads to less aggregate supply and fewer employment opportunities than if the politicians concerned had kept their mouths shut. The third thing that the monetary authorities, specifically, need to do is to be aware of the danger that excessive financial regulation will lead to a reduction in bank balance sheets and a collapse in the supplies of money and credit. It is probably necessary to employ public-choice theory to understand what international and domestic bureaucrats are up to in the area of financial regulation. Bureaucrats like a massively over-regulated banking system because that minimises the risks that: a) they will have to do too much hard detailed work concerning the situation of individual financial institutions; and 2) reduces the risk of embarrassing regulatory failures. There is also the consideration that regulatory activity may be becoming something of a gravy train for the bureaucrats concerned, many of whom are highly articulate economists, who might be less employable elsewhere.

While on the subject of bureaucrats, it is worth noting that the ONS decided not to publish the normal breakdown of the income and expenditure measures of GDP when they published the revised estimate of UK GDP on 26th August. The reason was to allow sufficient time for the major changes to the national accounts to be introduced in the 2011 ‘Blue Book’. It will not be until 5th October that a more detailed analysis will be available, and that will be on a different set of base-year weights and probably on a noticeably different set of definitions. Since most conventional macroeconomic forecasting models make extensive use of the expenditure breakdown of GDP, the effect is to ‘un-sight’ official and private sector forecasters at a critical time. As it is, the recent official data show a mixed picture of sluggish – but not collapsing – home demand, persistently stubborn inflation at both the producer-price and consumer and retail-price levels, and somewhat disappointing figures for the government accounts and international trade. The annual increase in the ‘double-core’ retail price index – which excludes all housing costs and appears to be somewhat less skittish than the CPI – increased from 5.4% to 5.5% between June and July, when CPI inflation accelerated from 4.2% to 4.4%, and both the old RPIX target measure and all-items RPI showed inflation unchanged at 5%. The current monetary background is completely different to that observed in earlier inflation episodes and the M4ex broad money measure rose by a relatively modest 2.2% in the year to July 2011, compared with the 1.6% recorded in June. However, it took only seven quarters in the early 1970s for RPI inflation to proceed from breaking through 5% to going through the 10% barrier and eight quarters for the same thing to occur in the early 1990s. Neither of these inflationary upsurges was widely anticipated in advance.

The main conclusions are as follows. First, in the US, Euro-zone and Britain the political and bureaucratic classes have behaved like gigantic wrecking machines as far as the non-socialised sectors of their respective economies are concerned. This needs to stop if animal spirits are to recover and the private sector is to start investing and employing on the scale that should be expected, given the high liquidity and reasonable profitability enjoyed by many companies. Second, financial regulators must consider the macroeconomic consequences of their regulatory initiatives and allow capital and liquidity cushions to be squeezed at present. Mandatory capital and/or liquidity requirements should only be raised later, and if recovery threatens to be excessively fast. This was well comprehended by earlier generations of monetary economists, who understood that liquidity ratios should be run down in a financial panic and rebuilt afterwards. The same applies to the capital-ratios that are preferred by modern regulators. Third, the main problems facing the UK, US and much of Continental Europe are to do with their supply sides and cannot be cured by further monetary easing. A recent example is the lunatic decision by the British government to implement the ‘European Union’s Temporary Agency Workers Directive’. This can only price the more vulnerable workers out of employment, inducing a rise in structural unemployment that cannot be compensated for by monetary easing. The final conclusion is that Bank Rate should be raised immediately to 1% and cautiously to 2½% or so in the longer run. Additional QE should be held in reserve – in case there is another run on the banks, possibly caused by sovereign default on the Continent – but not implemented at this stage. The recent collapse in bond yields has rendered further QE otiose. However, QE remains a potentially useful tool that should be employed without inhibition if the Bank has to act again as a lender of last resort in a financial crisis.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: Neutral.

The recovery in the industrialized countries after the Great Recession has been weak. The UK economy is no exception. The 0.2% growth in the second quarter was disappointing. It is noteworthy, also, that the growth of value added across the various productive sectors of the economy has been uneven. Manufacturing growth has slowed and construction and agriculture have contracted. However, services overall showed a higher than 1% growth in the second quarter.

Inflation is a cause of serious concern. The annualized monthly inflation measured by the CPI reached 4.4% in July, and it has been above 4% in every month since the beginning of the year. We can get a better idea about inflation dynamics if we calculate a three-month moving average of the CPI. Nine out of the twelve CPI categories had higher annualized monthly inflation in July than they did in December 2010. Inflation shows no signs of slowing down at the more disaggregated level. Rather, it is picking up speed and doing so in more and more CPI categories. The longer the current pattern prevails the more likely it will be that the public’s expectations of future inflation lose their anchor. Then inflation will speed up further.

The key question is whether one thinks that the weak growth of the British economy and the other members of the group of seven leading industrial countries (G-7) is primarily due to weak demand – implying a negative output gap – or due to supply constraints (indicating a close to zero output gap). If demand is weak, then observed inflation is temporary, and there is no need for monetary tightening. If supply is weak, then inflation is not temporary and without monetary tightening, it will not get back to its target. The output gap is notoriously difficult to measure. Current estimates suggest the existence of a significant negative output gap. That would indicate spare capacity, and no need for monetary tightening. On the other hand, survey evidence suggests that capacity utilization is not particularly low in the UK suggesting little excess capacity. This would call for monetary tightening. In addition, there were several factors prior to the crises that would distort any estimates of the output gap based on past time-series regularities. Hence, it is more likely that there is little excess capacity in the British economy at the moment. This implies that monetary policy should be tightened. My vote is for a ½% rise in the official interest rate. It would signal that the policy maker takes inflation seriously, and would keep inflation expectations anchored. However, there is no need to signal further tightening, thus, no case for a bias where future rate changes are concerned.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%; with no extension of QE at present.
Bias: To raise Bank Rate towards 2%.

Since the global credit and financial crisis erupted over four years ago, the path of quarterly real GDP growth has become much more erratic. Beyond the understandable foibles of the weather and the UK’s royal occasions, the increased volatility of quarterly GDP is an international phenomenon. The standard deviation of the contribution of net trade to GDP has risen by around 50% in Germany, France and the UK and by 70% in the US, when the period 2007 to 2011 is compared with 1997 to 2007. Hence, the task of extracting the signal (the underlying pace of real growth) from the quarterly GDP data has become much more difficult. Crisis-crazed media commentators have seized upon these erratic deviations to amplify their impact on the public psyche. The result is that timely survey indicators have also become prone to wild and meaningless swings.

Worse still, in an environment of sub-par, post-slump, economic growth, policymakers appear to have lost confidence in their own economic judgements. In the past, they might well have looked past an erratically weak quarterly GDP report but, fearful of a media storm, they now use it to justify a postponement of any tightening. The Bank of England’s MPC has retracted its modest inclination towards a Bank Rate increase despite a sizable body of evidence to suggest that the UK economy has gathered steam during the course of 2011 and that inflationary expectations are shifting higher. The ‘lower-for-longer’ message that emerged from the latest US Federal Open Markets Committee (FOMC) meeting, and was echoed by the body language of the Governor’s briefing after the August MPC meeting, translates as ‘be careful, we’re still in crisis’ to the business and household sectors. Instead of a word of encouragement, this policy sends the opposite message: to hold back and brace for another downturn.

The conclusion that we reached earlier in the year still stands: that the complex messages contained in the policies and directives such as Basel III, the Financial Services Authority (FSA) Liquidity Directive and Project Merlin and the planned withdrawal of Special Liquidity Scheme and Credit Guarantee Scheme funds have strangled the effectiveness of low interest rates for the UK economy. Bank Rate is merely one element of the UK monetary policy mix and probably the least significant at present. As the Euro-zone’s banks have recently discovered, the wholesale funds markets have not healed since the initial crisis in 2007 and remain a source of fragility for the global financial system. The continuation and even extension of central bank insurance schemes and money market initiatives would improve the transmission of Bank Rate and promote economic recovery.

The case for additional QE is even weaker than before, given the extraordinary plunge in gilt yields. The Bank of England’s MPC has the primary responsibility of inflation control and the secondary responsibility of promoting the government’s other economic objectives, notably output growth and high employment. The first demands, at least, a token response to inflationary outcomes and threats; the second requires the design of practical plumbing solutions that will revitalise the money markets transmission mechanism and widen access to cheap credit. My vote is for an immediate Bank Rate increase of ½% to 1.0%.

Comment by Mike Wickens
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: Then to hold Bank Rate temporarily.

Nothing much has changed in the UK economy in the last few weeks: inflation remains over twice its target level and the real economy is flat-lining. In other words, the economy is still in the grip of a large negative supply shock. Meanwhile, the Bank has continued to ignore the UK’s inflation rate and agonises ineffectually over its rate of growth. The Bank is likely to continue in this mode for some time, but is it the best it can do?

Since the recession, UK inflation has been largely imported. This limits the ability of the Bank to do much about it, but it does not entirely remove its room for manoeuvre. Prior to 2007, inflation was close to its target value of 2%. This was almost entirely the result of the average of two components of the CPI. Services had an inflation rate that fluctuated around 4% and goods had an inflation rate between zero and minus 1%. Since 2007, services inflation has continued as before, while goods inflation has climbed to 4%. The latter development has been due largely to the steady increase in commodity and energy prices; the Economist commodity price index increased 23% in the last year. The change in the UK’s inflation since 2007 is therefore almost entirely imported.

What are the options for the Bank? There are two channels open to the Bank. Both involve an increase in interest rates. One channel is domestic: it can reduce service inflation by inducing lower wages. However, with the economy stagnant, unemployment high and little sign of wage inflation, this would be politically unpopular and would probably not be very effective. The second channel is to offset imported inflation via a sterling appreciation. This would reverse the contribution to inflation of the depreciation of sterling since 2007. The effectiveness of this depends on the strength of the US$ and the Euro. Recently the US$ has been weak. As most commodities are priced in US$’s, this may have contributed to the commodity price rise but it has also offset sterling’s depreciation. Due to an interest rate increase by the ECB, the Euro has been strong. This does not greatly affect commodity prices but it has made UK exports more competitive in Europe. Nonetheless, exports have been weak recently. A sterling appreciation may therefore reduce imported inflation but it has the downside of making exporting more difficult. Further support for the exchange rate strategy is a finding of mine made some years ago from simulations of the Bank of England model. In the first year, 80% of the effect of an interest-rate increase on inflation comes via the exchange rate; this erodes rapidly thereafter as the other transmission channels, such as the costs of borrowing and capital, take over.

If the Bank of England appears to have given up on controlling inflation, how well is it doing in its alternative policy objective of stimulating the real economy? With interest rates close to the zero-rate lower bound, interest rate policy is impotent to stimulate the real economy. Furthermore, and with private sector borrowing stagnant despite the available liquidity in the banking system, even a further round of QE would be futile. Although, as noted already, a near zero interest rate has caused a depreciation of sterling and added to imported UK inflation, this increased competitiveness has not brought about an increase in exports. These have fallen recently despite a growth rate in excess of 4% in the non-western world. It appears, therefore, that foregoing the inflation target has had little or no benefit for the real economy.

With the economy stagnant, raising interest rates in order to reduce imported inflation is a difficult call for the Bank as it may also harm the real economy. This is always the case when inflation is due to a negative supply shock. The current monetary policy framework was, of course, designed to deal with inflation due to positive demand shocks when demand would be strong. Although there is a case for adopting a flexible inflation target rather than the current strict inflation target, officially the Bank does not have this option even though it has acted as though it did. The main danger in the Bank’s current policy is that it threatens to throw away the main benefit of its past success in presiding over low inflation, namely, anchoring inflation expectations at the target rate of inflation. Once this is lost we may expect considerable inflationary pressure from wages and prices. This would more or less complete the return to the disastrous conditions to the 1970s. There should be a small increase in interest rates now and, in the longer term, further increases in order to provide a sensible real rate of return. In the short term, it is the change in interest rates rather than their level that is more important as this affects expectations. A value of 1% rather than ½% would otherwise probably have little effect.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: To hold Bank Rate and be prepared to undertake further QE if money supply growth turns more negative and the economy slumps into recession.

A weaker global economy, especially in our main export markets, and the recent market turmoil in the financial markets indicate that a wait-and-see approach to monetary policy is the most appropriate response. That having been said, long-term nominal interest rates have become even lower and so real, inflation adjusted, rates are even more negative. This implies a monetary loosening. Also, it is becoming clear that loose monetary and fiscal policy are becoming part of the problem through inadequate returns to savers and the crowding out of the private investment necessary to help drive supply-side growth. The cut-backs in public sector investment in infrastructure are another minus where future growth prospects are concerned. However, rates will have to stay low until the economy has recovered sufficiently to be able to withstand a tighter – or, more accurately, a less loose – policy stance.

Unfortunately, the situation in the advanced economies is not getting better fast. The earlier monetary policy and regulatory mistakes are going to be reverberating for some time to come. It has to be hoped that any fiscal and other policy errors being made now do not compound the earlier ones. The revised data for UK GDP in 2011 Q2, released on 26th July, suggests that the economy is weak but not heading for recession. Manufacturing activity has turned the corner and seems to be holding up, albeit at a lower level than earlier in the year. With revisions likely to the level of output for the last few years, a rise in Bank Rate seems more likely to be the next policy move rather than further easing via QE. The immediate problem is that with so many uncertainties, moving rates up now would be counterproductive with recovery still so weak.

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 (Deloitte and 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), Gordon Pepper (Lombard Street Research and Cass Business School), 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 TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Following its latest quarterly gathering on 18th July, the Shadow Monetary Policy Committee (SMPC) voted by five votes to four that Bank Rate should be raised when the Bank of England’s rate setters next meet on 4th August. All five SMPC members who voted for an increase wanted to raise Bank Rate by ½% to 1%.

The main reason why a narrow majority of the shadow committee wished to see Bank Rate increased in August was concern that the UK monetary framework risked losing credibility if the Bank ignored the persistent overshoots of the inflation target. There was also a view that the current Bank Rate was appropriate when the global financial crisis was at its worst. However, things had now settled sufficiently to justify some element of interest-rate ‘normalisation’.

Another factor influencing the hawks was the belief that there had been a serious loss of aggregate supply stemming from the tax-and-spend policies of the post 2000 period, as well as the 2008 global financial crash.

The two main reasons that four SMPC members wanted to hold Bank Rate were their beliefs that: 1) the UK economy was weak for demand-side reasons, and 2) continued de-leveraging meant that present money and credit growth were inadequate to support real activity.

Two issues on which most people agreed were: first, that excessively heavy-handed financial regulation was in danger of causing a contraction in banks’ balance sheets and a renewed fall in economic activity, and, second, that the Euro-zone crisis posed a serious risk to Britain. There was a consensus that Quantitative Easing (QE) might need to be revived if the Euro-zone’s problems got out of hand.

Minutes of the Meeting of 18th July 2011

Attendance: Philip Booth (IEA-Observer), Tim Congdon, Jamie Dannhauser, Anthony J Evans, John Greenwood, Ruth Lea, Kent Matthews (Secretary), Patrick Minford, David Brian Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.

Apologies: Andrew Lilico, Gordon Pepper, David Henry Smith (Sunday Times Observer), Mike Wickens.

Chairman’s comments

David B Smith discussed the element of ‘flip-flopping’ that had appeared in some recent monthly votes of the SMPC. He suggested that, following the introduction of three new younger members, the membership of the committee had expanded to the point that the interest-rate recommendations made each month were unduly dependent on the random process of who got their commentary in first. He said that he believed ‘first come, first served’ remained the fairest method for deciding who voted. This was because it precluded any possibility of the Chairman swinging the poll by selecting whose votes were included. It also had the incidental benefit of incentivising members to get their votes in on schedule, facilitating the production process.

However, he suggested that the committee needed to consider reducing the number of members marginally – perhaps, by one or two of the older members standing down – if flip-flopping was to be reduced in future. The alternative was to devise a system that produced greater consistency but that would require people to commit themselves to voting several consecutive months in advance. The fundamental problems were that the SMPC was an unpaid voluntary body and that many members had extensive travel commitments. This meant that it was simply impractical to have a nine person committee in which every member voted every month.

He then asked John Greenwood to give his assessment of the global and UK monetary background.

The Monetary Situation
The International Situation – Developed versus Emerging economies
John Greenwood referred to the handout of charts he circulated to the committee. He began his presentation by asserting that the standard relationships in economics did not hold in times of severe balance-sheet repair. In particular, interest-rate policy was unable to gain traction. This was the scenario in those developed economies which had also seen credit and housing bubbles. In contrast, the emerging economies had not participated in the recent credit and housing bubbles but they had a more embedded inflation. In the past, these economies had linked their currencies to the US$. However, they were now engaged in a process of de-linking from the US$ and raising interest rates independently of the USA for the first time.

In the developed economies, there was little growth in lending or money despite the fact that interest rates had remained low. Asset prices and money growth had been supported by Quantitative Easing (QE). Deleveraging continued both in the US and in Europe, but the question was whether the US economy was going through a temporary soft patch or a more permanent slowdown. European broad money had recovered from its earlier negative growth, but the pick-up was mainly due to lending to the household sector in Germany and France, not to the corporate sector. Elsewhere in Europe, money-supply growth had been weak or the level of the money stock had been contracting. Monetary growth in the core economies of Germany, France, and the Netherlands had been positive whereas in the peripheral economies of Ireland, Greece, Spain and Portugal, money growth had been negative. In Italy, M3 had also turned negative. The Euro crisis was dominating the European scene. It was clear that Greece was insolvent, and therefore the only issues were the timing of its exit from monetary union and whether the exit would be orderly or disorderly.

China and the East Asia had avoided the credit bubbles of the 2000 to 2008 period and therefore had not participated in the excessive leveraging seen in the West. However, and partly as a consequence, there had been rapid money growth in China since November 2008 and in some other East Asian economies more recently.

The UK Economy – Balance sheet shrinkage
As far as the UK was concerned, weak domestic demand indicated the continuance of de-leveraging. The growth of M4 broad money and total lending was too low. Even the Bank’s preferred M4ex money measure showed little increase. There was little sign of exports or corporate investment offsetting the weakness in household spending. While inflation remained a worry for the MPC, the constant-tax consumer price index (CPIY) was only up 2.7% on the year in June. Bank lending to the private sector had been very weak but the corporate sector had been borrowing from the capital markets. Mortgage lending had recovered a little but still remained weak overall. All the various competing measures showed a flattening out of house prices. The slump in personal lending continued. However, and despite surprisingly good employment figures and unemployment indicators, earnings growth had been weak with household incomes being eroded by inflation.

QE had been successful in offsetting what would have been an even more catastrophic fall in the money supply. Bank of England assets have fallen back to £235bn from £250bn since July 2010 following the cessation of QE. This could have been brought about by the natural maturation and redemption of some shorter-term assets purchased by the Bank, rather than a deliberate policy decision.

Some parts of the economy such as manufacturing were doing better with the Confederation of British Industry (CBI) output expectations indicator having shown a rise. Order book volumes were also improving. However, as this development was largely driven by exports, domestic investment remained sluggish. On the domestic side there was a discrepancy between the CBI survey-based indicators of retail sales and the official figures from the Office for National Statistics (ONS) which showed negative growth in recent months. Given the weakness in GDP growth, the Coalition government was likely to have difficulty in meeting its budgetary targets.

Consumer price inflation remained well above target but CPI inflation excluding indirect taxes had fallen below 3%. Furthermore, calculations of inflation expectations derived from a comparison of five-year nominal and indexed-linked gilt yields produced a figure of below 1.5%. Inflation was likely to fall sharply, if and when commodity price inflation eased. Because of the state of the economy and the prospects for inflation in the near future, the rate of interest should remain on hold in John Greenwood’s view.

Discussion
Euro problems will dominate policy in short term
The Chairman thanked John Greenwood for his presentation and opened up the meeting to discussion. Philip Booth started the ball rolling by asking why depositors in Greek banks continue to hold Euro deposits, given the possibility of Greece exiting the Euro. He also questioned the measure of inflation expectations derived from the five-year nominal and indexed-linked gilt yields, which seemed counter to other measures. John Greenwood replied that there had been a capital outflow from Greece to other Euro-zone countries, especially Cyprus. Ruth Lea next enquired how close Portugal and Ireland were to the Greek situation. John Greenwood replied that unit labour costs in Ireland had reduced sharply, indicating flexibility in wages and increased productivity, but this favourable development had not happened in Portugal or Spain.

Patrick Minford said that the convulsions in the Euro-zone would inevitably impinge on the Bank of England’s interest-rate decisions. However, an orderly exit might be positive for financial markets as it would remove a source of uncertainty. Tim Congdon said that he broadly agreed with Patrick Minford. If Greece and Portugal were to exit, the banks in the remaining Euro-zone could cope with this through write-offs. The risk was that the regulators would wreck the whole business by demanding higher capital ratios. Trevor Williams said that there was no mechanism for an exit from the Euro and that there needed to be one. Philip Booth said that the chaos resulting from the problems of southern Europe might continue to reverberate even after a Greek exit from the Euro-zone. Akos Valentinyi said that there were historical precedents for the break-up of currencies. It could be done provided that there was sufficient political will; an example was Hungary after the First World War. Peter Warburton said that the European Central Bank (ECB) was prone to compromise in the use of its balance sheet as it had no desire to bring the curtain down on the Euro project. Despite its protestations, a further expansion of its loan and bond purchase programmes should be expected, perhaps to the extent of a 25% asset expansion. However, the ECB would also be reluctant to see an expansion of its assets by 25%, because that would lead to a devaluation of the euro. Tim Congdon said that if Italian deposits end up in Germany, then the Italian banks will go to the ECB as the only option available.

The Chairman then stated that, because there were two more than the obligatory nine voting SMPC members present, he would again apply the principal of ‘first come, first served’. Unfortunately, this meant that neither the votes of Jamie Dannhauser or Peter Warburton could be included. In compensation, he suggested that their views should be noted down and included in the discussion under alphabetical order.

Jamie Dannhauser said that he was most concerned about events in the Euro-zone and how to stop contagion spreading to Spain and Italy. He said that he was relatively dovish on interest rate policy. He said that he did not believe that the trend in global commodity prices would be sustained as the global environment would remain generally weak. While CPI inflation is the Bank’s official target, there was a danger of placing too much weight by it at this juncture. A broader measure of UK inflation, the annual increase in the market-sector deflator, was in the region of 1%. Taking out the VAT effect and government-sector inflation shows that actual inflation was very low. As a result, Jamie Dannhauser believed that Bank Rate should be left unaltered in August. Where later months were concerned, he had no bias

Peter Warburton said that the latest Bank for International Settlements (BIS) quarterly publication contained an important paper on the global output gap. While the OECD and most of its member central banks were clinging to the notion of a substantial negative output gap, there was a credible case to be made that the global output gap was small or had already closed. Inflation expectations were trending up in many countries, including the US and UK. Supply-side inflation was showing up to an increasing extent in import prices, which had reached double-digits for a number of Western economies. He was not so bearish on the UK economy. Household income growth had begun to recover and should now take an increasing share of national income. While employee income growth remains subdued, self-employment and property incomes were recovering strongly. He expected the pace of wage inflation to increase next year and for the pressure on real after-tax incomes to ease. As a consequence, he thought that Bank Rate should rise immediately to 1% in August and had a bias to tighten further in subsequent months.

Votes
The Chairman then asked each of the other nine SMPC members present to make a vote on the appropriate monetary policy response. The votes are listed alphabetically, in line with the customary SMPC practice. However, Patrick Minford had been obliged to make his submission part way through the meeting as he then had to rush off to the airport.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate. Reactivate QE if euro crisis deepens.
Bias: Neutral.

Tim Congdon said that idiotic supply-side policies of higher taxes had resulted in a lower trend rate of growth of capacity. Nevertheless, output was still below trend. The headline inflation figures had been exaggerated by the Arab Spring uprising. Stripping out oil effects, actual inflation was in the region of 1½% and this would fall further. Money-supply growth was very weak and credit availability from the commercial banks was not what it should be. He said that interest rates should stay on hold but QE should be resurrected if there were further shocks from an impending collapse of the European Monetary Union (EMU).

Comment by Anthony J Evans
(ESCP Europe)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Anthony J Evans said that he wanted to distinguish between an already loose monetary policy and the even looser monetary policy that resulted from accelerating inflation reducing the real rate of interest when the nominal rate was constant. He said that current monetary policy was getting looser and that there would still be a loose monetary policy even after a rate rise. The annual report from the Bank for International Settlement (BIS) had warned that negative real interest rates delayed adjustments and magnified risk, and the latest Organisation for Economic Cooperation and Development (OECD) survey warned of embedded inflation expectations. The balance of risks for the Bank was between falling inflation now and being able to exit quickly from QE and future inflation. The Bank needs to reclaim its independence. He said there was scope in the UK for an ‘expansionary fiscal contraction’, but monetary policy should not attempt to accommodate fiscal policy. The magnitude of the rate rise he was calling for should not have a serious adverse effect on the real economy but would influence expectations and future inflation prospects. The fact that the ECB had begun moderate rate rises had set a precedent that reduced the fear that any rate rise would cause a new downturn. He said that with hindsight the Bank of England should have raised interest rates earlier but, given that rates would need to rise, it was better to do it too soon than too late.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate. Reactivate QE if monetary conditions tighten further.
Bias: Neutral.

John Greenwood said that it was not possible to judge the stance of monetary policy by interest rates alone. Japan had experienced a history of zero interest rates but effectively tight monetary policy. The shrinkage in commercial bank balance sheets had led to limited growth and low underlying inflation. Current inflation was largely transitory and imported. Rates should not change. A rise in Bank Rate would squeeze monetary conditions further. QE should be reused if the supply of money contracted.

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

Ruth Lea said that the economy was in a very weak state and, although the ONS figures were not perfect, the GDP numbers due out on Tuesday 26th July would probably confirm this. (Editorial Note: the ONS data released after this comment was taken down showed a rise of 0.2% on the first quarter and 0.7% on the year, while non-oil GDP demonstrated equivalent increases of 0.3% and 1.1%). Ruth Lea added that she was bearish on the economy. The latest figures on net trade were not encouraging and household consumption was weak. She said that she did not buy the view that commodity prices were on a secular upward trend. The Bank’s measure of Inflation expectations had moved up but there was no runaway inflation and wage growth remained weak. Commercial bank lending had been muted with the pressure to raise capital. She voted to hold Bank Rate and keep QE in the wings in case of further economic problems.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%. Keep QE available in case the fallout from the Euro-zone crisis adversely affects the British economy.
Bias: Neutral.

Kent Matthews said that he accepted that there was considerable uncertainty about the output gap and he took the point made by John Greenwood that the level of the interest rate was not a good indicator of the monetary stance. He interpreted this as meaning that interest rates were so low that the demand for money was unresponsive to small changes to it. Yet, a small rise in rates may signal to the market a change in direction in policy and influence expectations, particularly in the market for foreign exchange. He said that a small rise in rates now may mean that an undesirable sharp rise in the future could be averted. Like Anthony Evans, he felt that the Bank had to take steps to restore its both its own credibility and the credibility of the inflation-targeting policy. The Bank had not convinced the markets of its strategy. This meant that they faced a signal extraction problem. However, there was sufficient uncertainty to recommend that a rise in Bank Rate should be followed by a pause. This was to see what the rate increase did to market expectations. Further rises might be necessary in the future. However, this could be done in staggered stages. QE should be held in reserve in case of further fallout from the euro crisis.

Comment by Patrick Minford
(Cardiff Business School)
Vote: Raise Bank Rate to 1%.
Bias: To tighten.

Patrick Minford said that the chaos in Europe would affect the UK and the Bank had to be aware of the potential fallout. If the US went to QE3, and credit growth continued in the far-East, world liquidity would rise at an alarming rate. The ECB was raising rates and the US would shortly begin the process of rate increases. Commodity price rises would not ease off. Therefore, the threats to UK inflation should not be underestimated. However, the key focus of the Bank was to restore credibility. Clearly, the fallout from the Euro-zone crisis was an important factor that would constrain the hand of the Bank. In the end, however, it was a question of balancing the various risks involved. The Bank could not neglect the loss to its credibility and commodity price inflation was not just a special case of inflation - it was inflation. The Bank of England had shown a serious lapse in judgement. Its raison d’être was the inflation target. It had given the impression that it had some other job. He said he agreed that the increased capital demand on banks was a problem. However, it was a problem for regulators not the Bank of England.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise bank Rate to 1%.
Bias: To raise Bank Rate again.

Akos Valentinyi said that the evidence from previous bank crisis was that capacity got destroyed. There was indeed a supply-side problem. Therefore, money-supply growth was not the point. He accepted that QE was helpful in the initial stages to mitigate the worst effects of the crisis. However, the present capacity constraints meant that it was no longer the principal issue. The role of the central bank was to target inflation and this was what the credibility of the policy and expectations hung on. The Bank was not supposed to target components of the CPI or alternative measures. The figures said that inflation had been rising.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1% but be prepared to re-activate QE if the Euro-zone crisis gets out of hand.
Bias: To tighten, subject to developments on the Continent.

David B Smith said that, during the 21st Century both the USA and UK had implemented ‘big-government’ policies that seemed hand crafted to do the maximum possible damage to aggregate supply, potential output and the structural rate of unemployment. After 2008, the recession in both countries had been exacerbated by ‘crass-Keynesian’ policies that had crowded out private-sector activity, not supported it. He said that current policies were likely to lead to what the late John Flemming had described as an upwards ‘gear shift’ in inflation expectations in his 1970s book ‘Inflation’ (Oxford University Press 1976, ISBN 0 19 877086 3, Chapter VII).

The increasingly negative real rates of interest paid on bank deposits had caused a downwards movement in the demand for broad money. The disequilibrium between the ex ante supply of, and the demand for, broad money was not easy to calculate. However, one way that it could be judged was through the response in the currency markets. If the exchange rate was weak – and the global monetary background was not unreasonably tight – then the demand for money was less than the supply.

The Coalition’s fiscal policy lacked credibility and the VAT and NIC increases perversely had reduced growth and worsened the budget deficit. When neither UK monetary nor fiscal policy had any credibility remaining, it was hard to see why the international financial markets should be willing to underwrite further British budget and balance of payments deficits. Tactically, it might be hard to raise rates now that the latest data had shown that CPI inflation had blipped downwards in June. However, a comparison of the annual increase in the CPI with the much smoother course of the ‘double-core’ RPI suggested that the much-commented-upon movement in the CPI in recent months was predominantly statistical ‘noise’. He remained of the view that Bank Rate should be raised by ½% immediately. However, he was perturbed sufficiently by the developments in Continental Europe to want QE to be put on standby in case the problems in the Euro-zone led to serious capital losses for UK banks.

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

Trevor Williams said that the situation was highly complicated because of the potential sources of shocks. Risks for the British economy came from the Continent, the US and Asia. The output gap was a less important influence in a small open economy like the UK. The underlying trends in Britain were weak and economic growth of 1% to 1½% was what was expected for 2011. The financial regulators were running scared of another banking crisis in the UK. However, by asking for potentially too much capital, the regulators had risked creating shocks to demand and supply conditions that could potentially derail the recovery. Since most of the risks to the British economy were on the downside, the Bank of England had been right to hold rates. Trevor Williams voted to hold Bank Rate and to keep the option of additional QE available on a ‘wait-and-see’ basis.

Policy response

1. A five to four majority of the shadow committee felt that Bank Rate should be raised by ½% to 1% on Thursday 4th August.

2. Of the five members who voted to raise rates, four had a bias to tighten further.

3. Of the four members that voted to hold Bank Rate in August, one indicated a bias to raise Bank Rate in the near future.

4. Four members felt that QE should be held in reserve and be activated if the Euro-zone crisis spilt over to the UK.

Date of next meeting

Monday 17th October.

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

SMPC membership
The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other members of the Committee include: Roger Bootle (Deloitte and 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), Gordon Pepper (Lombard Street Research and Cass Business School), 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 TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

In its most recent e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by a narrow margin of five votes to four that Bank Rate should be held at its current ½% in July. All four SMPC hawks wanted to raise Bank Rate by ½% to 1%. The lack of a ‘plus ¼%’ middle ground between the holds and the advocates of a ½% increase reflected divergent views on a number of issues.

One division concerned whether the sluggish growth of national output was a pure ‘demand-side’ phenomenon or whether it reflected a withdrawal of aggregate supply caused by the unprecedented peacetime increases in the burdens of UK government spending, borrowing and taxation during the 21st Century.

Another divide concerned how far Britain should be regarded as a small, open economy – in which case downward movements in the exchange rate should eventually become fully reflected in domestic prices – and how far it should be regarded as a large metropolitan economy, where the output gap could be regarded as the main influence on inflation.

Other important issues on which views differed included how much reliance could be placed on the official statistics and whether the sluggishness of broad money and credit meant that there was no long-term inflation risk. Some SMPC members worried about the threat to the Bank of England’s credibility caused by its non-reaction to overshoots of the inflation target. There was also concern that the British fiscal approach could lose market credibility, if public borrowing did not fall in line with the official forecasts. However, even the SMPC hawks accepted that additional quantitative easing might be needed if the Euro-zone crisis threatened UK banks.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold.
Bias: To hold.

The next few months will see further disappointment on the inflation front, as electricity and gas price increases come through. However, the indicators for demand and output are ambiguous, with consumer spending likely to be flat, at best, in 2011. The recent sharp rise in employment is encouraging, but also puzzling. Broad money is stagnating, as banks continue to shed risk assets. The latest data for both mortgage approvals and ‘unused sterling credit facilities’ imply that the broad money supply will continue to stagnate over the summer and autumn months.

Overall, it seems unlikely that output will grow at a well-above trend rate during the rest of this year and more plausible that the volume of activity will grow at a trend, or beneath-trend, rate. Since the level of output remains beneath trend – perhaps, by 2% to 3% – next year should see further weakness in underlying inflation pressures, as well as a marked abatement in the commodity and energy price cost-push inflation which has been so marked over the last year or so. My vote, therefore, is for no change in interest rates, with a bias to keeping interest rates at around their present level.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold.
Bias: Neutral.

At its latest meeting, two members of the Bank of England’s Monetary Policy Committee (MPC) voted to hike Bank Rate by ¼%. Arguments in favour of an immediate rate hike are reasonable, albeit misguided at this particular time. If one believed that the world economy could sustain output growth of 4% to 4½% in coming years (based on purchasing power-parity-weights, rather than market exchange rates), with robust expansion in emerging economies the main driver, then a net commodity importer, like the UK, could face a sustained deterioration in its terms of trade. This could only occur if there was a marked change in the balance of world demand, away from the so-called 'borrower' economies, towards those economies which had previously run large current account surpluses. A monetary stance focussed solely on hitting a target for consumer price inflation would have to be tighter than it otherwise might be. If such a scenario for the world economy were likely, one could reasonably argue that the current setting of the UK monetary policy is inconsistent with the MPC's remit.

This is not, though, the most likely outlook for global activity in coming quarters. Four years after the global boom finished, the structural imbalances in world demand do not appear to have diminished much. One need only look at the considerable gains in market share that Chinese exporters have made since the crisis erupted to get some sense of this. The Quantitative Easing (QE) type exercise Beijing undertook in the middle of 2009 did help to temporarily boost Chinese domestic spending. However, the monetary explosion has left China with a major inflation problem. With the authorities behind the curve, the Chinese economy looks set to slow sharply over the next year or so, taking much of the fizz out of the global recovery. Commodity prices should increasingly reflect that.

While UK inflation may even rise above 5% in the near-term, the prospective fall in commodity prices should bring headline inflation down sharply in 2012. But ultimately it is the underlying rate of inflation that monetary policy needs to focus on. In the short to medium run, it is the amount of spare capacity in the economy that drives firms' price and wage setting behaviour. In the longer term, inflation is ultimately pinned down by the rate of monetary growth and inflation expectations.

There has been much debate about the size of the output gap in the UK. Business surveys have generally pointed to a much smaller degree of slack within companies than statistical estimates of the output gap might suggest. The recent strength of employment growth is also hard to square with the idea that companies have lots of underutilised workers. In the downturn, labour was hoarded on a large scale. This should have left companies with considerable scope to raise output without additional staff. (A large Bank of England survey on this issue in January suggested that 90% of firms were able to raise output without additional workers.) Yet during the recovery, growth in labour productivity has been very limited. This could suggest a much greater degree of supply disruption than data on previous banking crises would imply. Yet, evidence for this is hard to come by. Corporate liquidations, a proxy for the amount of capital scrapping, have been remarkably limited; new company formation has been robust; and, while structural unemployment has gone up, it is hard to find evidence that it has risen very far. It is possible that labour and capital have been unable to move from declining sectors - e.g. banking, real estate - to growing ones - e.g. manufacturing. Again though, survey evidence does not support this, with labour shortages in industry, for instance, still below their long-run averages.

Notwithstanding the puzzles in the data, the big picture is clear. Private sector output is now 15% below where it would have been had output continued growing at its pre-crisis trend since the middle of 2007. Let us assume, as a slew of evidence suggests, that the economy was operating above its potential before the crisis struck, by, say, 3% points. Let's also assume that 5% of the drop in output has already been permanently lost. To add another level of conservatism, we will factor in a 0.5% point reduction in UK potential growth over the last four years. Even with all this, private sector output would still appear to be around 5% below its underlying potential. Six quarters into a recovery, the amount of slack in the economy is larger than at the depths of the 1980s recession.

Monetary analysis would seem to confirm the limited risks to UK inflation. Broad money growth has averaged 2% in the last three years. It has been even weaker during the recovery. Over the last year, bank lending to the private sector has declined outright. Had it not been for QE and commercial banks' gilt purchases, the money stock would almost certainly have fallen sharply in recent quarters. Given the outlook for private sector credit demand and banks' efforts to rebuild their balance sheets, lending growth will be very weak for some time. The expansion in broad money will be restrained further, as banks try to meet the new Basel rules. Other things being equal, a banking system with more capital and increased reliance on long-term wholesale debt means fewer deposits held by the private sector for any given level of bank assets.

Some have argued that strong growth in money velocity could mean that low broad money growth is consistent with risks to inflation. This is possible, if, for instance, the Bank of England were to lose control of inflation expectations, but highly unlikely in my view. Since the late 1980s, money velocity has fluctuated around a downward trend of 2% per annum. There are good reasons to expect velocity to trend higher after a banking crisis, as the cost of banking intermediation rises relative to other forms of credit. Ultra-loose monetary policy should also lower the investment demand for money by creating a large wedge between deposit rates and yields on risky assets. However, it is hard to believe that prospective monetary trends are likely to be consistent with a pace of nominal demand growth that would be undesirable as we exit a recession of this magnitude. If anything, the ongoing adjustment in the banking system still poses a downside risk to nominal spending growth and inflation.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold.
Bias: Hold Bank rate; expand QE if M4 or M4ex contracts further.

On the basis that the economic downturn of 2008 and 2009 was primarily a ‘balance-sheet recession’ caused by overleveraging in both the household and financial sectors, to understand the prospects for recovery we need: (1) to consider the progress of balance sheet repair in these two sectors; and then (2) to consider whether the balance sheet deterioration in the public sector is not so severe as to offset any improvements in the private sector. Standard macro-economic analysis which looks at the relation between (say) interest rates and nominal or real GDP growth based on past relationships will fail to explain what is currently going on. Currently, the desire to repair balance sheets before resuming normal behaviour – on the part of both consumers and financial institutions – overwhelms the normal linkages. The point is that an unspoken assumption underlying orthodox macro-economic models is that balance sheets are healthy. When they are not, typical relationships (coefficients) go awry.

Overleveraging by the household sector is most easily observed in the household debt-to-income ratio which peaked at 174% in the first quarter of 2008, having risen from a level below 110% in 2000-01. Eleven quarters later, in the fourth quarter of 2010 (the latest available data), this ratio had declined to 157%. The de-leveraging has come about largely as a result of increases in nominal household income, considerably less as a result of debt repayment since the amount of household debt outstanding has remained roughly static since mid-2009. Nevertheless, the decline in this gearing ratio probably has considerably further to fall. The ratio is still almost 50 percentage points higher than it was at the start of the housing bubble. Consequently, until consumers feel that they have reached an equilibrium debt-to-income ratio it seems likely that they will continue to restrain spending, maintain higher rates of saving, and certainly not add to their existing stock of debt. Irrespective of what typical coefficients from macro-economic models say about the low level of interest rates and prospective nominal or real household spending, one would bet that de-leveraging will win out over macro-models.

Turning to the financial sector, the evidence suggests continued de-leveraging in this sector also. The de-risking of bank and other financial sector balance sheets can be seen in a variety of recent data. Bank lending is still declining (M4 lending contracted by 1.3% year-on-year in April), banks are adding to their holdings of gilts while running down holdings of other types of securities, and interbank lending is shrinking. The net result is that UK banks’ sterling assets had declined by £375bn from £4.06 trillion in January 2010 to £3.685 trillion in April 2011. Again, balance-sheet repair is the dominant driver of bank behaviour, not some knee-jerk response to low interest rates. The hand-wringing by politicians, regulators or macro-economists who wish to see faster bank lending growth is laughably misdirected. They should be celebrating the progress in balance-sheet repair, not moaning about the lack of credit expansion.

Meanwhile, in contrast to the de-leveraging in the private sector, the leveraging up of the public sector continues. In May net debt (excluding financial interventions) reached £920.9bn or 60.6% of GDP. In the peripheral Euro-zone economies, government debt-to-GDP ratios have already reached substantially higher levels. These are such that investors are now extremely reluctant to hold the sovereign debt instruments of Greece, Ireland and Portugal, except at very high interest rates. Fortunately, the British Coalition government’s plans to close the deficit by 2015 and thereby stabilise the debt-to-GDP ratio still carry some credibility so Britain is not facing a similar debt crisis. However, such forbearance by international investors cannot be taken for granted.

Until there are signs that the balance sheet repair process is approaching completion, the best policy for the authorities is to assist in enabling such balance-sheet adjustments to occur – for example by keeping interest rates low, providing debt and interest-rate relief to deserving families or entities, or substituting lower cost, longer-term government lending for private loans. Raising rates now would only have adverse knock-on effects on households and business. If and when firms and consumers begin to re-leverage their balance sheets, then clearly there would be a case for raising interest rates. However, the evidence shows that moment has not yet arrived.

The higher rate of inflation in the UK than the US or the Euro-zone reflects two main sets of factors: (1) excess money and credit growth in the UK prior to mid-2009 (this period ended only two years ago and is well within the normal lagged effect of monetary policy on inflation), and (2) a series of transient, non-monetary factors such as the surge in commodity prices over the past year, the weakness of sterling, and the increases in the UK’s indirect taxes. The latter do not constitute a valid case for raising interest rates. The fact that the emerging economies are recovering strongly – in part because their balance sheets are in good shape – and are buying large quantities of commodities and pushing up their prices implies a change in the terms of trade and a change in the composition of inflation for the UK and other developed, western economies. Insofar as such changes are transitory, the correct response is to delay rate hikes until balance sheet repair is at least mostly completed and until the effects of the current exceptionally low rates of money growth provide a better indication of the true state of the economy.

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

The outlook for the domestic economy remains uncertain. The official Office of National Statistics (ONS) data suggested that the economy flat-lined between the third quarter of 2010 and the first quarter of 2011. Barely had the ink dried on the pages of the March Budget forecast from the Office for Budget Responsibility (OBR) than it was shown to be overoptimistic when the first quarter Gross Domestic Product (GDP) data were released by the ONS in April. However, this is now history.

The data so far available for the second quarter are not encouraging. April’s manufacturing data were disappointing and May’s retail sales were weaker than expected. The Markit/Chartered Institute of Purchasing and Supply (CIPS) surveys for both services and manufacturing have also disappointed. Furthermore, the housing market continues to ‘tread water’ (at best) with mortgage approvals well down. The labour-market data stand out as something of an anomaly and are hard to explain.

Recent data have however been distorted by one-off factors such as the Royal Wedding and the timing of Easter. There is therefore noise in the figures and a longer run of data will be needed to assess the underlying progress of the recovery. But given the factors bearing down on growth, GDP will probably rise by only 1½% this year.

Consumer Price Index (CPI) inflation remains above target and will probably remain above target into 2012. Upward pressures on utility prices, partly reflecting our insane energy policies, will probably ensure this outcome. But, unless there is another burst in commodity prices or further significant increases in indirect taxes, CPI inflation should fall back to target next year. Earnings growth is very subdued (around 2%), most British people seem resigned to their fate of falling real incomes, and there is therefore little sign of a ‘wage-price spiral’ becoming embedded. The Bank of England’s latest survey on inflation expectations, by which it sets such store, suggested that people’s expectations were slightly weakening.

Looming over Britain’s prospects is the ‘car crash’ of the Euro-zone, with the risk of a ‘Lehman-like’ shock to the global financial system. Under these circumstances, there should be no change in interest rates, together with a bias to keeping interest rates at their present level.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate further.

The UK monetary-policy debate has reached an impasse. Since the MPC did not raise rates in March, once it was clear from the survey data that the contraction in GDP in the fourth quarter of 2010 was merely a blip, it has been unclear what could possibly induce a rate rise. In a growing economy with inflation headed to 5% versus a target of 2%, leaving rates at ½% is simply derelict. The monetary discussion now appears to have returned to the possibility of more QE. Well, there should have been more QE last year, when some SMPC members urged it, starting at least by November in combination with the broader global QE2 programme. More QE now is simply chasing the problem, and likely to be pro-cyclical as a consequence. Now, if there were serious market disruption (e.g. from a Greek default or Chinese banking sector problems), then more QE might be a temporary liquidity expedient, of course. If the economy was to degenerate seriously, and inflation fall back, then again QE might be considered. However, this is not the situation at the moment. Currently, we have a growing economy and inflation heading towards 5%.

Do we have any idea what might induce action against inflation? What about if the yearly CPI increase goes to 6%, 7% or even 10%? Might we see a couple of quarter-point rises then? We seem to have abandoned entirely the idea that real-economy equilibria cannot be improved by having high inflation but can only be made worse. We should not be hoping to keep interest rates as low as possible for as long as possible. The MPC should be seeking every opportunity, every excuse available, to return interest rates back to their natural level. Now perhaps the sustainable growth rate of the UK economy has dropped in recent years, so that the natural rate is not the 5%, or so, we previously thought. Certainly, the message from bond-market data was that the risk-free rate - which theory suggests is a fairly close proxy for the equilibrium sustainable growth rate of the economy - started falling in the early 2000s, from levels around 2.5% to 3% down to below 2%. Indeed, some recent estimates go as low as 1%. That would, of course, be unsurprising given the damage to potential growth done by the combination of very high public spending, financial market problems, and excessive regulation in response. We should not rule out altogether the possibility that the UK's sustainable growth rate is now only a little above 1% per annum, implying a nominal interest rate of only around 3.5% in a natural equilibrium situation.

However, if the natural rate really has fallen as far as this, then the output gap is much smaller than the Bank estimates - indeed, the output gap could even be negative. So the idea that the natural equilibrium interest rate has fallen would not support keeping interest rates low. Rather, it would be an additional argument for raising them! We should be seeking every opportunity to return interest rates to their natural level. We may not know what that level is very well at the moment - whether 3½% or 5%. However, we know it's a lot higher than the current ½%.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again, and for QE to be held with a bias towards reversal.

The recent news for UK growth and employment has been mixed. The growth figures have been weak, with manufacturing slowing and the ONS GDP figures downbeat. However, employment growth has been solid and unemployment falling; while public sector jobs have been cut, private sector jobs have more than made up for such losses. Falling real wages must be contributing to this, via a rise in the labour-output ratio. It is also likely that the GDP figures will be revised upwards.

The inflation outlook has worsened, with expectations now that the CPI measure will go over 5% in the second half of this year. Real interest rates are now negative, even on much private sector debt inclusive of risk premia (such as tracker mortgages). It is reckless for the Bank to forecast that inflation will come down even though it is now being rumoured that MPC intentions are not to raise rates for another year. Inflation tends to persist when there is no commitment to reduce it. Since the Bank’s reason for taking no action is ‘weak growth’ there seems to be no reason to expect the Bank to raise interest rates sine die: our forecasts, like almost all others, now project weak growth as far as the eye can see.

This situation is dangerous to the Bank’s credibility. It was ‘endowed’ with this in 1997 by the long battle against inflation in the 1980s and 1990s. Up to 2010 and this year, it had seemed to be reasonably reliable as the holder of this endowment, which can be thought of as a piece of ‘social capital’. The Bank is supposed to have as its only objective the hitting of the inflation target ‘in the medium term’; so far it has tended to overshoot it on average but at least inflation has tended to return to around 2%.

The Bank retorts that it can keep rates at zero for as long as wage increases are muted and so real wages falling. However, it is forgetting its own role in setting the exchange rate. Essentially in an open economy the main transmission channel for inflation is through the exchange rate. This is how a floating currency enables a country to run a different interest rate and inflation rate from elsewhere. The Bank has chosen to run a more expansionary monetary policy than the Euro-zone for example; this has reduced the sterling/euro rate. No doubt this was appropriate during the financial crisis in 2008 and 2009. However, it has ceased to be appropriate when inflation is threatening to move well above its target. The risk is that the Bank will lose control of sterling first and soon after lose control of domestic wage costs. If that were to happen, credibility would be lost; regaining it could be a painful process. For this reason I continue to suggest an immediate rise of ½% in rates, with a bias to raise further. QE should cease indefinitely.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%.
Bias: To ‘normalise’ Bank Rate in small steps until it reaches 2½% but be prepared to re-launch QE if Greek crisis threatens UK bank defaults.

Britain’s monetary policy makers face an unusually high degree of uncertainty at present in a situation where the world economic recovery has apparently lost momentum, a Greek default threatens the integrity not just of Continental banks but also their UK counterparties, and the ONS labour-market data appear to be telling a significantly more buoyant story than the official GDP numbers. The MPC will need to be either brilliantly clever - or brilliantly lucky - to correctly read the runes of these potential influences while trying to bring inflation back into its target zone quickly enough to hang onto some reasonable level of credibility following the inflation overshoots of recent months. Fortunately, small changes in Bank Rate have only a limited impact on the domestic economy and a ‘mistake’ of ½% or 1% in setting Bank Rate would probably not be fateful. However, this is especially true at present when the ‘pass through’ from Bank Rate to the lending rates that directly affect households and smaller businesses is unusually attenuated – large companies have little need to borrow from the banks because they appear to be flush with cash. The Bank’s low-interest rate policy seems to partly represent an unannounced strategy to boost the commercial banks’ monopoly profits, through widening the spread between lending and deposit rates, in order to build up their capital and reserves. This re-capitalisation is at the expense of depositors who are currently facing a covert inflation tax of, perhaps, 3½% to 4½% of the value of their interest-bearing deposits each year. The negative real return on bank deposits is probably inducing a downwards shift in the demand for money – whose effect would be symmetrical to an increase in the supply of money in a naive monetarist model – and means that the weakness of the M4ex broad money definition may not have its normal recessionary implications.

Some of the divergence between the relatively satisfactory rise in private employment of 520,000 (2.3%) in the year to March, and the weakness of the GDP figures, probably reflects the fact that, having falling far more sharply than GDP in the recession, the non-socialised component of real expenditure has bounced back more rapidly than the total since its 2009 Q4 low point. With the government and the private sectors of GDP of roughly equal size, total GDP is not a meaningful measure of private activity in an era when the public sector’s demand for resources is being deliberately, and necessarily, reined back. This distinction is crucial for monetary policy because monetary instruments only operate on the non-socialised sector.

Unfortunately, it is difficult to separate out the public and private sectors with adequate precision using the ONS statistics. Another statistical issue is that Britain’s national accounts will shortly be rebased yet again. When this has happened in the past, the economy has often turned out to be in a different position to that which was previously believed. There can be a surprisingly poor fit between GDP and its main components measured on one base year and another one. Indeed, one would frequently have to reject the hypothesis of a useful predictive relationship between the new base year figures and their predecessors using normal statistical criteria (Editorial Note: The Power Point presentation Uncle David’s Chamber of Data Horrors, available from xxxbeaconxxx@btinternet.com provides the evidence for this statement).

This does not mean that the UK economy is not suffering from genuinely poor growth prospects. However, it does mean that it is important to separate out the extent to which poor growth reflects inadequate demand and how far it reflects a permanent supply withdrawal caused by the spend, borrow and tax policies of the Brown years and Mr Osborne’s misguided decision to raise VAT to 20% and implement Labour’s damaging ‘jobs tax’ increase and 50% income tax rate. The more ‘gung-ho’ advocates of monetary expansion appear to be assuming that the entire weakness of UK activity is down to pure demand factors. However, there is widespread evidence from international growth studies that increasing the share of government consumption in GDP crowds out private capital formation almost on a one-for-one basis and leads to a deceleration in the growth rate of real GDP per head. On reasonable assumptions, the 8.4 percentage points rise in the ratio of British government spending to GDP between 1996-2000 and 2006-2010, a comparison that smoothes out the current recession, might be expected to slow growth by some 1¼ percentage points, say, from 2¾% per annum to 1½%. This is a supply side problem that cannot be cured by monetary policy.

It is also arguable that there has been too much concern about the impact of the, actually pretty paltry, forthcoming public spending cuts on wider UK economic activity. The explosion of fiscal indebtedness in many leading economies has led to much new international research into the extent to which increased government expenditure stimulates national output. Recent examples include: How Big (Small?) are Fiscal Multipliers?, by Ilzetzki, Mendoza and Vegh, International Monetary Fund working Paper WP/11/52, March 2011; Keynesian Government Spending Multipliers in the Euro Area, by Cwik, and Wieland, European Central Bank Working Paper 1267, November 2010; and The Impact of High and Growing Government Debt on Economic Growth: An Empirical Investigation for the Euro Area, by Checherita and Rother, European Central Bank Working Paper 1237, August 2010.

This research suggests that the extent to which extra government spending boosts or contracts GDP (which includes government spending by definition) depends on a range of factors. However, there was considerable evidence that cutting government consumption frequently led to expansionary effects elsewhere in the economy and not the negative ones that might be expected on the basis of naive Keynesianism. Incidentally, Cwik and Wieland found that this finding was true of so-called ‘New-Keynesian’ models once these incorporated forward looking expectations. Such findings mean that this research is not just a re-run of the Monetarist versus Keynesian ‘crowding-out’ debates of the Thatcher years. The ‘crowding in’ effects of public consumption cuts were especially marked when the cuts were announced in advance and where the economy concerned was open, had a floating exchange rate, and had a gross public debt stock greater than 90% of GDP. Britain meets all these criteria for an ‘expansionary fiscal contraction’, however oxymoronic that might appear to people who have not studied the literature.

The institutional separation of fiscal and monetary policy in Britain does not mean that they cannot feedback on each other or that a loss of credibility in one area cannot cross infect the other. It is hard to avoid the conclusion that the Bank’s credibility has suffered from the persistent overshooting of the inflation target over such a significant period. However, the financial markets have given the UK fiscal authorities the benefit of the doubt until now and assumed that the fiscal consolidation announced by Mr Osborne was running on track. One reason is that financial markets notoriously only concentrate on one thing at a time and bond investors have been fully occupied with the ramifications of the Greek debacle. However, the independent forecasts generated by the Beacon Economic Forecasting model suggest that, while falling, the ratio of Public Sector Net Borrowing (PSNB) to UK GDP will remain well above the highly-optimistic path set out in the official OBR forecasts (Editorial Note: the outlook for the public finances is discussed in more detail in Chapter 2 of the forthcoming IEA publication Sharper Axes, Lower Taxes: Big Steps to a Smaller State, edited by Philip Booth, to be published on 13th July).

The view that Mr Osborne is unlikely to meet his borrowing forecasts is supported by the recent £3.8bn upwards revision to the PSNB deficit in 2010-11 and the disappointing figures for the first two months of fiscal 2011-12. The UK will not be in a happy position if it simultaneously loses both fiscal and monetary policy credibility in the financial markets in, say, a year or eighteen month’s time. A modest upwards tweak to Bank Rate of say ½% – basically to show that the authorities care about inflation and the external value of sterling – seems an appropriate insurance against such a double-credibility loss. However, this assumes that the Greek crisis remains under control. The Bank’s Plan B, in a situation where the Greek crisis does get out of hand, would almost certainly need to include a QE2, since there are no shots left in the interest rate locker.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

A slow recovery of UK credit and monetary aggregates is underway. M4 lending growth (excluding securitisations) narrowed to minus 1.3% in April, with positive month-on-month growth for the fourth consecutive month. Other financial corporations expanded their balance sheets by 1.2% between March and April, whilst the household sector marginally increased its stock of mortgages. All other borrowing declined on a month-on-month basis as repayments continued to outstrip lending. M4 deposits have also strengthened, with financial institutions outstanding liabilities gaining 0.1% month-on-month, in both March and April, and the twelve month growth rate improving to minus 0.9%, up from minus 1.1% in March. The stock of retail deposits has continued to rise but there has been a slowing of pace since January, with the annual growth rate slipping to 2.7% in April. This is indicative of households reducing their propensity to save in response to a squeeze on their real disposable income. Wholesale deposits, on the other hand, remain in negative growth territory, but to a lessening degree.

Headline consumer prices rose by 4.5% in the year to May, breaching the official 2% target for the eighteenth consecutive month. Upward pricing pressures have become increasingly broad-based over this period, with core consumer price inflation at 3.3% in May (after reaching a record high of 3.7% in April). Supply-side inflationary pressures are permeating the economy. Some examples are: tools or equipment for the house or garden (11%), postal services (10.5%), household textiles (5.3%) and dry cleaning (4.6%). Although wage inflation remains subdued at present (total pay growth reached 2.2% in April), there are signs of growing inflation accommodation among large companies. Inflation expectations, as reported by the Bank of England’s/GfK National Opinion Polls’s inflation attitudes survey, remain elevated at around 4% for the near term, and above 3% for both the two-year and five-year horizons. The credibility of the Bank’s inflation target regime is disintegrating and a strengthening of second-round inflationary effects should be anticipated.

Despite the various setbacks in economic activity revealed by the data for recent months, the case for a Bank Rate increase remains intact. UK import price inflation soared to 7.3% In April. Further energy price increases are likely to induce sticker shock for headline UK inflation over the next few months. An immediate 50 basis point increase in Bank Rate is necessary to protect the UK from a scenario of further depreciation in the external value of Sterling and inflation accommodation.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: To hold Bank Rate and undertake further QE.

Recent domestic news on the UK economy has showed little change over the past month. That is to say that signs of weakness dominate, with some data weaker than others. Weaker data are related to consumer and government spending, like retail sales and the Confederation of British Industry’s distributive trades’ survey. Stronger data mainly relate to the export-oriented sector, with a softer bias to industrial production but still signs that orders are holding up.

Somewhat worryingly though, the M4 broad money supply data show that liquidity is still an issue, with the headline rate falling by 0.9% in the year to April. Crucially, the MPC’s preferred M4ex measure fell by 2% on a three-month-annualised basis. It has also been exhibiting a weaker bias over recent months. Indeed, this outcome prompted a mention in the MPC June minutes that further QE might be required. This was the first such mention by someone other than Adam Posen for some time. Not surprisingly, the housing data have not improved, with the lending, housing approvals and prices and elements all flat or negative month to month.

Meanwhile, the inflation data showed that price pressure remained, with CPI inflation staying at an annual 4.5% for May. Pipeline inflation also maintained its tight bias. None of this makes for easy decisions. However, the June MPC minutes showed little appetite for any change in policy and, arguably, showed a bias to staying on hold for longer, especially since the new member Ben Broadbent voted to leave rates on hold.

None of this matters for my vote per se as much as the fact that global trends weakened in the last month, with the risk of debt default in Europe closer and the International Energy Authority releasing oil from its strategic stockpile to help drive prices lower and ease global price and growth pressures. Overall, there are too many uncertainties to do anything other than leave Bank Rate on hold. Yes, there are supply price pressures, and a threat of prices rising further, but with fiscal tightening looking ominous and a global growth pause, it might be best to wait for longer before raising rates. Hence, the appropriate vote is to hold Bank Rate with a bias to using QE if money supply falls further. It is clear that the economy cannot yet withstand a rate hike. Nevertheless, as soon as it looks like it can, a rate rise will be necessary to ensure that inflationary expectations remain anchored. For now, though, expectations of future inflation are anchored and real wages seem likely to stay low for some time. This means that low rates can be justified for a while longer, in my view.

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 (Deloitte and 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), Gordon Pepper (Lombard Street Research and Cass Business School), 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 TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Following its latest quarterly gathering on 13th April, the Shadow Monetary Policy Committee (SMPC) voted by five votes to four to raise Bank Rate to 1% in May.

All four dissenting members voted to hold the official interest rate at its present ½%. There were various reasons why a majority of SMPC members wanted to raise Bank Rate. One was concern that the overshooting of the inflation target – when combined with the fact that the annual increase in the target consumer price index (CPI) was running 1.4 percentage points below the previous RPIX target measure rather than the 0.5 percentage points gap claimed at the time of the official changeover – was undermining the credibility of the monetary framework.

There was also concern that the present negative real interest rate was leading to a serious misallocation of capital, as well as doing injustice to savers. A third reason for wanting a rate hike was the belief that the monetary authorities would have more flexibility in both directions if Bank Rate was raised to 1% immediately and perhaps 2% to 2½% in the longer term.

There was also concern that high levels of public borrowing would prove more intractable than was predicted in the Budget, and that this could test the patience of the global bond markets at a time when sovereign risk concerns were escalating.

The main reasons that four SMPC members wanted to hold Bank Rate at ½% was the fear that the UK economic recovery was not yet firmly established together with the belief that the banking system remained so weak that there would be a long period of sluggish money and credit growth ahead and that this would seriously limit the scope for recovery. This meant that low interest rates currently existed alongside abnormally tight money and credit conditions, not just in Britain but in many other developed economies as well.

Minutes of the Meeting of 13th April 2011
Attendance:

Philip Booth (IEA-Observer), Jamie Dannhauser, Anthony J Evans, John Greenwood, Andrew Lilico, Kent Matthews (Secretary), Gordon Pepper, David Brian Smith (Chairman), David Henry Smith (Sunday Times-Observer), Akos Valentinyi, Peter Warburton, Robert Watts (Sunday Times-Observer), Trevor Williams.

Apologies: Roger Bootle, Tim Congdon, Ruth Lea, Patrick Minford, Mike Wickens.

Chairman’s comments

David B Smith opened the meeting by formally proposing a vote of thanks for Peter Spencer who had kindly stepped down to make way for the three new members who were attending that evening’s meeting for the first time. Peter Spencer had been one of the SMPC’s founder members in July 1997 and his many contributions were much appreciated. David B Smith then welcomed the three new SMPC members: Jamie Dannhauser (Lombard Street Research); Anthony J Evans (ESCP Europe), and Akos Valentinyi (formerly of the Hungarian Central Bank and now at the Cardiff Business School).

As there were more than nine potential voting members present at the meeting, the Chairman suggested that the discussion of everybody should be recorded but that only two votes should be taken from the three new members. He also suggested that this should be done in alphabetical order, since any method of choice was essentially arbitrary. This meant that Professor Valentinyi’s vote would not be counted on this occasion but that a slot would be reserved for him in the June SMPC poll. This would be conducted on the usual ‘first come, first served’ basis otherwise. The Chairman then invited Peter Warburton to give his assessment of the world and domestic economy.

The Monetary Situation
The International Situation – Tentative recovery in global monetary growth
Peter Warburton referred to his previously prepared charts and began his assessment of the international economy. The global recession had resulted in some rebalancing of current account imbalances, but the revival of capital flows to emerging markets in 2010 had propelled global gold and foreign exchange reserves to exceed US$10trn. The second phase of the US Federal Reserve’s Quantitative Easing (QE) policy – commonly referred to as QE2 – would continue through to end-June. However, the big news was the events in Japan, with the Bank of Japan making a huge liquidity response to the earthquake disaster. The growth of the Bank of Japan’s balance sheet was the magnitude of a QE3, with particular purchases of short maturities. On a superficial comparison, there had been a strikingly strong correlation between total US Treasury purchases by the Federal Reserve and global commodity prices. Calculations of US inflation expectations derived from the break-even rates on inflation-protected Treasury bonds (TIPs) show a sharp increase to 2.6%. However, world trade volumes had apparently extended their strong recovery from their 2009 lows. This was indicated by the growth in international freight volumes.

After a delay, a new global private sector credit cycle had begun in 2010 and seemed to be continuing. Nominal global GDP growth had waned but was still growing in the region of 7%. Global de-leveraging had continued, but at a slower pace. Most countries had reported a healthy growth of bank credit. However, there was a split between size and growth and between developed and emerging markets. The largest economies had shown the weakest credit growth and credit growth had been slower in the developed countries than in the emerging markets. Global money supply growth had shown signs of a modest recovery. De-leveraging had continued but the incipient threat from higher oil and other commodity prices was materialising. There was a strong perception that the US would be the last economy to raise interest rates, while the ECB appeared ready to move faster. However, this perception could easily be overturned: the ‘doves’ in the US Federal Reserve could not ignore the import-led inflation pressures indefinitely.

In response to Peter Warburton’s comments, Andrew Lilico and Philip Booth both questioned why the strong correlation that was obvious from the chart of QE2 and global commodity prices should be so widely ignored. There followed a short discussion about global monetarism and the transmission mechanism involved. This suggested that it was normal for financial markets and then commodity prices to respond to monetary ease well before consumer price measures. However, Peter Warburton felt that it would be difficult to draw statistical inferences from only two years of data. David B Smith said that it was widely accepted that investors went long of commodities when interest rates were below inflation. This was because the so-called ‘cost of carry’ of investing in commodities rather than holding cash became negative under these circumstances.

The UK Economy – Blame the weather for Q4 weakness Turning to the domestic economy, Peter Warburton noted that the severity of the cold weather spell last December might have subtracted as much as 1% from the level of GDP in the final quarter of 2010, rather than the official estimate of 0.5%. Since then, there had been a rebound in service sector output. Peter Warburton said that he expected a 1% rebound in growth in the first quarter of this year. David Henry Smith (Sunday Times-Observer) said that the monthly figures for construction had led to some down grading of activity in 2011 Q1. David B Smith said that he had done a lot of work on the quality of the national accounts data produced by the Office for National Statistics (ONS).The historic data contained what looked like clerical errors. He suspected that the ONS numbers were a highly unreliable guide to what was happening in the real-world economy and that it was necessary to treat them with a large pinch of salt.

Peter Warburton argued that the conventional monetary transmission mechanism remained dysfunctional. He said that the expectation of the Office for Budgetary Responsibility (OBR) in June 2010 – and that of many other economists – was that the pace of mortgage lending would quicken in 2011. However, despite a fall in the cost of fixed rate mortgages, mortgage approvals had sagged in recent months. Mortgage lending appeared disconnected from the price of credit, implying that other factors were rationing the supply of credit. More broadly, the UK has one of the weakest private sector credit recoveries in the world, despite record low interest rates. Trevor Williams said that borrowers that met the conditions of higher deposits were getting loans at low rates.

Akos Valentinyi and Andrew Lilico discussed the meaning of credit rationing and commented that combinations of deposits and mortgage rates constituted the price of credit and did not reflect credit rationing. Trevor Williams added that as a result of the crisis both borrowers and lenders had altered their respective risk preferences. Peter Warburton countered that more people were entering the labour force and employment had grown but first-time buyers had been frozen out of the market. Akos Valentinyi said that the backdrop of robust mortgage borrowing in the past had been one of rising house prices. It should not be a surprise that mortgage demand had not recovered as no one expected house prices to grow as rapidly as in the recent past. There was a brief discussion between David H Smith, Jamie Dannhauser, Andrew Lilico, and Phillip Booth about the driving factors and the dynamics of the housing market. Peter Warburton said that a combination of altered bank management objectives, the Basle III accord, and a plethora of other interventions by the Financial Services Authority (FSA) and the Independent Commission on Banking (ICB) had acted to constrain bank behaviour. Peter Warburton referred to the chart of the decomposition of the retail price index. This showed that the inflation rate of private sector goods and services had left its normal channel and was settling at a much higher level. Weakness in broad money growth showed no sign of reversing. This, again, was consistent with dysfunctionality in the monetary transmission system.

Peter Warburton summed up by saying that the stagnating monetary aggregates remained a concern, but that the UK economy was continuing to recover from the 2009 slump. UK visible trade figures for the first two months of the year showed an acceleration, which may signal the long-awaited boost from currency depreciation. Kent Matthews said that the basic story was that, because credit rationing existed and monetary conditions had been sluggish, a rise in Bank Rate would not have any effect on monetary conditions anyway. He said that you did not have to buy the credit-rationing story to argue for a rate rise. Andrew Lilico then asked Peter Warburton for his assessment of growth prospects in 2011, Would UK economic growth stagnate or accelerate? Peter Warburton said that he expected growth to be in the range of 1½% to 2% with capital expenditure and inventory rebuilding leading the way.

Discussion
Bank’s hopes of inflation falling back to target are misplaced
Andrew Lilico said that business cycle research suggested that one should expect a one quarter downturn in any recovery phase and by mid-year there should be signs of a normalisation of markets. He expected that the main driver of growth would be capital expenditure and that the prevailing doctrine that inflation would tend to fall back to target was simply wrong. Trevor Williams said that the global output gap was negative but small. Peter Warburton added that the gap argument was misleading. The output gap in most of Asia was closed. The way world prices had developed in the context of the supply-side means that inflation could persist even in the face of a negative output gap elsewhere. The Chairman, David B Smith, then expressed his worries about the British government’s fiscal position and questioned the patience of the global bond markets if the UK budget deficit overshot the official projections by as much as he expected. The Sunday Times observer, David H Smith, said that it was right to be concerned. It was less than a year into the coalition and already expenditures on defence and the NHS were being revisited. However, he did not foresee any immediate problems with the international bond markets.

Votes
The Chairman then asked each SMPC member present to make a vote on the appropriate monetary policy response. The votes are traditionally listed alphabetically rather than in the order they were cast, since the latter simply reflected the arbitrary seating arrangements at the meeting.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold.
Bias: To tighten.

Jamie Dannhauser stated that he voted for no change. The analogy he used was taking the foot off the accelerator rather than applying the brake. The real short rate may not be the best monetary indicator. All measures of liquidity in the UK, USA and Euro-zone pointed in the same direction. They were not consistent with the above trend nominal spending growth needed to hit the inflation target over the medium term. He added that the idea of a mechanical link between bank reserves and lending was inaccurate. The Bank will have plenty of warning of a rise in the money multiplier. Regarding the output gap, he suggested that there was a huge gulf between where the economy was and where it could have been had the crisis not come along. On the likely pace of global recovery, the forecasts produced by the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) appeared overly optimistic. He said that he was not confident that the recovery, both at home and abroad, had entered a self-sustaining phase. The legacy of the financial crisis would mean a long drawn out recovery.

Comment by Anthony J Evans
(ESCP Europe)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Anthony J Evans said that the Consumer Price Index (CPI) inflation target was not the only appropriate measure to look at. He said that he was uneasy about the shift in the target measure from the Retail Price Index (RPI) to the CPI. He added that monetary policy should not be too accommodative of fiscal policy. Spending cuts could spur growth. Low interest rates had resulted in a serious misallocation of capital. He said that he had no confidence in the exit plan from QE. This may not provide enough early warning to absorb the bank reserves that would otherwise feed into broad money growth.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate. Reactivate QE if negative monetary growth continues.
Bias: Neutral.

John Greenwood said that the key distinction to be observed in Peter Warburton’s charts was the difference between the emerging economies where broad money growth was accelerating and now reaching 14% to 16% on average (e.g. in Asia and Latin America), and the developed economies where broad money and credit growth was at historically low rates. Consequently, the revival in the emerging economies had been strong, with monetary expansion flowing from property and stock markets through to strong domestic demand and now rising inflationary pressures. Inflation in these economies was therefore likely to be much more embedded.

In developed economies, by contrast, deleveraging continued with the repair of balance sheets, resulting in historically low rates of broad money and credit growth. In these economies the inflation problem was mainly confined to imported commodities, or was due to the imposition of higher indirect taxes. Reported inflation would therefore diminish once commodity prices stabilised. Rising headline inflation in the UK did not imply any easing of monetary policy since interest rates were an unreliable signal of the tightness or ease of monetary policy. Currently, low interest rates existed alongside tight monetary and credit conditions. This was mainly because the demand for credit had fallen so much, but also because banks were reluctant to lend. While the process of deleveraging continued, there would be low growth. These conditions did not justify any increase in Bank Rate.

Comment by Andrew Lilico
(Policy Exchange and Europe Economics)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Andrew Lilico said that press commentary suggested that the Bank of England would need a reason to raise Bank Rate but, in fact, it needed a justification for keeping rates at a three-hundred year low. Over time, the automatic tendency should be for Bank Rate to revert to some ‘Wicksellian’ notion of a natural position. A small rise in rates will not make a big difference in the short term. However, it was better to raise rates now so that the jump will not be so great when the monetary authorities were forced to raise Bank Rate in 2012. He said that he expected quarterly growth to be in the order of 1% to 1½% by 2011 Q4, driven by an aggressive rise in investment spending. The Bank should have raised rates earlier and did not do so in February only because of the weak 2010 Q4 output figure. He said that the Bank of England would regret waiting too long. As it was, inflation targeting now had little credibility as a policy.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold.
Bias: Neutral.

Gordon Pepper said that Peter Warburton’s commentary had barely touched on the monetary situation. Although the current margin of spare capacity in the economy should be sufficient to stop the current increase in the price level from becoming inflation, money-supply policy should be in support. Given the risks involved, the current supply of money should not significantly exceed the current demand for money. Sluggish data for the money supply suggest that there is at present a monetary squeeze. However, this was misleading because the demand for money as a home for savings had collapsed. This saving demand for money depended on wealth and the rate of interest on bank deposits relative to the expected return on other assets, for example on equities, after allowing for perceived risk of loss. The current rate of interest on bank deposits was abysmal. The overall demand for money had fallen, possibly faster than the supply of money. The position was not clear. Additional evidence was needed.

Generalising, Gordon Pepper suggested that the gathering should suppose that the supply of money currently exceeded demand. Some of the excess would be spent on goods and services – which would stimulate economic activity – and some would be spent on assets, the prices of which would rise. Because financial markets reacted more quickly than the economy, a rise in the stock market preceded an economic recovery. The rise in equity prices was a necessary but not sufficient condition for economic recovery. (In the opposite case of a monetary squeeze, similar reasoning explained why the equity market had predicted five out of the last ten recessions!) Currently, the stock market had risen; it had bounced back nicely from bad news. If it had carried on falling, this would have been clear evidence of a monetary squeeze but the rise was insufficient evidence to argue that money supply should be tightened. The case has not been made for money supply to be either tightened or eased. The conclusion was that it should not be changed.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Kent Matthews agreed with the comment by David B Smith (see below) that uncertainty about the nature of the disequilibrium in the monetary sector was not a reason for doing nothing. The argument could be equally applied to the do something camp if policy is thought to be out pushing the economy in the wrong direction. He said that you did not have to buy Peter Warburton’s argument of credit rationing to agree with the policy conclusion of raising rates.

An indicator of where the market believes the economy was going could be gleaned from measures of inflation expectations. Both the short measure of inflation expectations collected in the Bank’s own survey and the longer term measures got from bond yields and indexed linked of equivalent maturities, suggest an edging upwards of inflation expectations. The reason why these measures were rising but lagging behind actual inflation measures was because the markets faced a ‘signal extraction’ problem. The Bank had not persuaded markets of the view that the rise in actual inflation was purely temporary. The probabilities that above target inflation was temporary rather than permanent were an indicator of the credibility of the inflation target. Kent Matthews agreed with Andrew Lilico that the credibility of the policy was under question. Creeping inflation expectations measured the loss of credibility. A series of small rises in interest rates starting now might restore credibility and circumvent the need to raise interest rates more sharply in the future. He voted to raise rates now with a bias to rise further.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%. Hold QE stock at present level.
Bias: To tighten gradually until Bank Rate is at 2% or 2½%.

David B Smith said that Gordon Pepper’s comments about disequilibrium money were most interesting. However, while he did not disagree with Gordon Pepper’s analytical framework he did disagree with the conclusion that Gordon drew from it. In particular, if there is no confidence on which side any disequilibrium between the supply of, and demand for, money existed, policy makers had two options - either to do nothing or, alternatively, move towards a neutral position. If the economy needed to be stabilised in either direction again, it was easier to do so from a position where Bank Rate was, say, 2½% than from the current ½%. There was scope for a strong global recovery because of the nature of the preceding crash – which was the result of a collapse in global supply chains and intermediate demand that was now being rapidly reversed. Britain’s small trade-dependent economy meant that the country would benefit strongly from the upswing in global activity. Britain’s real problem was its sclerotic supply-side. This supply-side problem had been made worse by excessive government spending and over-regulation during the past decade. Applying undue monetary stimulus to a supply-constrained economy would cause stagflation, not growth. Unfortunately, this was the situation that we were now in.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again.

Peter Warburton said that the prevailing structure of retail interest rates continued to bypass Bank Rate and that a reconnection might not occur until Bank Rate reaches 1½% to 2%. Hence, raising rates into this range should not have a detrimental effect on economic growth. The restoration of wholesale markets to their former health is an urgent priority if Bank Rate is to play a key role in the monetary transmission process again. The failure to normalise interest rates last year had cost the Bank of England its inflation-fighting credibility. The Bank had misjudged the inflationary climate and lacked the tools to restrain inflation expectations.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: To loosen via QE if economy weakens sharply in first half 2011.

Trevor Williams said that the depreciation in the exchange rate had not had stimulated the desired response from external demand but that it had generated inflation. In addition to the regions John Greenwood had referred to, Latin America and Africa were also growing more rapidly. World growth was rising. Although doing well, UK exports had not grown as fast as other countries. The effects of the crisis would take a long time to wear off and the recovery was a long process. There was still a negative output gap and wage inflation remained low. Monetary policy had to act as an offset. Commodity prices would come off the boil in time.

Further Comments by non-voting participants

The chairman then asked Akos Valentinyi, Philip Booth, and his near namesake from the Sunday Times if they had anything that they wished to add to the written record. David H Smith declined the offer but the other two contributed as follows.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise bank Rate to 1%.
Bias: To raise Bank Rate again.

Akos Valentinyi said that he had three points to make. First, strong investment spending with some contribution from exports would be the drivers for growth. Second, it was unclear how monetary data could be interpreted when massive deleveraging was going on. Third, inflation expectations were crucial. It signalled the serious intent of policy to influence private sector behaviour. It was also the case that central bankers have to signal their ‘conservativeness’. The main task of central banks was to defend the value of the currency.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)

Phillip Booth said that, while he did not wish to cast a vote, he did want to comment about the measure of inflation in the inflation target. Going back ten years, there were many technical and economic debates about how inflation should be measured. The Bank was then given the CPI inflation target and since then we have seen the increased politicisation of the inflation measure. The government has endorsed the CPI measure particularly for purposes that suited the government rather than taking explicit decisions to, for example, ‘under-index’ benefits. Furthermore, direct taxes allowances are to be indexed to the CPI whilst indirect taxes will be indexed to the RPI.

Policy response

1. A five to four majority of the shadow committee felt that Bank Rate should be raised by ½% to 1% on Thursday 5th May.

2. Of the five members who voted to raise rates, four had a bias to tighten further.

3. Of the four members that voted to hold Bank Rate in May, two indicated a bias to raise Bank Rate in the future.

Date of next meeting

Monday 18th July 2011.

What is the SMPC?

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

SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (University of Derby and Beacon Economic Forecasting). Other members of the Committee include: Roger Bootle (Deloitte and 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), Gordon Pepper (Lombard Street Research and Cass Business School), 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 TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

In its most recent e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by five votes to four to hold Bank Rate at its present ½% when the official rate setters meet on 7th April. All four dissenting SMPC members wanted to raise Bank Rate to 1%.

There were several reasons why the majority of SMPC members wanted to leave Bank Rate unaltered. One was concern that the UK economy would struggle this year as increased taxes and high energy costs damaged household budgets. A second justification for a rate hold was the continued weakness of the banking sector. This meant that there was little elasticity in the supplies of money and credit.

A third reason was the potentially malign effects of government spending cuts and increased National Insurance Contributions on employment. Finally, there was concern that the political turmoil in the Middle East and the tragic events in Japan would adversely affect the global economic environment.

The main reason that four SMPC members wanted to raise Bank Rate to 1% was the persistent overshooting of the inflation target and the fear that this risked undermining the credibility of the entire monetary framework. Another issue was that accelerating inflation meant that real interest rates were negative and falling.

This was unfair to savers but also inappropriate now that the worst phase of the financial crisis was over. As far as the 23rd March Budget was concerned, there were few strong views expressed by the SMPC membership. This was mainly because it was felt that the important fiscal initiatives had already been taken in 2010. However, one member feared that the upwards-revised official borrowing projections were still over-optimistic and that there could be financial-market difficulties once this became apparent.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold.
Bias: To increase Quantitative Easing (QE) as and when the need arises, but not yet.

All the signs are that the economy will struggle this year. The chief difficulties continue to be the pressures on consumers, the reluctance of banks to lend and the fiscal squeeze, only now getting under way. Inflation may well move considerably higher under the pressure of higher oil and commodity prices. But with average earnings not reacting, the pressure on consumers’ real incomes will be intense. In due course, this will bring underlying inflation much lower.

It is true that inflation expectations have increased considerably and that this does pose some sort of a threat. But the evidence from the period 2007 to 2009 is that such expectations are heavily influenced by the experience of inflation itself, without themselves necessarily having that much impact on inflation. Expectations should fall back when inflation starts to fall at the end of this year. The inflation danger will subside and the economy needs all the help it can get from monetary policy. Even a small rise in interest rates might deliver a serious blow to confidence.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold.
Bias: To hold Bank Rate and expand QE if M4 or M4ex money contract further.

Numerous recent research papers and books have shown that recoveries after severe banking and financial crises are almost invariably sub-par. The reason is that banks, firms and households have only limited means of repairing their balance sheets after a prolonged period of credit expansion. These means are: 1) raising equity, which is difficult for banks and firms and not feasible for households; 2) selling assets and using the proceeds to pay down debt, which is problematic after the bubble has burst; or 3) cutting consumption and increasing savings to pay down debt year by year out of savings, which necessarily undermines the strength of any economic recovery.

Added to this, in the current episode in the UK, government expenditure had already increased substantially ahead of the recession, and even more during the recession, further burdening the private sector with huge pre-emptive claims in the form of both taxation and public sector borrowing.

In these circumstances, the Coalition’s fiscal strategy has been designed to reduce the structural budget deficit and hence the amount of official borrowing as quickly as reasonably feasible. The Budget of March 23rd reaffirmed this broad strategy, without significant changes in target or timing, despite the downgrading of economic growth forecasts by the Office of Budget Responsibility (OBR). Against this sombre background, the question for members of the Bank of England’s Monetary Policy Committee (MPC) is how to set monetary conditions so as to fulfil the inflation mandate while facing so many headwinds to economic recovery.

If the underlying sub-par rate of growth was the only problem, the answer would be fairly simple – namely to keep monetary policy on an expansionary or accommodative course until inflation was forecast to approach its target. However, with Consumer Price Index (CPI) inflation now at 4.4% year-on-year and more than double the 2% target, the question is whether there has been a series of external shocks that cannot be handled adequately by tighter monetary policy, or whether there has been some inherent failure of monetary policy.

The mainstream line from the MPC has centred on the first of these explanations, offering four main reasons for the series of inflation shocks: the weakness of sterling, the external nature of commodity price increases, the extent of their pass-through by firms, and exogenous VAT and fuel duty increases. All of these do, indeed, provide a measure of comfort to policy-makers. Nevertheless, this debate misses some of the key, quantitative issues, given that inflation rates in the US and the Euro-zone are far lower than in the UK.

In my view, the primary failure of monetary policy was in the years preceding the credit crisis, and less so subsequently. Broad money growth in the UK has persistently exceeded that in either the US or the Euro-zone. For example, in the decade from 2001 to 2010, Britain’s M4 broad money growth exceeded the equivalent increase in the Euro-zone’s M3 by as much as 2.4% each year on average, generating a cumulative gain of 28% relative to the Euro-zone during that period. All of the excess money growth in the UK was concentrated in two sub-periods: 2004 to 2006 and in 2008 to 2010, the latter being during the crisis itself. The earlier error resulted mainly in a big increase in asset prices and has by now washed out of the system, but it should leave policy-makers with a strong lesson not to ignore or overlook sustained excess monetary growth in future.

The more recent error (2008 to 2010) occurred as a result of the re-intermediation of funds from the capital markets and from Structured Investment Vehicles (SIVs) and conduits, etc. back into the banking system and to that extent was unstoppable. But this simply pushes the problem back one step – why was such rapid growth of credit in the non-bank financial sector tolerated for so long? This highlights both the failure to control or adequately monitor the growth of credit and money-like instruments beyond the regulated banking perimeter, and the pro-cyclical tendencies inherent in a leveraged financial system.

Two issues remain relevant today – scale and timing. First, there was a substantial overhang of money and credit that had been allowed to build up, and was likely to emerge at some stage in either asset prices or goods and service prices. This is the underlying source of today’s inflation overshoot. Second, rapid credit growth in the broader UK financial system continued at double-digit growth rates until as recently as the second half of 2009, or less than two years ago; therefore, it should naturally be expected to impact prices in the economy during 2011 given the standard lags between monetary policy and inflation.

Money and credit growth rates, both inside the regulated banking system and outside it, have fallen dramatically in the past two years and no longer pose an inflation threat. Therefore, there is no need to raise interest rates now to slow money and credit growth. On the contrary, the problem is to ensure these growth rates are adequate to avoid a deflation problem in two years time. For this reason I vote to keep Bank Rate at its present ½% and to keep QE at the ready in case money and credit start to decline in absolute terms.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold.
Bias: Strong bias towards a ¼% rise.
The outlook for the economy continues to worsen. Unsurprisingly, the OBR, in their March 2011 Budget forecast, downgraded their GDP projections for 2011 yet again. Instead of the 2.3% growth forecast last June and the 2.1% forecast in November, they now expect 1.7%. Changes further out were minor, comparing the November 2010 and March 2011 forecasts. It should, however, be questioned whether this is a sufficient downgrade, given the very weak 2010 Q4 figure and the rather patchy evidence to date from the ‘Markit’ Purchasing Managers Index (PMI) surveys. These reveal that manufacturing, which makes up 12% of GDP, is doing well but that growth in services (70% of GDP) could be slowing. The OBR is forecasting 0.8% quarterly growth for 2011 Q1, which seems optimistic.

Whilst the OBR’s forecast for household consumption is commendably restrained, business investment is expected to be buoyant and net exports very positive. Given the persistence of a positive ‘output gap’ over the forecast period business investment could disappoint. Furthermore, whilst exports have grown well in recent months their growth rate has been outstripped by that of imports, acting as a drag on GDP, despite the weak pound. Given the modest expectations for growth in our export markets there is a real risk that net exports could disappoint also.

CPI inflation has continued to overshoot projections and was 4.4% in February. It is expected to rise to 5% by mid-year and the OBR expects it still to be as high as 4.2% in 2011 Q4. Much of the inflationary pressures have been driven by higher commodity prices. Here, there is more to come, as the turmoil in North Africa and the Middle East pushes up oil prices. Libya’s production is about 2% of global output and could arguably be replaced by other sources. Libya’s problems are, therefore, containable as far as the oil market is concerned. If supply were severely disrupted in the UAE or, even more drastically, Saudi Arabia, then such disruption would clearly have very major implications for oil prices and inflation generally.

Higher prices inflation is still not feeding into wage inflation to any degree. Thus, earnings growth was 2.3% including bonuses in the three months to January. Furthermore, the various surveys are suggesting that pay settlements might only pick up modestly in 2011. A significant ‘wage-price spiral is not expected to materialise in the foreseeable future, given the current economic uncertainties.

The Bank of England is caught between Scylla and Charybdis. In other words, the only choice available to it is between: 1) rising inflation and concerns over lost anti-inflationary credibility if no action is taken; and 2) damaging a fragile recovery through higher interest rates when the economy is also confronting fiscal retrenchment. The Organisation for Economic Co-operation and Development (OECD) recently advised keeping interest rates low, “for longer than investors currently think likely, even if headline inflation is significantly above target”. My central view remains that the Bank should start ticking-up interest rates fairly soon, not least of all to ‘normalise’ them away from the emergency ½% level agreed in March 2009. If the first quarter GDP figure, which is due at the end of April, suggests that underlying growth has resumed then May looks an appropriate time to increase Bank Rate to ¾%. However, Bank Rate should be held at its present level before then.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate to 1%.
Bias: To raise further and to hold QE.

Retail Price Index (RPI) inflation reached 5.5% in February, representing its highest level since the early 1990s, and it is set to rise even further over the coming months. This increase in inflationary pressure is confirmed by producer output price inflation, which accelerated to 5.3% in February, while producer input price inflation reached 14.6%. There is little need to point out what has happened to CPI, since that is merely a policy index and not, contrary to government policy on benefits and tax allowances, a cost-of-living index. Since the Bank of England has long since ceased to have any interest in keeping to target, CPI has ceased to be of relevance.

Broad money growth is very weak, with M4 actually shrinking in the year to January and M4ex recording only 2.1% growth. However, the scope for broad money to expand rapidly and suddenly if there is GDP growth is considerable, reflecting the quadrupling of the monetary base as a consequence of QE and other liquidity measures. This means that the current very low broad money growth does not indicate that there is little scope for inflation to accelerate over the next eighteen months under present circumstances. This contrasts with more normal times when broad money growth can be an excellent indicator.

There is definitely scope for GDP growth to accelerate. Following last December’s negative snow-blip, the survey data indicates some modest return to growth in the first quarter of 2011, although probably less than 0.5%. The second quarter of 2011 may not involve much faster growth, as tax rises and spending cuts commence in earnest. Thereafter, however, one might expect rapid investment-driven growth, unless there is a meltdown in the Euro-zone, China or Japan, or political turmoil in the major Arabian-peninsula oil producers. This investment boom will be driven by: 1) a calming down in corporate bond markets; 2) catch-up on investment foregone during the recession, once it is clear that double-blip will not turn into sustained malaise; 3) exploitation of negative real interest rates; 4) use of large corporate sector cash balances, and 5) the desire to get into real assets ahead of further rises in inflation. Quarterly growth could be, in the region of 1% to1.5% by the second half of 2011.

Much commentary focuses upon the consumer, as if consumption-led growth were the only possibility, or government spending, as if more government spending made economies grow faster, rather than slower! However, we do not need rapid consumption growth or government spending growth - or, indeed, rapid export growth - to have a rapid growth in GDP. Falling investment was a key driver of the contraction in GDP. Investment expansion can be the key driver of recovery.

There is almost no reason to believe that inflation will ease in the way that the Bank hopes. Why, if inflation is 6%-odd, Bank Rate is below 2% (implying negative real interest rates), and the economy is growing at 1% to 1.5% per quarter, should inflation be expected to fall back? The Bank's case rests on the output gap. However, the output gap is difficult to observe ex ante at the best of times - even if it may be useful as a tool for ex post analysis of policy. Large recessions typically have an adverse effect on the sustainable growth rate but we can only observe how large the impact has been many years later. Some pre-recession investment becomes stranded in a large recession (i.e. it was ‘mal-investment’) but we have only a tenuous basis for estimating by how much. This means that estimates of the output gap depend on adjusting something difficult to observe at the best of times, to take account of a change in the sustainable growth rate that we can only guess at. This then has to be adjusted downwards by a further guess at the amount of capacity ‘permanently lost’. Consequently, the output gap is almost useless as an analytic tool under current circumstances even if it may have some value in placid economic conditions.

Furthermore, output gap analysis neglects the point that, following a very deep recession, as well as there being a levels constraint driving inflation - i.e. once we are above capacity prices rise because of scarcity - there may be a rate constraint in that the economy can only add additional capacity at a certain rate without that creating its own forms of scarcity. Output growth in the second half of 2011 and early 2012 could well impinge upon rate constraints - the UK economy will struggle to expand at 1.5% without that being inflationary.

Altogether then, although it is no longer possible to have any clear idea what basis the MPC has for decision-making, it has clearly long-since ceased to be anything to do with any inflation target. One can only assume that the Bank should be conceived of as exercising a discretionary approach. However, the economy faces a brute inflation problem next year that even a discretion-exercising central bank with no nominal anchor should care about. There is no point in trying to prevent that now; it would not be possible to raise Bank Rate to the 5%-odd required without inflicting a further terrible recession. All we can do, for now, is to try to keep pace with inflation as it rises through 2011. This would reconnect Bank Rate to the monetary transmission mechanism and place the authorities in a position where the rises are a little less steep when the serious work of raising interest rates comes in 2012. In this context, I note that the OBR's Economic and Fiscal Outlook for March 2011 included a scenario (paragraphs 3.117ff) in which CPI inflation peaked at 4.5% in the third quarter of 2011, but starts rising again in early 2012, eventually rising back above 4.5%. The OBR forecast was that, under this scenario (which I consider too optimistic) Bank Rate would average 4.8% in 2012 and 6.1% in 2013. In 2012, Bank rate will need to rise very aggressively - much more aggressively than financial markets or households are expecting. The sooner we start acting, the less of a surprise it will be when we act later and the less steeply rates will later need to rise. The time to start is now.

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

The tension posed by the strong inflation pressure and the anaemic economic recovery mounts with every set of monthly figures. It is now an understatement to say that this poses a dilemma for the MPC. Although the reasons for this situation are plain to see, there is little consensus about the best way of handling it.

The money and credit markets remain depressed following the crunch and will continue to hold back the recovery. The retrenchment in the public sector will have a similar effect. At the same time the strong recovery in Emerging Asia, together with tension in the Middle East and a series of terrible natural disasters, has pushed up commodity prices across the board. World prices for food, fuel and fibres are now working through to the consumer inflation figures with a vengeance.

In the bad old days, this would have triggered a vicious wage-price spiral. But this time it has been totally different. The workforce realises that it would be futile, or rather counterproductive, to try to compensate for this by demanding higher wages. The median settlement has drifted up a bit, as wage freezes have ended in the private sector, but it is still running at around half the rate of CPI inflation. The paradox is that high inflation is a deflationary force, hitting household disposable income spending hard in this situation, a reality that most people are coming to accept. The Chancellor, instead of worrying about runaway inflation, is concerned about the impact on hard pressed families, desperately trying to find a few crumbs of comfort for them in the Budget. It not just families that have been caught out by the squeeze: the OBR and other forecasters have been busy revising their growth figures down as inflation has risen.

It is not clear how much further the boom in commodity prices has to run. Talk about a ‘super-cycle’ sounds very much like the ‘new paradigm’ that was used to justify the excesses of the dot-com boom. Historically, commodity prices are mean-reverting, though that is probably no longer true of oil prices. Fortunately, they only need to stabilise for the effect on headline consumer price inflation to wear off, allowing this to gravitate back to the low underlying rate. This year’s increases in indirect taxes will wear off in exactly the same way next year. Indeed, the Budget cleverly postponed the hike in fuel duties to next January, when the echo effect on the CPI will provide plenty of cover for additional increases in duties.

While there seems to be some measure of agreement about the nature of our predicament there is little agreement about what to do. On the one hand it has been suggested that the effect of indirect tax and commodity prices is temporary and that there is nothing that the MPC can do about it in any case. Domestic cost inflation, like the economy remains depressed. On the other hand, it has been argued that the MPC is damaging the inflation framework by allowing inflationary expectations to increase and that sterling commodity prices can be influenced through the effect of interest rates on the exchange rate. I am firmly in the first camp.

There is no need to be too concerned about rising inflation expectations as long as they do not provoke a rise in wage inflation. Moreover, with the economy so depressed, I doubt that base rates would have much purchase over the exchange rate. The last time we were saddled with a depressed economy and base rates were stuck at a lower bound – when we were in the Exchange Rate Mechanism in the early 1990s – Bank Rate increases proved entirely counterproductive. The markets could see that they would simply depress the economy further. The economy and, eventually, the pound only recovered after we removed the lower bound by leaving the system.

It is a pity that we could not kick the lower bound away this time. Had we been able to lower real interest rates faster initially, without relying on rising inflation to do the job, I do not think we would be in this predicament now. QE was arguably effective and allowed monetary policy (like diplomacy) to be continued by other means. However its effects remain unclear. Lower interest rates would surely have had a more obvious impact. I would not raise interest rates now, but wait until there were clear signs that the economy was taking the retrenchment in its stride. An increase in Bank Rate would intensify the pressure on households (especially those with tracker mortgages) and further weaken the recovery. It could also backfire badly in the foreign exchange markets once traders could see the effect on the housing market and the high street. Despite its uncertain impact, I would also revive the QE programme if the weakness in economic activity persisted.

(Editorial note: Peter Spencer was a founder member of the SMPC in 1997. He has now generously volunteered to step down from the SMPC in order to make way for the three new members of the committee who will be joining in April. The Institute of Economic Affairs and the other SMPC members are deeply grateful to Peter Spencer for his contribution to the work of the committee over the past fourteen years.)

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%; hold QE at present level.
Bias: To raise Bank Rate again.

The Bank of England is usually reluctant to change Bank Rate in the months each side of a Budget, in case their actions are seen as an implied criticism of the Chancellor’s measures. It would, correspondingly, be a major surprise if there were to be Bank Rate change at the 7th April MPC meeting. It is also arguable that the Bank is so far ‘behind the curve’, where inflation and the money-market ‘swaps’ rates that drive lending costs are concerned, that raising rates in April would indeed be a ‘pointless gesture’. The main reasons for wanting to increase Bank Rate now are to demonstrate that the monetary authority remains seriously committed to its inflation target and to prevent accelerating inflation leading to an unwarranted further reduction in the real rate of interest, which is already highly negative. In terms of natural justice, also, it is hard to see why savers, people buying annuities, and private-sector pensioners should be robbed of the fruits of a lifetime’s savings through a covert inflation tax in order to make life easier for buy-to-let speculators, the financially improvident, and a feckless political class who have come close to losing control of the national finances. While there may be a tactical case for holding Bank Rate this month, it would certainly have been preferable if the MPC had chosen to half normalise Bank Rate – by which is meant raising it to a figure of around 2% to 2½% - during the autumn of 2010 before the latest VAT hike, had pushed up inflation and weakened household living standards.

The 23rd March Budget measures were no big deal when viewed superficially, largely because the main strategic decisions had already been taken in the June 2010 ‘emergency’ budget and the 22nd November 2010 government spending review. However, there were two aspects of the 2011 budget that give rise to longer-term concern. One was the upgrading of the projected Budget deficit in 2011-12 and subsequent years, which looks rather like the continual borrowing slippage observed under the previous government. The international bond markets have given the Coalition the benefit of the doubt so far. However, they may not be prepared to do so in a year or eighteen month’s time if public borrowing is not palpably falling in line with the official forecasts. In that case, the incipient sovereign-debt crisis that would have hit the UK financial markets last summer if a Labour government or Liberal-Labour coalition had been the electoral outcome will have been postponed, not averted, and the Conservatives and Liberals will take the blame.

The second negative aspect of Mr Osborne’s March 2011 Budget was the resort to Gordon Brown style populist fiscal attacks on North Sea oil producers and the banks, including overseas banks operating in London who have received no financial support from the British taxpayer. Such arbitrary imposts are inconsistent with due process and the rule of law and exacerbate the perceived political risk for people who are contemplating investing in Britain. It is also odd, from an energy self-sufficiency perspective, to take measures that will reduce the supply of home-produced oil and natural gas, while increasing the demand for fuel by squashing the planned duty increase, when the Middle East is in turmoil and nuclear power looks less attractive because of events in Japan. The present coalition seems to have a tin-ear for the effects that its policies are having on the incentives to supply goods and services in Britain, just as the monetary authorities appear to be blissfully unaware of the adverse impact that their regulatory proposals are likely to have on the supplies of money and credit to the non-bank private sector.

The Coalition government has been strongly criticised by the political opposition and state spending lobbies for the alleged excessive speed and size of the so-called public expenditure cuts, even if the cash value of total general government spending is still officially predicted to increase from £665bn in 2009-10 to £763bn in 2015-16. This means that these are not cuts as this term would be understood by a private-sector manager facing a normal cash-constrained Budget. However, the question that no-one has dared ask is whether the public spending retrenchment over the next few years will be sufficient to maintain fiscal credibility at a time when UK monetary policy credibility has been badly compromised by persistent inflation overshoots, if not lost entirely.

Having run the March Budget measures and the 29th March UK national accounts and balance of payments data through the Beacon Economic Forecasting (BEF) model, it is hard to see how the Coalition can achieve its borrowing intentions over the next few years, even if the economy grows broadly in line with the official predictions. On a ten-year view, it is possible to foresee a broad balance emerging on the Public Sector Net Borrowing (PSNB) definition by 2017-18, with growing surpluses emerging thereafter. However, the PSNB is expected to come in slightly worse in 2011-12 than the £145.9bn officially projected for 2010-11 before it starts falling away from 2012-13 onwards. This fall is also noticeably slower than the one shown in the official forecasts. This is partly because of a disagreement about the taxable capacity of such a highly-socialised economy as Britain’s. In logic, the government cannot tax itself. With general government expenditure amounting to 53% of the factor-cost measure of GDP in 2010-11 – albeit, officially projected to drop to 45% by 2015-15 – the private sector tax base is simply too small to generate the tax receipts that Mr Osborne is relying upon. Furthermore, many of his tax initiatives, such as the hike in VAT, appear to have made the public finances worse not better. However, it is also not obvious that the cash expenditure projections in the official OBR projections are realisable, even if one takes the volume projections – which are given up to 2016 Q1 on the OBR website – as given. This is partly because the official projections appear to assume a much smaller cumulated increase in the cost of general government consumption by 2015-16 than one would expect on the basis of historic relationships.

Finally, and having consistently voted for an increase in Bank Rate to 1% since February 2010, there seems to be no point in changing this recommendation now, even if there seems very little likelihood of a rate hike in April. The longer the required monetary normalisation is delayed, the greater the risk that, when Bank Rate does go up, it will do so dramatically and in a way that does far more collateral damage than if the Bank had acted in good time. The outcome of the current official approach to both fiscal discipline and monetary rigour – which looks uncannily like the ‘establishment Keynesianism’ of the 1960s and early 1970s – will presumably be the same mix of weak growth and disappointing inflation that got to be called stagflation. It will be instructive to see the financial market’s verdict on this policy mix in a year or two’s time.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%; no extension of QE at present.
Bias: To raise Bank Rate to 2% by end-2011.

Measured either in terms of the current or the expected rate of inflation, UK real interest rates have fallen in recent months to leave this aspect of the policy stance even looser than before. The commencement of nominal interest rate increases up to around 100 basis points would merely reset the policy stance to where it was six months ago. The argument over MPC policy is between those who desire an even looser stance and those who desire, at a minimum, the reversal of recent policy loosening.

Notwithstanding some gradual improvement in the growth of the adjusted monetary aggregates, the UK has one of the weakest private sector credit and money recoveries in the world. In a recent comparison for fifty countries, only Ireland displayed weaker bank credit growth. It has been obvious for some time that the overall stance of the Bank of England towards the credit and capital markets is much tighter than could be inferred from the level of interest rates. In 2004-05, prior to the final, dramatic expansion of Value-at-Risk (VAR) in the UK financial system, monetary financial institutions (MFIs) issued £50bn of net capital per annum and other financial corporations another £50bn. The current rates of annual net issuance are £14bn and minus £24bn.

Without going into detail regarding the timetables for the adoption of Basel III, the Financial Services Authority’s Liquidity Directive and the withdrawal of Special Liquidity Scheme and Credit Guarantee Scheme funds, it is becoming clear that the complex messages contained in these policies and directives have strangled the effectiveness of low interest rates for the UK economy. Bank Rate is merely one element of the UK monetary policy stance and probably the least significant at present. Quite simply, the Bank of England is operating a policy of credit rationing towards the banking and other financial sector. The only reason that the UK has any prospect of economic growth in 2011-12 is that the corporate sector is able to finance its own capital requirements from internal sources.

Mortgage approvals have slackened off over the past year; the house price recovery has petered out and prices are softening. Despite the lowest effective mortgage rates in modern history and a first-time buyer mortgage repayments ratio back to its long-run average, few deals are going through. The Bank has taken us back to the credit policies of the 1970s prior to financial de-regulation. Until this mutually conflicting policy mess is resolved, the Bank Rate vote has huge psychological, but little operational, significance. Nevertheless, my vote is for an immediate increase of ½% to 1.0%.

Comment by Mike Wickens
(Cardiff Business School)
Vote: Raise Bank Rate to 1%.
Bias: To hold after the ½% rise.

In recent months, I have argued several times that interest rates must be increased if the inflation target of the MPC is to be taken seriously. The immediate aim should be to reverse the depreciation of sterling in order to reduce imported inflation, which is the main reason why UK inflation has been above target. In other words, the transmission mechanism is via the exchange rate, and not output or the cost of capital. Over this period, CPI inflation has steadily increased and now stands at 4.4%. As a result, the public’s inflation expectations are naturally rising and indexed contracts will soon cause costs to increase. Yet the MPC has done nothing about this, on the grounds that the additional inflation is temporary and is outside their control.

To add to the confusion, the Chancellor has just confirmed that the inflation target will remain at 2%. What are we to make of this? The obvious answer is that either the MPC is mistaken about the temporary nature of inflation – which is what the evidence shows - or that the monetary framework has changed but this has not been announced publically. Why else would the Chancellor be content to receive without serious comment the series of letters received from the Governor explaining why inflation is above target, and still confirm that the target is 2%?

If we assume that the objectives of monetary policy are changed, then the whole debate about what interest rate to set is changed too. The new aim seems to be to subordinate targeting inflation in favour of economic growth. The Government and the Bank seem to be hoping that the public have not yet realised that the change has taken place and so will not affect inflation expectations. The de facto new policy objective is not unreasonable in the current circumstances. It is similar to that of the US Federal Reserve, but not the European Central Bank which is still a strict inflation targeter. It does, however, raise an old question: is it better for the wider economy if the government distorts prices – in this case, the real interest rate – rather than allow market forces to set the correct prices? This is a re-run of the Hayek-Keynes debate of the 1930s.

Government intervention is expected to result in a misallocation of resources. In particular, a low interest rate generates little incentive to save as real interest rates are currently negative at around minus 4%, but investment – if the finance were available – would be stimulated and the cost of government debt finance is kept low. According to the interventionist position, this is an argument for the long run whereas the policy problem is to stimulate the economy in the short run.

The problem with adopting a new flexible inflation targeting remit in the current circumstances is that, whatever view one takes about the effectiveness of government intervention, it would have to take the form of fiscal, and not monetary policy measures, as interest rates are near the zero lower bound and QE has proved not to increase lending to the private sector. Hence, even if the Bank were given a new remit to be a flexible inflation targeter, monetary policy would be ineffective as a way of stimulating the economy. To summarise, the MPC refuses to try to control inflation and is powerless to assist in stimulating a recovery. It therefore does nothing. It might be better if the MPC stuck to its original remit of controlling inflation via the exchange rate by raising interest rates.

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

What are we to make of the message for interest rates in the latest UK data? On the surface, the evidence is clear and unequivocal, inflation is rising and so interest rates should rise. After all, the reason that Bank Rate was cut to ½% two years ago was because the economy was faced with the prospect of a contraction of at least 5% and, possibly, double that. Now, price inflation for February was up by 4.4% on the year and RPI was rising by 5.5%, some of the fastest increases since the early 1990s. In the meantime, the international economy is recovering, with the US growing by 3% currently, Germany by 3.6% in 2010 and the emerging markets expanding once again by between 4% and 10% per annum. In addition, the UK economy expanded by 1.3% last year, ending one of the worst recessions since the Second World War.

Underneath the recovery, however, all is not well. Domestic demand in the UK is still very weak, with real consumer disposable income set to drop again this year, after falling in 2010. Unemployment is likely to start to rise as government cut backs - confirmed in the March Budget - start to bite. Indeed, the Budget growth rate forecast of 1.7% for this year was mainly generated by a net trade contribution of 1%, something that seems highly implausible against the small positive contribution of just 0.2% in the end quarter of last year and more recent trends. It is not that manufacturing exports are not rising, they are, and boosting manufacturing output by 6% year on year in January. It is just that imports are rising even faster. With manufacturing accounting for some 13% of output, its expansion is not fast enough to pull the whole economy along, as consumers are retrenching and government spending is set to fall. Money supply growth is rising on the government's preferred measure, but is still at the lower end of the 4% to 6% range judged necessary to ensure growth of at least 2% a year.

Historically, one of the risks of price inflation is that it leads to a spiral in wages as workers demand, and get, higher nominal wages to compensate them for rising consumer prices, this is then paid for by firms raising their prices, which in turn leads to workers demanding more pay, thus setting off a vicious inflation spiral that can only be ended at great cost in employment by swingeing rises in interest rates. If that is the risk, then the earlier interest rates start to rise, the lower they may then end up. But this does not seem to be what is happening at the moment. With pay roughly stagnant, higher prices are instead reducing spending power and so slowing the recovery. If the economy was buoyant and demand was strong, then there would be a real threat that higher inflation would result as firms paid workers more. However, the evidence is that this is not happening and, moreover, seems unlikely to happen in the near future.

Taken together with the uncertainty around the impact of the Middles East, Japan, and ahead of fiscal tightening, I think rates should be left at ½%. Once it is clear what is happening to demand, then I believe that rates should go up – probably, later on this year. For now, the recovery is not secure enough and there are too many deflationary forces at work at this delicate stage of the recovery cycle.

Note to Editors

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly 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 (Deloitte and Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Policy Exchange and Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Peter Spencer (University of York), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

Forthcoming membership changes

Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School) and Akos Valentinyi (Cardiff Business School) will be joining the SMPC in April 2011 while Peter Spencer will be retiring after fourteen years as an active member.

In its most recent e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by six votes to three to raise Bank Rate to 1% when the official rate setters next meet on 10th March. All three dissenting SMPC members wanted to hold Bank Rate at its present ½%.

The SMPC members advocating a ½% increase in Bank Rate did so for three main reasons. A repeatedly mentioned one was the threat to the credibility of the UK’s counter-inflation framework if the Bank went on ignoring persistent overshoots of the inflation target. The concern was that it would eventually require a more aggressive and disruptive monetary tightening if credibility was lost than if Bank Rate went up immediately.

Three SMPC members also questioned the Bank’s reliance on a closed economy ‘output-gap’ model of inflation rather than an open-economy model in which sterling had a major role to play in determining the price level and was a crucial transmission mechanism through which monetary policy affected the economy. The third concern amongst the SMPC hawks was that accelerating inflation was covertly and inappropriately reducing the real rate of interest, and that this could itself lead to a self-feeding upwards spiral in the rate of price increase.

One explanation of why other SMPC members thought that it was better to hold Bank Rate was the apparent weakness of UK activity in late 2010. Nobody doubted that the negative fourth-quarter growth figure was distorted by December’s severe winter weather. However, the doves believed that there had been either a ‘growth pause’ or a small fall once the weather distortion was removed.

The counter view was that reduced oil production, a worsening in the trade deficit on real non-oil exports, and a growth in the negative national accounts discrepancy had also distorted the figures and that real private-sector home demand was still recovering at a satisfactory pace. Other reasons for wanting to hold rates were the slow growth of broad money and concern about the possible consequences of the government’s fiscal retrenchment.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold.
Bias: Strong bias to a ¼% rise.

Over the last two to three months, the economic outlook has worsened in two very obvious ways. The final quarter 2010 GDP data were very disappointing, even after discounting the impact of the well-publicised bad weather. There were expectations that the Office for National Statistics (ONS) might have revised the preliminary estimate in a favourable direction in its second estimate. However, the opposite happened and the Government statisticians now estimate that GDP fell by 0.6% in the quarter. Within the components, household consumption and fixed capital formation both slipped back – both affected by the weather. However, it is noteworthy that the growth of household consumption was less than 1% in 2010 as a whole, because consumers’ real incomes were squeezed by prices outstripping earnings and higher taxes. Government consumption was the most buoyant component in the final quarter, but this is set to reverse as fiscal retrenchment begins to squeeze the public sector this year. Net exports continued to disappoint in the quarter (and indeed for 2010 as a whole). Exports growth was commendable, but was outstripped by the increase in imports. On present form, it is hard to see quite how this component of demand will deliver the contribution to GDP growth over the next few years that the Office for Budget Responsibility (OBR) expects.

Indicators so far available do suggest that there was some bounce-back in activity in January. But how much of this was ‘noise’, and how much an improvement in underlying activity, is impossible to say at present. In the meantime, unemployment is rising. It was some 44,000 higher in 2010 Q4 than in Q3. Unfortunately, inflation has also taken a turn for the worse, mainly reflecting rising global commodity prices. The turmoil in North Africa adds to the uncertainty over oil prices. Consumer Price Index (CPI) inflation was 4% in January and the Bank’s forecasts suggest that it could rise towards 5% in forthcoming months. Higher indirect taxes have also added to CPI inflation. The ONS’s estimate of year-on-year CPI inflation excluding indirect taxes (CPIY) was just 2.4% in January, though this does look on the low side. Nevertheless it is clear that the increase in prices inflation is being driven by factors outside the Bank of England’s direct control.

The worry is, of course, whether higher price inflation lifts medium-term inflation expectations and/or wage settlements. On the former the Governor of the Bank was tantalisingly Delphic at his February Inflation Report conference. “The experience of above-target inflation may materially push up longer-term inflation expectations. Or it may not. Only time will tell” he said. On the latter, earnings growth has remained subdued but recent surveys suggest that pay settlements might pick up modestly in 2011. I do not expect a significant ‘wage-price spiral’ to materialise in the foreseeable future, however, given the current economic uncertainties.

The Bank of England is in a dilemma, torn between a weak real economy and above-target inflation. My central view is that the Bank should start ticking-up interest rates fairly soon, not least of all to ‘normalise’ them from the emergency ½% level originally agreed in March 2009. If the first quarter GDP figure (due out at the end of April) suggests that growth has resumed, then May looks an appropriate time to increase Bank Rate to ¾%. However, and before then, I vote to keep the official discount rate at its current ½%.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate to 1%.
Bias: To raise and to hold QE.

Monetary policymakers face an unenviable task, and lack adequate guidance. Broad money growth picked up a little towards the end of 2010, but was still low at 2.3%. The economy contracted by 0.6% in the end quarter of last year and yet we have inflationary pressures that are partly, though by no means wholly, accounted for by an increase in the velocity of circulation of money. The US Federal Reserve's second phase of quantitative easing has set off a commodity scramble amongst developing countries, with oil and food prices rising. These rising food prices have then been a contributory factor to the civil unrest in the various Arab states, feeding back into further oil price increases.

The UK could, of course, have insulated itself against import price inflation by tightening so much that the pound appreciated. However, this might have come at the expense of net trade and thus even less growth through the course of 2010 than we actually saw. Furthermore, Britain has just commenced upon a very significant fiscal contraction, with spending scheduled to fall by close to one fifth, relative to GDP, over the current Parliament. This fiscal tightening should have been accompanied by additional quantitative easing, from June 2010 onwards, but the natural window was missed. It is easy to understand why the Monetary Policy Committee (MPC) has felt paralysed from acting in either direction - neither raising interest rates nor doing additional QE, when in fact it probably should have done both. Doing additional QE would have been difficult from a presentational perspective with inflation above target and some growth being observed through mid-2010, whilst raising interest rates would have been difficult to justify when the economy fell back into contraction.

The MPC cannot be expected to manage everything about the economy alone. Under the operational independence framework for the Bank of England, it is supposed to be set an inflation target by the government that it then attempts to meet. But the inflation target in the UK has failed, in four key ways. First, it has produced a huge asset price cycle to which the framework had no response. Second, the top-end of the target was effectively redefined in 2007, and then all-but continuously exceeded thereafter. Third, a monetary policy framework only has meaning if it constrains policymakers to actions that they would not pursue absent the framework. However, the UK's inflation target has not constrained the MPC at any meeting since the summer of 2006. Finally, the only putative advantage of an inflation target over a price-level target is that an inflation target can be changed each year. However, it has become politically almost impossible to vary the target - missing the target has become preferable to resetting the target to a level at which it constrains action. The consequence is that the target has become degenerate.

For some years now - but especially in 2008, 2010, and 2011 - the government of the day has been setting the Bank targets of 2%, with an error band of 1% either side, that almost nobody considered it a good idea for the MPC to try to adhere to. The MPC has duly made no attempt to prevent inflation being above 3%. Then, and in letter after letter, Mervyn King has written to Chancellor after Chancellor stating that inflation is above 3% because it would have been a bad idea to try to keep it below 3%. And Chancellor after Chancellor has accepted that that was fine - not a single admonishment for consistent missing of the inflation target has come from any occupant of No. 11 Downing Street. The UK's inflation target has become nothing more than an explanatory device. When has it constrained policy since 2006? What monetary policy decision has the Bank taken since 2006 that it would not have taken if it had not had an inflation target to meet? In what sense is the UK's inflation target a framework of constrained discretion, as an inflation target is supposed to be? The essence of the credibility of a target is not that economic agents have a vague generalised sense that the Bank cares, a bit, about inflation. The credibility of a promise is that one will try to keep the promise whether one wants to or not. The inflation target has no credibility in precisely this sense: that nobody believes that the MPC will attempt to try to stick to the target if it does not want to. This is because repeated and sustained experience tells us that the MPC does not try to stick to the target when it is inconvenient to do so and that there are no consequences for the MPC from missing it.

Something must give if credibility is to be restored. And it is crucial that credibility is restored, for there will need to be a concerted effort to get inflation down in 2012, with serious rises in interest rates – these will need to be much, much faster than is currently priced in or even discussed - and the cost of getting inflation down, in terms of unemployment rising and GDP lost, will be less if credibility is greater. The least attractive, indeed, disastrous, course would be to attempt to enforce the target already in place. It would probably be best – and, indeed, most feasible and straightforward - for the government to replace the inflation target with a price-level target, declare that the new price-level target would be enforced, and then enforce it properly. Alternatively the government could, for 2011, adjust the inflation target to something that it does believe it would be appropriate for the MPC to try to deliver upon, and then enforce the target.

These are matters for Mr Osborne. For now, the MPC must decide how to proceed with the unconstrained discretion it possesses. Much press discussion is very confused. There is no-one that wants actually to tighten policy - which would entail raising real interest rates. Even were there to be a 1% rise in rates by mid-year, inflation-adjusted interest rates by then would still be lower than in mid-2010. The only issue before us is how much lower we permit real interest rates to go as inflation surges up. In my view, we should take the opportunity of falling real interest rates to try to get nominal rates back towards their natural floor at about 1.5%. This is not about tightening, for two reasons, at least. First, raising rates to 1.5% would only return them to a natural zero level, reconnecting Bank Rate to the monetary transmission mechanism and reducing the margin subsidy creates by below-floor Bank Rate. Second, even raising interest rates by 1% will not keep pace with the rise in inflation. Let us begin with a half-point rise, and take matters from there.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: To raise Bank Rate again. QE to remain on standby in case the economy turns down further.

There are plenty of good reasons for why a rise in the rate of interest should be delayed. The economy is far from recovered from the depths of the recession. The pace of recovery in 2010 was much less than was originally thought with the fall in output in the last quarter being worse than the flash estimate. Consumer spending was flat in the fourth quarter but importantly business investment fell back reversing the gains in the third quarter and hope that QE was beginning to filter through to domestic demand and the real sector. Earnings growth, at around 2%, remains muted in all sectors so underlying inflation shows no immediate prospect of taking off, and the news from the job market is not an encouraging one.

So why would an interest rate rise at this juncture be at all appropriate? The argument for a rise is one of credibility. If the Bank of England believes that the factors driving up headline inflation are temporary, they have failed to get this message over to the markets, which have signalled a systematic rise in inflation expectations. The mounting expectations of an immediate interest rate rise may have halted temporarily with the news of the worsening economy. However, anticipations of a rate rise will gather pace at the next sign of cost pressure. The problem for the Bank is that the costs of a rate rise are already building up through the expectations effect. Sterling is strengthening and investment possibly delayed. The Bank of England is in the unenviable position of overseeing an economy that is adjusting to a rate rise that is yet to happen and will take the flak for a policy that is still waiting in the wings. It might just as well try and salvage what little credibility it has left and raise rates now instead of waiting any longer.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1% and hold QE.
Bias: To raise Bank Rate further and reverse QE.

Various commentators have been focusing on the potential weakness of the economy as a reason for holding interest rates down, and therefore have been thinking of monetary policy purely in terms of the short-term trade-off between inflation and growth. However, this trade-off is dominated in the Bank's remit by the requirement to keep inflation on target over the medium term. This responsibility comes ahead of any short-term objectives for growth or unemployment. The inflation target is the Bank's only objective technically. It has to satisfy it and only then, if it does so, may it look at issues of growth and unemployment. The problem for the Bank is that it has now failed to satisfy it for three out of the last four years. Hence it has failed to keep inflation on target 'over the medium term'. In the current year and probably next year it will again fail almost certainly, and by a wide margin; hence its failure is now systematic.

What we are witnessing is a nasty outbreak of 'time-inconsistency' in which the Bank argues that it should allow this failure to continue because if it were to bring inflation down it would damage growth. It uses weasel words like 'inflation is caused by factors beyond its control'; these words are nonsense since it can perfectly well bring inflation down with the factors that are under its control. Inflation in total is under the Bank's control - full stop. However, what the Bank has decided is that inflation above target does not matter compared with growth.

This is a bit like an alcoholic saying that one more drink does not matter because in the medium term he will be sober. But of course an alcoholic ought to obey rule-based behaviour, if he wants to be cured - i.e. in his case not to drink at all. The Bank needs to remember it is subject to a rule, i.e. that it has to control inflation to a target systematically, 'over the medium term'. Now, of course, it says it is doing this by promising to do it in two years' time. However, sincerity about the future is not enough. For it to be behaving according to this rule, it must be seen on average to achieve its target. This it is not doing. Hence, inflation expectations are rising and commentators such as Jeremy Paxman on the TV programme Newsnight publicly question whether the target is meaningful and is told by reputable economists that it is 'not binding'.

This is dangerous stuff; far more dangerous than whether growth will be somewhat reduced by money tightening now. Look at it this way. The UK has spent thirty-odd years of sweat, lost output and general political capital getting inflation under control and getting agreement from society as a whole that inflation should be kept down at 2% as a primary target of government policy. Ordinary people who do not understand economics have come as a result to accept this as an axiom of economic policy, not to be questioned. We call this state of affairs 'credibility' of a fundamental economic policy, much as we treat the credibility of the 'rule of law', another basic institution of UK society. We obey and implement laws with a literalness and seriousness that leaves continental observers incredulous; for them EU law for example is partially disregarded, but here it is treated on a par with all our law - because the rule of law is a strong institutional pillar of our society.

The Bank is putting this institutional capital at risk with its casual talk of current trade-offs and its endless violation of its target. It may be – since we do not really have a good model of how credibility is created and destroyed - that it will get away with it. Or it may be that it will, in a matter of a year or two, completely destroy the framework that has been erected with such pain over three decades. The point is that this risk is just not worth taking. This is why in this particular comment I will not talk about the short-term outlook. I will simply argue on the credibility issue that it is time for the Bank to take no further risks with it and do something. As it happens its first moves to raise rates will not be very painful; but they will be far from a 'futile gesture'. Rather they will be a cheap down payment on a new direction in which they give notice that inflation will be brought down and in a matter of months not years. We need a return to rule-based behaviour by the Bank. The next move in rates should be a rise of ½%, with a bias to raise further. There should be no further QE, with a bias to reversal.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold Bank Rate.
Bias: Hold QE in reserve.

The Governor of the Bank of England has wider responsibilities than those as Chairman of the Monetary Policy Committee, for example, to prevent the UK from following the path to financial crisis trodden by Greece and Ireland. Whilst it is legitimate for members of the Monetary Policy Committee (MPC) to differ from their Chairman, they run the risk of being impertinent if they criticise the Governor. Are they also going to criticise the International Monetary Fund (IMF) and the US Secretary of the Treasury for indulging in UK party politics?

Commentators in general may also be criticised. The quarterly GDP figures are an erratic series; the first published estimates are frequently revised; and the revisions may be substantial. Commentators who blow from hot to cold about the economic outlook because of a fluctuation in the latest data are ridiculous. A legitimate worry, however, is that inflationary expectations will rise because people fail to distinguish between a jump in the price level and inflation. It is certainly the job of the MPC to stop the former from turning into the latter but monetary policy cannot prevent an increase in UK prices that is caused by commodity prices rising in US$ terms - this is distinct from that part of the rise in sterling terms that is due to a fall in the external value of the pound, which is affected by monetary policy.

The current amount of slack in the economy, fiscal tightening and little money available for expenditure on goods and services should be sufficient to stop the jump in the price level from becoming inflation. In the past action to manage expectations that conflicts with reality has usually been proved wrong in other than the short run. In my judgement there is not yet sufficient evidence to justify an increase in interest rates. The data for wage settlements have, for example, not yet responded to the increase in the price level. I side with the Governor.

For those who disagree, an extreme case clarifies the issues. Suppose that chaos in the Middle East extends to major oil wells, which close down, leading to an acute shortage of oil, the price of which doubles. Should the MPC really increase interest rates because of the resulting rise in the UK consumer price index at a time when the shortage of energy is threatening a very serious worldwide recession?

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%; hold QE at present level.
Bias: To raise Bank Rate again.

Nothing puts a military alliance under more pressure than the prospect of defeat. It is not surprising that some dissonance has arisen within the MPC given how badly the war against inflation seems to be going. Fortunately when they invented the jury system – which is the essential model for the MPC - the Anglo Saxons produced an institution that could accommodate a wide range of views while delivering a clear verdict at the end of the process. A ‘not in front of the children’ attitude to free and open debate may be more comfortable for the officials involved. However, it does not make for better policy making. Consensual ‘group think’ is always dangerous. The British economy would be in a better position if an earlier generation of MPC members had questioned the restricted inflation targeting mandate and the unduly limited range of monetary policy tools allocated to them under the 1998 Bank of England Act. The nation would also be better off if dissident MPC members had requested prudential increases in capital and liquidity requirements in the mid 2000s, when there were clear signs that the credit excesses of the Heath-Barber and Lawson booms were being repeated. However, the most likely result of increasing capital and/or liquidity requirements - now that it is far too late to avert ‘boom and bust’- will be a damaging increase in credit rationing, which will make the recovery from the recession even more problematic.

At the heart of the debates on the MPC seems to be a divergence of view as to whether Britain should be predominantly regarded as a small, open, trade-dependent economy or as a large closed economy, similar to the US or the Euro-zone. In practice, all economies are a hybrid of both, so the debate may be about the relevant weightings to attach to each approach. In a small, open economy, the logarithm of the domestic price level should eventually settle to equal the logarithm of the overseas price level minus the logarithm of the exchange rate. This seems to be the analytical approach underpinning the views of the MPC’s most hawkish member, Andrew Sentance. In a pure closed economy, there is no exchange rate to worry about, and the output gap arguably becomes the dominant influence, if one is prepared to ignore the stock of money. Even so, the different time-series properties of inflation and the output gap mean that the output gap can only affect the rate of change in inflation, not inflation itself. This need not be an insurmountable problem because inflation can then be related to the cumulated past history of the output gap. However, the output gap approach can still be rendered irrelevant if there are frequent large shocks to aggregate supply. People have also questioned whether the output gap model of inflation can be applied to a primarily service orientated economy, where the concept of full capacity is more nebulous than in old-fashioned metal bashing.

In practice, the world economy appears to be so integrated that the output gap works at the level of the aggregated world economy, to the extent that it operates at all, while the UK itself lies closer to the small, open economy paradigm than it is to the large closed economy model. The two implications are that: 1) the purely domestic output gap is unlikely to have a strong effect on British inflation; and 2) the external value of sterling has a powerful influence on UK prices in the long run. This does not mean that both the output gap and the open-economy determinants of the price level – overseas prices and the exchange rate – cannot be included in one ‘error-correction’ model (ECM) of the UK price level. Simply relying on the output gap alone, however, leads to a castrated and incomplete ECM in which neither the price level nor the inflation rate are properly determined. Such a model will almost certainly understate inflation when the pound is trading well below its equilibrium level.

From a tactical perspective, it is a pity that the Bank of England did not move towards a ‘half-normal’ Bank Rate of, say, 2% to 2½% in 2010 before the VAT hike took effect and recent turmoil in the Middle East had pushed up the price of oil. Such a hike would probably not have trickled too far down the money-market yield curve given how far Bank Rate appears to be a slack variable in the system. However, it would have demonstrated that the MPC was committed to its inflation target and might have helped to tether inflation expectations. However, that is water under the bridge. The question now is where we go from here.

The first point is that recent inflation figures are pretty poor, even if one does not accept that CPI and RPI inflation have been understated because of the failure to properly allow for clothing price increases (see: page 39 of the February 2011 Bank of England Inflation Report for details). As they stand, the official ONS figures show that: annual CPI inflation was 4% in January; both the all-items RPI and RPIX were 5.1% up the year, and the yearly inflation in the ‘double-core’ RPI, which excludes mortgage rates and house prices, was 5.2%. Much of this inflation can be arguably attributed to higher indirect taxes. The CPIY measure, which excludes indirect taxes, was only 2.4% up on the year in January, while its retail-price equivalent, RPIY, was 3.8% higher. However, the ‘Y’ measures are virtually unknown to the general public and are irrelevant where wage bargainers, domestic savers and overseas investors are concerned.

One reason for not wanting to raise Bank Rate is the apparently weak fourth quarter national accounts data published on 25th February, which revised the weather-distorted contraction in real GDP in 2010 Q4 from 0.5% to 0.6%. However, on closer inspection the figures are not as poor as they look. Furthermore, the large negative contribution from net exports at a time when world trade is bouncing back and sterling is highly competitive suggests that the UK economy is badly supply constrained. This poor supply elasticity has almost certainly resulted from the damage done to the productive base by a decade’s feckless tax-and-spend policies.

In particular, while headline GDP rose by only 1.3% on average last year, and by 1.4% ‘through the year’ (i.e. fourth quarter to fourth quarter), the non-oil component of GDP showed equivalent increases of 1.6% and 1.7%, respectively, and the volume of private domestic expenditure – which had contracted by 10.9% in 2009 – showed an annual average increase of 3.6% in 2010 and an increase of 4.6% through the year. The main reason growth was not faster was the deterioration in the deficit on real net exports. This knocked 1 percentage point off the average growth of real GDP in 2010 and 0.9 percentage points off the growth rate through the year. One odd thing about the ONS figures is the growth in the negative statistical discrepancy between 2009 and 2010, which reduced growth by 0.4 percentage points on both an annual-average and through-the-year basis. It may be unduly harsh to claim that anyone who trusts the initial ONS estimates probably also believes that fairies live at the bottom of the garden. However, there are grave problems with the national accounts, which are illustrated more fully in the Power Point presentation Uncle David’s Chamber of Data Horrors (available from www.xxxbeaconxxx@btinternet.com).

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%; no extension of QE at present.
Bias: To raise Bank Rate further.

The intensification of global inflationary pressures has added to the UK’s embarrassing departure from the official inflation objective. Over the next three months, the headline CPI inflation rate might reach 5%. The rationalisations provided by the Governor of the Bank of England in a recent speech have fuelled the debate over the seriousness of the inflationary outbreak and accentuated the divisions within the MPC. The latest Inflation Report conceded little to the contrary view that higher inflation was liable to persist without corrective action. To assume that Bank Rate will be raised in line with the profile implied by the money market curve is to believe that MPC members are unified in a course of action. The intransigence of some members suggests that there should be no presumption that the MPC will secure a majority in favour of a Bank Rate rise at all soon.

For my part, much of this intransigence is the result of overconfidence in the model used by the Bank of England to simulate the behaviour of the UK economy. I believe that this model is woefully inadequate in several respects and provides an unreliable guide to likely inflation outcomes in the UK. The re-ordering of the global economy and the advent of supply chain management in the 1980s calls for a radically different characterisation of the production process, the management of inventory, the role of modern logistics and powerful new technologies of supply management and control. It is little short of insulting to persist with the archaic characterisation of the economy as a giant factory, as implied by the output gap paradigm.

The modern reality for Britain, as it will become for other developed economies, is that large global corporations or domestic conglomerates dominate the distribution of goods and services and manage their supply chains so as to retain pricing power and preserve profitability. The forces of effective competition have been in secular decline for more than a decade, but it has taken the global credit crisis to reveal their inflationary overtones. Currency depreciation has highlighted the transformation in supply elasticities that have accompanied the new supply-side paradigm.

The MPC is heavily compromised in its policy actions by its adherence to the failed paradigm of the negative output gap. Having refrained from the commencement of the normalisation of Bank Rate during 2010, the decision has become complicated by the erratic data points in the fourth quarter of last year. The very weak reading for UK GDP in 2010 Q4, of a minus 0.6% quarterly change is distorted to an unknown degree by severe December weather. A better sense of the underlying growth rate of the economy will not be known until the latter part of April. While economically justified, interest rate increases have become politically unpalatable. The Bank of England has missed its moment to address inflationary concerns and the consequences of this neglect may well become a cause of great regret in future. Sterling is a vulnerable currency and its fortunes should be carefully observed. My vote remains for a ½% increase, with an end-year target of a 2% Bank Rate.

Comment by Mike Wickens
(Cardiff Business School)
Vote: Raise Bank Rate to 1%.
Bias: Hold at 1% in short term. Rates will need to rise further in longer term.

The key issue for the MPC continues to be how seriously it regards its remit to achieve a target inflation rate of 2%. For five consecutive quarters, the Governor has had to write to the Chancellor to explain why inflation is above 3%. Each time he has argued that inflation is only temporarily above target and is expected to fall back soon. The current Inflation Report admits that this might take over a year. It is significant that, in its response to the Governor, the new government has not objected to inflation being above target. With the recent increase in VAT, perhaps the Chancellor feels he is not in a strong position to do so. Nonetheless, there is increasing concern that inflation expectations are rising, something that would undo much of the past achievements of the MPC.

There are two main reasons why inflation has risen over the last year or so. One is the VAT rise. The other is the increase in commodity prices. In other words, demand, which has been weak, is not the cause, although the Inflation Report shows that it is strengthening and expected to continue to do so. The intellectual basis for inflation targeting is the use of interest rates to control demand. As demand is not currently a problem, the MPC appears to be sitting on its hands and waiting for something to happen. There is, however, an alternative strategy. As inflation is largely due to the price of imported commodities and these are priced in foreign currency, mainly the US$, the obvious policy is to appreciate sterling by raising interest rates. In the process this would reverse the fall in sterling over the last two or more years that has made UK inflation so vulnerable to commodity price increases. An appreciation of sterling might reduce the demand for exports and hence output. Nevertheless, with UK export markets recovering strongly, especially in the Far East, income growth abroad will almost certainly dominate the higher cost of UK exports.

To judge by the amount of discussion of the role of sterling in the current Inflation Report, the MPC does not appear to have taken into account that the UK is an open economy with a floating exchange rate. Nor does it seem to realise that its own model shows that the exchange rate channel is the most important in the transmission of monetary policy in the short run. Those with a long experience of the UK economy know this only too well. The US is a flexible inflation targeter and has a relatively closed economy in whose currency most commodities are priced. This means that it does not provide a good exemplar where the UK is concerned. In the longer term, the correct response to a worsening terms-of-trade is to adjust to relative prices. These may entail currency depreciation. However, and in the short term, a country like the UK that is in principle a strong inflation targeter should appreciate the exchange rate by raising interest rates. Doing nothing either suggests a lack of understanding of how an open economy with a floating exchange rate should behave, or that the MPC does not take its remit seriously.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold Bank Rate.
Bias: To ease via QE.

Despite the legitimate worries about price inflation - after all, the headline rate was 4% in January, twice the target rate of 2% - the steady drift towards increasing interest rates will make a bad situation worse. The economy is not growing and the fear about inflation could lead to a rise in rates that could lead to renewed recession. In particular, it seems highly unlikely that the economy is on the verge of an inflationary episode to rival that of the 1970s or 1980s, even if this is being obscured by the shift in relative prices that is globally underway. That having been said, a number of events in the last few days and weeks ought to give pause to the growing cacophony of noise to raise rates. Start with the latest GDP figures for 2010 Q4, which showed after the recent revisions a larger fall of 0.6% rather than the initial 0.5%. This meant that, real GDP contracted by 0.1% in the fourth quarter without the ‘snow effect’ and not the flat outcome reported earlier.

The indications for the first quarter of this year are that there is some growth bounce back underway, following the weather-related shock of 2010 Q4, but that its extent is highly uncertain and less than the assumption of 0.8% growth made in the Bank of England’s February Inflation Report. Instead, the economy may essentially still be stagnant in 2011 Q1 when adjusted for the ‘snow effect’ of 0.5%. Of course, those that worry about inflation will not be swayed by arguments about growth.

The point for those that want to see higher Bank Rate is that price inflation is above target and has been so consistently for some time. This is felt to be undermining the authority of the MPC because it is not being seen to react to its remit to keep inflation at 2% in the medium term. And this will lead to its job being harder in future, meaning that it will have to keep interest rates higher for longer than otherwise to keep inflation on track. However, this analysis is the wrong way round, in my view. Reacting to relative-price shifts by pushing the economy into renewed recession would: 1) lead to a fall in domestic prices as internal deflation is used to offset imported price inflation; 2) undermine the MPC’s position and make its job harder as its apparent lack of proportionality leads to calls for it to be reformed, and 3) perhaps, cause the Bank to be deprived of its operational independence to set rates if it loses public trust.

Unfortunately, another shock is coming from the soaring oil prices as a result of the democratic movements sweeping away dictators in the Middle East and North Africa. With economies in the advanced nations weak, the effects of the higher oil prices should be more deflationary than inflationary. The risk, though, is that it is the fear of inflation that might win out, because oil prices are likely to keep consumer prices in the UK higher for longer at a time of heightened concern.

With consumer confidence declining, business confidence is at risk of a fall and with it industrial output. Unemployment is set to be under upward pressure as the fiscal squeeze starts in earnest from April and May, meaning that the private sector may not be able to take up the slack. With wage inflation weak, and under pressure from rising unemployment, there is little risk of a wage-price spiral. What is more, with no possibility of a looser fiscal policy in the form of tax cuts or spending increases to offset the cut in income from the rise in oil prices, only monetary policy is in a position to take the strain. In practice, this means keeping official rates where they are in the face of the rise in oil prices. Money supply growth and the pace of UK export growth do not seem sufficient to offset the deflationary headwinds the economy currently faces. For these reasons, Bank Rate should remain on hold.

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 (Deloitte and Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), John Greenwood (Invesco Asset Management), Ruth Lea (Arbuthnot Banking Group), Andrew Lilico (Policy Exchange and Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Gordon Pepper (Lombard Street Research and Cass Business School), Peter Spencer (University of York), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds TSB Corporate Markets). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that nine votes are cast.

Forthcoming membership changes
Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School) and Akos Valentinyi (Cardiff Business School) will be joining the SMPC in April 2011 and Peter Spencer (University of York) will be retiring after fourteen years as a member. Peter Spencer’s valedictory submission will appear in the April SMPC poll.

Following its quarterly gathering on 18th January, the Shadow Monetary Policy Committee (SMPC) voted by five votes to four to raise Bank Rate to 1% on 10th February. The four minority SMPC members all voted to hold Bank Rate at ½%.

The five SMPC members who wished to increase Bank Rate did so for three main reasons. One was the threat to the credibility of the UK’s counter-inflation framework if the Bank continued to ignore persistent overshoots of the 2% Consumer Price (CPI) inflation target, especially when the inflation rate perceived by many people was the 4¾% or so recorded by the various retail price measures. Another was the view that the aggregate global economy was closer to overheating than depression.

The third reason for a rate rise was the belief that the depreciation of sterling had not been an exogenous ‘Act of God’ but that it, instead, reflected the relative laxity of Britain’s monetary stance compared with other countries.

Several factors explained why four SMPC members thought that this was not a time to raise Bank Rate. One fear was that the economic recovery was so anemic that it would be de-railed by the additional business uncertainty generated by even a small hike in Bank Rate. Another concern was that the UK banking system was so fragile that it would be incapable of generating sufficient money and credit to support recovery if the official rate went up.

Both doves and hawks agreed, however, that the Basle III proposals on bank regulation were perversely pro-cyclical and risked reduced global supplies of money and credit leading to a renewed global recession. Finally, there was a fear that the hike in Value Added Tax to 20% would squeeze living standards even further, depressing household consumption.

Minutes of the Meeting of 18th January 2011
Attendance: Philip Booth (IEA Observer), Roger Bootle, Tim Congdon, Ruth Lea, Kent Matthews (Secretary), Patrick Minford, David Brian Smith (Chair), David Henry Smith (Sunday Times Observer), Peter Warburton, Trevor Williams.

Apologies: John Greenwood, Gordon Pepper, Peter Spencer and Mike Wickens.

Chairman’s comments
David B Smith began the meeting by stating that it was time to recruit some new, younger members to the SMPC, which had now been in existence for almost fourteen years with most of the founder members still actively involved. He had no particular bias as to whether the new members should be primarily academic or business economists, provided that they had youth on their side. Some of the more senior members had already indicated that they were willing to step down, if suitable replacements could be found. He thought that it was now time to start the recruitment process before the present membership ended up on the great Monetary Policy Committee (MPC) up in the skies. It was agreed to invite two new members, one from the academic side and another from the professional side. Two names were put forward and the relevant Curriculum Vitae circulated. He then called on Trevor Williams to provide his analysis of the global and domestic monetary situation.

The Monetary Situation
The International Situation – Global activity positive surprises
Trevor Williams referred to his prepared slides on the SMPC Quarterly Meeting – Recovery Slows as Inflation Rises. (Editorial note: these can be obtained from Trevor.williams@lloydstsb.co.uk) He referred to the first slide which showed forecasts for world GDP, Trade and UK GDP and outcomes to date, which all showed better than expected results. Global GDP had bounced back along with a turnaround in global money supply growth. Both the US and Euro area showed a strong pick up in nominal GDP growth but the money supply, while reviving, remains weak. Emerging markets showed strong monetary growth and inflationary pressure. However, figures from the Organisation for Economic Co-Operation and Development (OECD) showed that the current recession was on a lower recovery path both from ‘normal’ ones and even previous recessions associated with financial shocks. The worst of the credit conditions problems may be over, however. Both American and Euro-zone credit conditions had improved since late 2008. Nevertheless, spreads continue to widen, albeit at a decreasing rate. Bank lending in the USA remained tight. Poor loan availability also continued to be an issue for the UK.

The UK Economy – output growth will weaken sharply in first quarter
Referring back to the charts, Trevor Williams said that broad money growth was declining but Consumer Price Index (CPI) inflation was accelerating. A comparison with historic UK recessions showed that the recovery path of the current recession was above that of the 1930s and now matched the same phase of the 1979-83 business cycle. The Lloyds-TSB Business Barometer survey pointed to a slowdown in the final quarter of 2010 and sluggish growth this year. One reason was that household real income was falling although consumer spending had shown some revival. Exports have helped the recovery and order book surveys suggest that good export performance will continue. However, inflation is rising and inflation expectations based on the Lloyds Consumer Barometer survey had risen to a two-year high. The Purchasing Managers Index (PMI) survey of input prices suggested that inflation was unlikely to abate in the coming months. Firms were raising prices to rebuild profit margins and there was ample evidence of spare capacity in the economy. Fiscal tightening will see the loss of 450,000 public sector jobs by the end of 2014. While bond-market yield curves were signalling a rise in short rates, consumer confidence remained weak and house prices had started to fall again. Importantly, the inflation figures were not all what they seemed. The CPIY inflation measure, which stripped out the effects of indirect tax changes on the CPI, was bang on target at 2% and RPIY was at 3.5%. There was plenty of spare capacity in the economy. Now was not the time for the MPC to raise rates.

David B Smith then thanked Trevor Williams for his presentation. The Chairman added that recession comparisons using GDP as the main measure may not be all that helpful now that government has such a large share of it. The OECD’s figures showed that general government expenditure was 51% of UK GDP last year, with the equivalent figures for the US, Euro-zone, and OECD in total being 42.2%, 50.7% and 44.6% respectively. These were at least twice the ratios observed in the US and Britain in the late 1930s, for example. David B Smith then invited Patrick Minford to record his comments as he knew that Patrick had to leave early. Peter Warburton added that, with a return to fiscal balance a remote prospect, he anticipated that indirect taxes would rise even further.

Discussion
Fiscal tightening and QE to increase broad money growth
Patrick Minford said that he was unmoved by Trevor’s excellent presentation and that he remained consistent with his previous vote set out in the January SMPC report that Bank Rate should be raised by ½% to 1%. He did not think that the money supply figures were a good guide currently to the availability of liquidity; new external finance was now being raised largely from equities, and small firms appeared to be participating in this. He remained hawkish and posed the question, what rate of inflation would persuade the MPC to raise rates? He remained concerned about the Bank’s loss of credibility and rising inflation expectations.

Roger Bootle said that there were three arguments regarding the direction of Bank Rate. First, except for the actual inflation numbers, all the other indicators suggested that there was no underlying inflation problem and other numbers were foreshadowing weaker inflation figures. Unit labour costs had gone up with the productivity collapse at the low point of the recession. However, cost pressures were now easing as productivity recovered. Second, the money supply figures indicated a very weak economy and Quantitative Easing (QE) had not changed that. The third - and the only meritorious argument - was the one about credibility. However, he said that the Bank acting now would not do anything for its credibility but could damage the wider economic recovery.

Peter Warburton said that he took a different view. For too long, the Bank of England had relied on an unobservable variable – ‘excess capacity’ – as an argument for inflation to come down. Its own inflation forecasts had been serious under-estimates for two years. The latest story from the Bank, that hidden spare capacity would re-emerge in the economic upturn, was no more credible. It was time to switch from the old paradigm of capacity utilisation to the modern paradigm of supply-chain management. Global supply chains were pregnant with global inflation, he asserted. Private-sector inflation was coming back and people were getting used to it. An inflationary psychology was taking hold again in the UK. From the monetary side, the question was one of monetary disequilibrium, which related to the levels of money. On the evidence of the past year, there had been sufficient liquidity in the economy to allow the GDP deflator to hit a 5% annual pace. Inflation was observable and rising and demanded a policy response.

Kent Matthews said that he gave much greater credence to the credibility argument than Roger Bootle. He accepted the monetary argument of Tim Congdon and others that the costs of raising Bank Rate might be severe, given the weakness of broad money growth and that recovery was not fully established. The only good news was the recovery of manufacturing exports; a sharp appreciation of sterling could damage this improvement. It was a finely balanced position but allowing inflation psychology to take hold could pose even greater long term costs. The problem was that economic agents faced a signal-extraction problem about the source of world energy and commodity price inflation and were unable to distinguish between absolute and relative prices. It was indeed the case that real factors in the emerging markets would raise energy and commodity prices and these would be relative price effects with no long-term inflation consequences. However, the global monetary argument also had force and this could explain the rise in energy and commodity prices. The signal extraction problem could lead to imperfect responses by markets. This explained the upward creep in inflation expectations to some extent. The Bank could not afford to allow inflation expectations to rise, even if the rise was based on imperfect information in its view. It was better for the Bank to be seen to be leading the market rather than reacting to it. Even though the financial markets were discounting a rate rise, in the near future, by acting sooner rather than later, the Bank could go some way towards restoring its credibility.

Ruth Lea said that inflation was driven by high commodity and rising input prices caused by the depreciation of sterling as well as the impact of increased indirect taxes. The Bank could not be expected to do anything about these factors. Unemployment would begin to rise. Indeed, it was already edging higher, and would stay high. She said that she would be surprised if pay settlements would respond. She said that Bank Rate should not be raised unless wage settlements start to rise.

Tim Congdon said that the enforcement of the Basle III rules would lead to the shrinkage of commercial banks’ assets, and weaker monetary growth than would have been the case otherwise. The Euro-zone had its problems with the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain). However, he did not think that there would be a double-dip recession in the UK. There was no serious medium-term problem of inflation at current rates of broad money growth.

Votes
The Chairman then intervened to suggest that the voting and discussion had become unduly conjoined, with people making their rate recommendations along with the discussion. In order to restore discipline, he asked each SMPC member present to make a vote on the appropriate monetary policy response. The votes are listed alphabetically rather than in the order they were cast, since the latter simply reflected the arbitrary seating arrangements at the meeting.

Since only eight members of the shadow committee were present at the meeting, Philip Booth was co-opted to vote as a ninth SMPC member, in order to eliminate the need to call for an additional vote in absentia. The Chairman traditionally votes last, so as not to influence the votes cast by the other members of the shadow committee.

Comment by Philip Booth
(Institute of Economic Affairs and CASS Business School)
Vote: Raise Bank Rate to 1%. Increase QE when appropriate.
Bias: Neutral.

Philip Booth said that he was reminded of the 1970s when the argument was continually made that inflation was caused by special ‘cost-push’ factors. The Bank of England is supposed to target the CPI and CPI has been above target for some time - it is wrong to blame specific ‘one-off’ increases in prices for this. Philip Booth added that we should also be wary of dealing with problems such as slow economic growth - which may have other causes - by loosening monetary policy; this was another mistake of the 1970s.The rise in commodity prices cannot be completely divorced from monetary looseness, either in the UK or elsewhere. There was also a valid concern about the credibility of the UK monetary framework. He voted to raise Bank Rate by ½%.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold.
Bias: Neutral on Bank Rate; do more QE.

Roger Bootle said that the problem with Philip’s argument was that the timing was all wrong. The depreciation of sterling occurred alongside the banking crisis and QE came later. He voted to keep Bank Rate on hold.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold. Continue with QE.
Bias: Neutral.

Tim Congdon re-iterated his previous warning concerning the dangers of Basle III for bank lending. He voted to hold Bank Rate.

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

Ruth Lea said that inflation was caused by factors that were beyond the control of the Bank of England. She voted to hold UK borrowing costs.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%. Conduct QE if economy weakens.
Bias: Neutral.

Kent Matthews said that the decision to raise interest rates was a finely balanced one. He voted to raise Bank Rate to 1% but then to hold and monitor its effect.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1%.
Bias: Tighten.

Patrick Minford had made his recommendation in the early part of the SMPC gathering as he then had to attend another meeting. He argued that the Bank needed to react to the large inflation overrun to ensure its long-run credibility. Giving such a signal would have little contractionary effect on activity as Bank Rate was now of little relevance to market conditions. He voted to raise Bank Rate to 1% with a bias to tighten further.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%. Hold QE stock at present level.
Bias: To tighten at a measured pace until Bank Rate is 2% or 2½%, then to pause.

David B Smith said that the way inflation was generated in a small open economy was through: 1) the world money supply and interest rates affecting global inflation; and 2) the relative stringency of domestic monetary policy - as opposed to the monetary stance overseas - determining the exchange rate. The weaker pound of recent years was not an exogenous ‘Act of God’, but a direct result of the policies adopted by the MPC. He said that the Bank’s model of inflation would be improved if it had the real exchange rate as well as the output gap among its determinants and that a slightly stronger exchange rate would aid the disinflationary process. Credibility was also an important consideration when setting Bank Rate. The private sector had come through a very serious recession. Setting policy on the basis of GDP figures that reflected such a highly socialised economy was pointless. A more sustainable fiscal balance can only be restored if the private-sector tax base expanded relative to the spending of the government sector. Fortunately, private sector activity now appeared to be bouncing back quite strongly in both the OECD area and Britain in particular, and supply chains were cranking up again. From a purely tactical perspective, he regretted that Bank Rate had not been raised in 2010, some months before the 20% VAT rate was implemented, and said that February 2011 was not his preferred month for implementing a rate hike. However, the MPC was losing its credibility with large sections of the population whose perceived inflation rate was 4¾%. One reason for raising Bank Rate now, at the start of the 2011 wages round, was to demonstrate that the MPC would not remain supine in the face of further inflation overshoots. He said that there was no imperative to be over aggressive with policy but a ½% rise was overdue.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%.
Bias: Tighten.

Peter Warburton argued that there had been a strong economic case for raising Bank Rate from its emergency low rate for more than a year. An excellent opportunity to begin the interest rate normalisation process against a backcloth of vibrant output and employment growth had been wasted last summer. The Bank’s inflation gambit had failed and its credibility was at issue. If for no other reason, Bank Rate should rise by ½% rise immediately to restore faith in the inflation mandate. The Bank should look through any weather-related economic weakness and seek to bring its discount rate back to 2% as soon as was prudently possible. Should the economy suffer a material setback during the course of this year, the more appropriate remedy would be another dose of QE.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: To loosen via QE if economy weakens sharply in first half 2011.

Trevor Williams said that he accepted the points made about the confusion between relative and absolute prices. This does have an impact on credibility. However, it is for the Bank to carefully explain the argument that inflation factors are temporary. The Bank should hold its nerve and put rates on hold. The UK is not benefitting from the upturn in world economic growth. The monetary situation is bleak. He voted to keep Bank Rate on hold and be prepared to re-engage in QE if the money supply continues to contract.

Further Comment by David H Smith (Sunday Times)

The chairman then asked the non-voting Sunday Times observer, David H Smith, if he had any comments to add based on his own extensive observation of the UK economy.

David H Smith said that it had been an excellent debate. He did not agree with his namesake that GDP was a meaningless concept or that the government sector was so large as to make the measure meaningless. The Bank of England faced an inflation problem and a forecasting problem. However, the main problem for the Bank was one of communication. The Bank needed to explain the turbulence in inflation and the reasoning behind its policy inaction.

Policy response

1. A five to four majority of the shadow committee felt that Bank Rate should be raised by ½% to 1% on Thursday 10th February.

2. Three of the rate raisers had a bias to tighten further.

3. Three out of the nine voted to hold QE as a policy contingency if the economy worsened further.

4. One member felt that QE had run its course and further action was required.

Date of next meeting

Wednesday 13th April 2011.

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

SMPC membership

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

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by six votes to three to leave Bank Rate unchanged at ½% when the Bank of England’s rate setters assemble on Thursday 13th January. All three dissenting SMPC members wanted Bank Rate to be raised to 1% in January.

The six SMPC members who wished to see Bank Rate held unchanged did so for a variety of considerations. One was the continued de-leveraging of the banking system, which meant that the growth of broad money and credit was likely to remain sluggish.

Another was the uncertain outlook for activity in Britain’s traditional mature-economy trading partners. However, there was also a counter view that buoyant Asian activity meant that the aggregate global economy was closer to overheating than depression.

The third main reason for wanting to hold Bank Rate was concern that the government’s fiscal tightening would reduce activity as it took effect during the course of 2011.

Several factors explained why three SMPC members wanted a higher Bank Rate. One worry was that the Bank risked losing credibility if it did not react to sustained above-target increases in the consumer price index (CPI) and ignored the extent to which CPI inflation was running below the more popular retail price index (RPI). However, there was also debate as to whether the present ultra-low Bank Rate was as expansionary as the authorities seemed to believe. In particular, the fact that the household sector’s bank deposits were not much smaller than its borrowings meant that consumers in total gained little when rates were low.

This was especially so when banks were widening their rate spreads and draining income out of the non-bank private sector. An associated concern was that ultra-low interest rates at a time of record fiscal deficits might look so indistinguishable from ‘printing money’ that it increased the perceived uncertainty about future inflation and perversely boosted precautionary saving.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; further QE should be implemented if UK home demand proves weaker than expected.

The dominant monetary theme in 2010 was that, because banks were obliged to restrict their balance sheets (and particularly their risk assets) because of the threatened Basle III rules, the growth of the quantity of money – on the broad measures – was negligible or very low across the industrial world. The dampening effect of this pattern on economic activity was countered in two main ways by the policy-making authorities. First, money market rates were held at virtually zero. Secondly, central banks created money by issuing cash reserves to the commercial banks and using the proceeds to purchase assets from non-banks. A fair comment is that officialdom’s intellectual rationalizations for the second of these responses, and indeed the implementation of the various measures, were both confused. Nevertheless, the quantity of money did not fall, as it had done in, for example, the USA in the early 1930s. With the return even on interest-bearing deposits being poor relative to non-money assets, weak money growth was compatible with good recoveries in asset markets and a return to economic growth. Nevertheless, at the end of 2010 output remained well beneath its trend level in North America, Europe and Japan. Countries outside the Basle rule framework – notably China and India – had very different monetary conditions and macroeconomic outcomes. The growth rates of bank credit and money remained rapid; demand was buoyant, and the main macroeconomic issue was the control of inflation.

In the Basle rule group of industrial nations, advance indicators of the growth of bank balance sheets remain worryingly sluggish. In the Euro-zone, banks in Portugal, Ireland, Greece and Spain (the so-called PIGS group) have severe and apparently worsening difficulty in funding their assets from market sources, while the European Central Bank seems determined to wean them off their dependence on it for loan support. The pressure on the PIGS countries’ banks to shrink their balance sheets is therefore intensifying nearly two-and-a-half years into the Great Financial Crisis (GFC), if it is accepted that the GFC began in August 2007. This is a shocking comment on the incompetence of Euro-zone banking regulation and monetary management. Admittedly, the specification of the central bank’s role as lender of last resort in a multi-country single currency area is inherently problematic - as some of us had warned in the early 1990s.

In the USA, Ben Bernanke, the chairman of the Federal Reserve, has said that his institution will pursue large-scale asset purchases (dubbed ‘quantitative easing (QE)’ by markets) to whatever extent is necessary, meaning ‘whatever is necessary to ensure that the recovery continues’. The positive impact of this statement on market confidence was considerable. Nevertheless, it might have been greater if either Mr Bernanke or his officials recognised that an increase in the growth rate of the quantity of money, broadly defined, was vital to the wider success of the Fed’s operations. Instead, he and his officials decry or even deride the role of money in macroeconomics, and emphasize ‘credit spreads’, ‘credit conditions’ and the like. In their work on the Great Depression, notably chapter 7 of A Monetary History of the USA, Friedman and Schwartz belaboured the Fed for neglecting the role of money in the determination of macroeconomic outcomes, and emphasizing ‘credit conditions’ etc. What was that someone said about history, that it may not repeat itself, but it rhymes?

As far as the UK is concerned, Mervyn King – the governor of the Bank of England – made statements in 2010 which suggested that he had bought into a monetarist view of the world, where the relevant aggregate was broadly-defined. Since King signed the notorious 1981 letter from the 364 against the then government’s fiscal restraint, a radical and very welcome intellectual shift seems to have occurred. The implied interpretation is that – in the UK, as in the USA – the authorities will prevent the quantity of money contracting. They will do this, despite the sheepishness and muddle of nearly all official statements on the matter. The UK does indeed seem to be enjoying a relatively benign macroeconomic prospect at present, certainly compared to some of its European neighbours. 2011 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 high relative to target, but underlying upward pressures on labour costs are very weak. Bank Rate should be kept at ½% at least for the next few months, while policy makers should remain open to the need for another round of QE if demand is weaker than expected.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; QE to be implemented only to avoid M4 contraction.

Last year witnessed the second year of balance sheet adjustment by the household sector and by the UK financial sector, following the deepening of the global financial crisis in late 2008. The year 2011 is likely to prove to be a third year of balance sheet repair, but that does not rule out a moderate growth of real GDP. The balance sheet repair process can best be seen in the household sector in the continuing decline of the household debt to disposable income ratio. This peaked at 174.0% in 2008 Q1, and had fallen to 158.3% by 2010 Q3. From a starting point of around 110% in the year 2000, it is highly likely that this ratio has further to fall. The recent decline is mainly accounted for by the growth of household disposable incomes (up 10.3% in nominal terms since 2008 Q1), and much less by the decline in debt outstanding. Although unsecured borrowing - mainly credit card debt - has fallen sharply, secured borrowing - mainly mortgage debt - has risen by 4.1% over the same period. Nevertheless, the combination of the need to lower indebtedness and the pressure of debt servicing in a time of very slow real income growth means that both household borrowing from banks and building societies and household’s M4 balances are hardly growing at all.

The balance sheet repair process in the broad financial sector is perhaps best captured by the dramatic plunge in bank lending to, and the bank deposits held by, Other Financial Corporations (OFCs are private financial institutions other than banks and building societies). From growth rates of 46.5% and 51.6% (year-on-year) at the height of the financial panic in early 2009, these figures have now plunged to minus 3.9% and minus 5.5% respectively. For the banks and building societies themselves, the freezing of the interbank markets from late 2007 resulted in a disastrous plunge in the size of their balance sheets - and especially their interbank lending and borrowing - but they were then rescued or at least stabilised by the Bank of England’s large-scale emergency loans amounting to some £200bn immediately after the Lehman bankruptcy in September 2008. Without the Bank’s lending, the contraction in the banking sector and in the wider financial sector would have been much worse.

The non-financial corporate sector is in much better shape than either the household sector or the financial sector, but nevertheless such industrial and commercial companies continue to reduce their bank borrowings (which are currently declining at 3.8% year-on-year), while their holdings of M4 are growing quite modestly (at 4.5% in October). However, aside from responding to demand overseas, it is difficult to envisage a recovery led by the UK corporate sector so long as household demand remains subdued. On the inflation front we are about to see the impact of the January hike in VAT to 20%, but beyond that one-time event and some further increases in commodity and utility prices, inflationary pressures should be very restrained, eventually causing inflation to fall to below the target (as suggested by CPIY inflation which excludes indirect taxes and was only 1.5% in November). UK inflation is still reflecting the sustained, double-digit growth rates of broad money in the years preceding, and in the early stages of, the crisis. It would be wrong to raise interest rates in the UK now on account of either temporary factors such as the VAT hike or high imported commodity prices, or past events such as the excessively high monetary growth rates permitted up to 2008/09. With M4 (excluding OFCs’ balances) currently growing at close to 3% year-on-year, bank rate should remain unchanged.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate and no further QE.
Bias: To hold Bank Rate and keep QE in reserve.

There are a few signs that economic growth is easing after the better-than-expected recovery in the second and third quarters. But it should be noted that the latest National Institute of Economic and Social Research (NIESR) estimates suggested GDP grew by 0.6% in the three months to November, slightly up on the 0.5% estimated for the three months to October. This, in itself, is encouraging. Bad weather will of course knock activity in December. The latest official labour market data were less positive. In the three months to October Labour Force Survey (LFS) employment was down and LFS unemployment up – though the claimant count figure was marginally down in November.

But the ‘big story’ over the last month has been the higher-than-expected CPI inflation rate, which was 3.3% in November. Crucially the Monetary Policy Committee (MPC) have shifted their position from the inflation forecast they made as recently as November. The MPC minutes of the December meeting reported “the MPC noted that inflation was likely to rise further over coming months and could well reach 4% by the spring, somewhat higher than the November Inflation Report central projection”. The MPC attributed the higher-than-expected inflation numbers to the effect on import prices of sterling’s past depreciation (two years ago!) and to the impact of substantially higher prices for food, oil and other commodities, of which the upward trend, one might add, shows no sign of flattening out.

But these higher-than-expected prices inflation numbers are insufficient to justify triggering monetary tightening. The fiscal consolidation has only just begun and that in itself is good enough reason to keep monetary policy accommodative. The key issue is whether Britain risks locking into a 1970s-style ‘wage-price’ spiral that would become difficult to control. There are, as yet, no signs that this will happen. Earnings inflation (ex. bonuses) was only 2.3% in the three months to October. And even though there is evidence that strike action over pay is picking up there are few signs that employers, especially in the public sector, where money is very tight, are prepared to countenance inflationary pay awards. They will surely do all they can to resist them. Under these circumstances, there is no compelling reason for increasing interest rates. But given the reasonably well established recovery, there seems no compelling reason for an extension of QE either, though it can always be kept in reserve if the need arises.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold; seek permission for additional £50bn QE this quarter.
Bias: To hold.

The January VAT rise means that the serious phase of the fiscal consolidation has begun. There is good reason to believe that the deficit is so high that even raising taxes, rather than cutting spending, might bring it down without damaging growth even in the short term. But is it worth the risk of finding out? On the surface, this is perhaps the case. Growth has been better than one might have anticipated this year. Inflation has been just enough to keep nominal wages rising. Indeed, inflation over the next few months seems likely to accelerate further as recent energy price increases feed through. All this suggests that a case is emerging for monetary tightening to prevent inflation rising excessively. Households have managed a little further balance sheet repair, with mortgage equity injections and a rising savings rate.

And yet, household balance sheets are still extremely fragile, with perhaps as many as three million households liable to fall into financial distress if mortgage interest rates rose by even 2 percentage points. Unemployment is rising again, and is likely to go up further as the fiscal consolidation bites. Although fiscal consolidations are often associated with rising growth, they are almost invariably associated with rising unemployment. The financial sector appears to be so fragile that the government has felt obliged to provide billions in further funding for the banks, thinly veiled by the subterfuge of a bailout for the Irish government. The US recovery is far from robust; some part of the Euro-zone could blow up any day, and even China appears to have switched to a tightening mode.

Thus, although the central scenario is probably that of a sufficiently robust recovery which has not been materially derailed by fiscal tightening - implying that further QE is not required and would actually be counterproductive (indeed, perhaps even that we should be tightening now, not loosening) - the downside risks to that central scenario are sufficiently serious that it would be wiser to err on the side of excessive monetary ease, even at the expense of a little more inflation down the line. Furthermore, certain of the standard arguments about the damage inflation causes do not apply in the current situation. Specifically, there are the arguments that inflation damages incentives to hold fixed income securities or to save in cash terms. The truth is that the current situation is massively distorted in favour of depositors and bonds. Between 2007 and 2009 (and perhaps even now), some banks should have gone into administration, with bondholders and, perhaps, also depositors losing some of their money. Some of these owners of fixed income loans - and a deposit is a loan, too - should have lost some of their money.

The fact that they did not do so creates a huge distortion. It is arguable that that distortion would be reduced by all fixed income loan-holders losing some of their money, via inflation. It is also arguable that inflation, in this situation, would lead, in the next financial crisis, to holders of high-quality loans (i.e. those that did not loan their money to banks that went bust) being opponents of bailouts - since the consequence of bailouts might be inflation that would damage the interests of those that had made wise, as opposed to imprudent, loans. It is not being contended that this is a central direct consideration for policymakers (i.e. it is not being suggested that they should deliberately create inflation so as to punish depositors in bust banks). However, the overall inflationary impact arising from optimal policy geared towards growth, employment and financial stability objectives is likely to be to the detriment of depositors and bondholders in institutions that would not have gone bust if proper market processes had been permitted to proceed.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate to 1% and hold QE.
Bias: To raise Bank Rate further and reverse QE.

The latest figures around the world suggest two things. The world recovery is strong and inflation is high and mostly rising - towards 5% for example in China, and nearly double-digits in India. The OECD central banks have loose monetary policies, keeping rates extraordinarily low and in the case of the US Federal Reserve aggressively printing new dollars via QE2. Money is flowing from the OECD to the East and, there, it is not being allowed to raise Eastern exchange rates. Instead, it is being bought by local central banks with newly printed local money. We have de facto a world economy on fixed exchange rates with the world monetary printing presses whirring.

The question that arises is how OECD central banks react to this situation in the post-crisis world? Essentially, they are deciding to ignore 'imported' inflation, such as commodity price rises, as being temporary or 'non-core'. This contrasts with their reaction in 2007, when the European central banks treated this inflation as needing monetary tightening. Thus, interest rates in Europe generally, including non-Euro-zone countries like the UK, were not lowered much in 2007, despite the incipient crisis, and this attitude continued into 2008. Only in the US, where the sub-prime crisis had already become serious, was money loosened sharply and imported inflation totally ignored.

The difficulty about treating imported inflation as ‘non-core’ in this world environment is a world fallacy of composition. If everyone does so, world money supply growth will be uncontrolled; this is what is now happening. OECD countries have 'inflation targets' but in practice are ignoring them, replacing them with implicit wage-inflation targets. If, when wages start rising in response, the central banks treat this too as temporary, the target underpinnings will be in difficulty. We will be witnessing classic time-inconsistent responses where the response to inflation becomes deferred because of the desire to postpone 'derailing' of the 'recovery'. Such a tendency to defer the response to inflation could easily spill over into an upward drift in the target itself. This in turn will feed higher inflation expectations. At this point, the benign effect of 'expectations anchoring' will dissipate and turn into the dreaded effect of 'expectations drift' that worsens the inflation-output trade-off.

The danger, therefore, is of a progressive undermining of the target's credibility. Nowhere is this more the case than in the UK where inflation will shortly go over 4% on the official CPI, and no doubt much higher on the RPI. This is bound to generate a response in wages. At some point, the situation will tip over, with the Bank of England losing the initiative and having to act violently to restore its credibility. When the target policy is working properly, then there is never any need to be too strict in response to temporary shocks. This is like the Swiss village in which order is maintained without any visible police presence because everyone knows that any eruption of lawlessness would be met with an iron response. However, once that response gets into doubt, the village becomes more like a UK inner city where violence is endemically out of control and the police presence sporadic and unconvincing.

What is disappointing today is that the Bank is also failing to recognise that the UK economy is growing at a reasonable rate considering the raw material availability constraints facing it and the world generally. Therefore, there is no longer any serious risk of 'derailing' it; on the contrary the environment is increasingly one where real yield is again being hunted by households and firms tired of getting pathetic returns on monetary assets. If the Bank, which ought to be the repository of anti-inflation 'toughness' starts to sound like a Keynesian nanny, where will credibility go? When credibility is so fundamental to the whole monetary policy transmission process, we cannot trifle with it.

The conclusion from all of this is that it is time to hear the smack of firm monetary government. Interest rates should rise forthwith; QE should be ended. Soon it will need to be reversed. We need rapidly to see a shift in views about inflation and the monetary environment. At this stage the Bank can probably get away with only modest rises in rates, say to a 1½% to 2½% range. Bank rate has become detached from normal market rates and the interbank market is hardly being used. Thus, much of an effect of its rise on market rates is not to be expected. It may even be that the revival of the interbank market will ease banks' fears about lack of liquidity and improve their lending growth. This would in turn help to reassure policymakers about the recovery, even if monetary channels appear to be bypassing the banks currently anyway.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold Bank Rate.
Bias: Hold QE in reserve.

It is widely accepted that a reduction in interest rates should stimulate the economy. Existing borrowers certainly gain but how about depositors? They lose. Thus, the predominant effect of lower interest rates is simply to transfer income from one set of households to another. The private sector’s deposits with banks are not all that much smaller than the loans that banks make to the private sector. If the rates of interest on deposits and loans fall by the same amount, the net impact on the cash flow of the private sector is normally small. However, this time banks have widened their profit margins. Loan rates have not fallen anything like as much as deposit rates. In effect, banks have pinched cash flow that should have gone to the private sector. The impact of lower interest rates on the net cash flow of existing borrowers and depositors may have been mildly contractionary as a consequence.

How about new borrowers, more importantly net new borrowing? The Times on 30th December reported that the reduction in mortgage debt between July and September was the second-largest rate on record and gave two reasons. One was low interest rates! But low interest rates are meant to encourage rather than reduce borrowing. The explanation is that many borrowers, according to mortgage lenders, have chosen to maintain their monthly payments, despite the fall in interest rates, thereby paying off more of the capital owed each month. If this is correct, the impact of lower interest rates on net new borrowing may have exacerbated rather than offset the negative impact of low interest rates on the cash flow of existing depositors.

So, if the impact of lower interest rates has been negative overall, why not raise Bank Rate? Reversing the above argument implies that the effect would be expansionary if banks can be discouraged from increasing their lending rates. Furthermore, foreigners would be attracted by higher interest rates on deposits. The Bank of England might then intervene in the foreign exchange market to stop sterling from rising. The effect would be to re-liquefy the economy as happened after we borrowed from the IMF in 1976, which offset the contractionary impact of the tighter fiscal policy imposed by the IMF.

The conclusion from this analysis is ‘do not judge the stance of monetary policy by the behaviour of interest rates’. It should be judged instead by in depth analysis of the behaviour of the monetary aggregates. The monetary data for November, published on Tuesday 4th January, show little change on the previous month. The annual growth of aggregate M4ex has fallen from October’s 1.5% to 1.4% in November. The annual growth rate in the M4 holdings of private non-financial corporations declined from 4.4% to 2.6% between October and November but that of households has risen from 2.5% to 2.7%. These changes are not significant, given the error margins in the data, so my conclusions that interest rates and the stock of QE should remain unchanged are the same as last month. One would merely add that, if sterling strengthens, the Bank of England should intervene in the foreign exchange market to stop it from rising. Allowing money to come in from abroad would be a different form of QE.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate to 1%; hold QE at present level.
Bias: To raise Bank Rate further during course of 2011.

The New Year is traditionally a time for looking forward and our latest forecasts for the British economy incorporating the revised national accounts and balance of payments figures released just before Christmas are summarised below. However, it is firs