A review of my book Something Will Turn Up, for the Society of Business Economists

By Andrew Sentance

Something Will Turn Up is a very readable, semi-autobiographical account of the UK’s economic fortunes since the mid-1950s, as seen through the eyes of David Smith, Economics Editor of The Sunday Times.

David starts his narrative with a description of the Black Country economy around Walsall in the West Midlands, where he was born and brought up. The local economy was dominated by manufacturing industry, which prospered in Britain in the 1950s and 1960s. As our industrial competitors in continental Europe and Japan rebuilt their economies after the ravages of the Second World War, Britain supplied a wide range of manufactured goods to customers at home and abroad. ‘Made in Britain’ was a hallmark of quality and a source of national pride.

One key theme of David’s book is the story of how a country dominated by manufacturing industry has evolved to become the post-industrial British economy we now inhabit. The peak year for UK manufacturing jobs was 1966, when British industry employed over 9 million people. Around 50 years later, the figure is down to around 2.5 million, a decline of over 70 per cent. UK manufacturing industry was partly undermined by its own weaknesses – poor management and bad industrial relations. But it was also the victim of tougher global competition, big financial shocks and mismanagement of the national economy.

Another major theme of the book is periodic economic crises. After the shock of the 1967 devaluation, the UK economy appeared particularly accident prone in the 1970s, 1980s and early 1990s, which included three major recessions, the 1976 IMF crisis, and exit from the ERM in 1992. The UK economy seemed to follow a steadier economic path from the mid-1990s until the mid-2000s, but the illusion of stability was shattered by the Global Financial Crisis.

Despite this tale of industrial decline and economic misfortune, the big picture portrayed by this book is positive. The UK economy has generally performed well relative to its counterparts in the western world since the early 1980s. How did the fortunes of the UK economy in fact improve over David Smith’s journalistic career, despite so many economic mishaps?

The narrative identifies three key ingredients. First, more disciplined macroeconomic policies – which were implemented from 1976 onwards, after the IMF crisis, under both Labour and Conservative governments. There were setbacks and policy failures along the way, and no government has an unblemished record. But by 1997 the incoming Labour government had taken the bold step of giving independent control of monetary policy to the Bank of England MPC. This arrangement has proved remarkably durable given the many economic policy switchbacks the UK has experienced since the late 1960s.

The second ingredient was microeconomic reform – reducing union power, increasing employment flexibility, tax reform, financial liberalisation, privatisation, encouraging inward investment, promoting competition and deregulating business. The Thatcher government in the 1980s was the key innovator in this sphere, but subsequent governments generally built on, rather than rowed back on, its changes.

The third key element in the turnaround of the UK economy was the adaptability and flexibility of the private sector. Despite the decline in manufacturing jobs, new industries and sectors have created alternative employment and growth opportunities. Financial services was one of these key growth areas, but even when they faltered after the crisis, other sectors have picked up the baton and created nearly 2.5 million extra private sector jobs since 2009. Manufacturing itself has been transformed, though our industrial base is now narrower and more specialised than in the 1950s and 1960s. A new generation of high-tech, highly productive and export-oriented firms dependent on technical knowledge and skills now forms the core of British manufacturing.

David Smith does not gloss over the downsides – the high unemployment and industrial wastelands created in the 1980s, particularly in his West Midlands homeland. But he tells the story of British economic decline and recovery in an engaging and personal way, drawing on his own experiences and the relationships he built up along the way with key policy-makers including Chancellors of the Exchequer, Prime Ministers and Governors of the Bank of England.

Like David, I was born in the 1950s and this book brings back my own memories and experiences of the key events he relates. For a younger generation of readers, this is a highly accessible guide to a world they cannot recall personally. And the roller-coaster ride that the British economy has endured over the past fifty years reminds us that it is remarkably resilient. The UK has economic ‘bouncebackability’. Something will turn up – and normally does.

Following the pattern of the last few meetings, albeit with a smaller majority,
the SMPC has voted to hold Bank Rate in June. The election result, and
the consequent removal of some of the political uncertainty, had little
impact on the voting.

The majority continued to argue that rates should remain on hold due to
negative inflation and worries about growth later in the year.

Those arguing for higher rates remain worried about financial market
distortions caused by leaving rates ‘too low for too long’, and wanted to
at least start to normalise rates.

The SMPC is a group of economists who have gathered quarterly at the
IEA since July 1997. That it was the first such group in Britain, and that it
gathers regularly to debate the issues involved, distinguishes the SMPC
from the similar exercises carried out elsewhere. To ensure that nine votes
are cast each month, it carries a pool of ‘spare’ members. This can lead
to changes in the aggregate vote, depending on who contributed to a
particular poll. As a result, the nine independent and named analyses
should be regarded as more significant than the exact overall vote. The
next two SMPC polls will be released on the Sundays of 5th July and 2nd
August 2015, respectively

Votes

Vote by Jamie Dannhauser
(Ruffer)
Vote: Hold Bank Rate & QE
Bias: No bias
One year ahead: Bank Rate at 1%; no change in QE

Official data suggest the UK economy hit a soft patch in the first
quarter. Output expanded by only 0.3%, despite the tailwind that lower
oil prices are providing to UK real incomes. Consumer spending growth
came in at 0.5%, although more timely data on retail spending suggest
this apparent slowdown is largely transitory – the volume of sales in
April was markedly higher than the first quarter average, implying a
potentially much stronger Q2 outturn for consumer demand.

The more important point is that business surveys suggest the economy
is much more robust than the ONS’ official data. There appears to be
an especially large discrepancy in the construction sector, where ONS
figures point to declining output. But the gap between survey evidence
and recorded output is fairly widespread.

As relevantly, forward-looking indicators suggest the economy will
continue to grow at an above-trend rate in coming quarters. There are
especially encouraging signs that house-building is gathering pace;
and corporate investment intentions remain elevated. Two additional
considerations are pertinent: first, the tailwind from oil, which theory
suggests should be at its most supportive in Q2 and beyond; and
second, a further easing of credit constraints, which should bolster
monetary growth and lower the precautionary demand for cash.
As has been true for some time, an external ‘shock’ is the greatest
threat to the UK growth outlook. The debacle in Greece still poses
a meaningful threat to the Euro Area and by implication UK export
demand. China too is a worry, given the severity of the downturn in
the construction sector, the key fault line in the Chinese financial
edifice. However, there are also upside risks that should be taken into
account, including a positive Euro Area growth surprise as well as a
strengthening of the Japanese economy.

The case for not beginning the rate normalisation process centres on
the weakness of inflation, especially measures of underlying inflation.
The negative print on headline inflation should not concern us, since it
is largely a product of sharply lower oil prices. However, we have seen
a marked fall in ‘core’ CPI inflation in recent months, as well as a rapid
decline in retailers’ margins. Both would be consistent with a greater
degree of slack than is widely perceived. Some have suggested this
reflects the upward move in sterling and the counterpart change in
import prices. While surely playing a role, it is notable that the rate
of inflation for consumer items with a low import-component has also
fallen markedly this year.

Monetary policy has to be forward-looking though, so at issue is
prospective inflation. The economy has had two years of above-trend
growth. That seems likely to continue for the rest of 2015 and beyond.
While there remains huge uncertainty about the current degree of slack,
and the extent to which potential supply is responding to faster demand
growth, there is surely a good deal less spare capacity than seemed to
be the case two years ago. Indeed, forward-looking indicators of wage
growth suggest improving trends ahead.

One should also note decent monetary growth, as well as evidence of
a further easing of credit constraints in both the mortgage market and
SME lending market. Depressed underlying inflation provides a reason
to hold off a rate move this month. Subject to a clear turnaround in
domestic pricing pressures, and a resolution of the Greek debacle,
however, the case for a hike later this year could become compelling.

Vote by Anthony J Evans
(ESCP Europe Business School)
Vote: Hold Bank Rate
Bias: Raise once inflation returns to 1%-3%

According to the ONS house price inflation rose from 7.4% to 9.6%, Halifax
report that house prices are growing at 8.5% and Nationwide at 5.2%. The
message across all of these measures is the same: house price remains
strong and even ticking up slightly. The concern is that this suggests home
owners are capitalising on low interest rates to gamble on capital gains.
March 2015 saw Average Weekly Earnings grow at 4.3% in the private
sector (compared to the previous month) compared to an average of just
1.4% from September 2013 through February 2015.

Divisia money is growing at a sustained, strong rate whilst M4ex growth for
March 2015 was back up above 4%. M3 growth continues to be negative,
but the rate of deflation jumped from -3% in February to only -0.5% in March.
If the Bank of England were blindly following their inflation targeting remit,
then there is a stronger case for looser monetary policy than tighter. Recent
sluggishness in CPI has now turned into outright deflation; however it is
of a mild and benign sort. Driven by transport services and food there
is little to suggest that it is a symptom of insufficient aggregate demand,
although the second estimate of the National Accounts will be a crucial way
to assess this (especially if nominal GDP falls below 4%).

Overall my concern is that the Bank of England is contributing to
misallocations of capital due to low interest rates adopted during a crisis.
We have clearly emerged from that crisis period and any opportunity
should be taken to normalise interest rates. Temporarily low inflation must
put those plans on hold, but not indefinitely.

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

Going into the election on 7 May, the British economy was in robust shape.
Growth was strong and inflation near post-war record lows, enabling real
wages to start showing meaningful growth. This background means that with
the Conservative party continuing to hold the reins of power, there should be
little change in the immediate outlook, although longer term uncertainties
about membership of the EU and the future of the union with Scotland may
persist. In the short term financial markets have welcomed the return of Mr
Cameron with increases in the stock market and the value of sterling, and a
surge in the number of deals for London property.

Although the ONS reported that the GDP had increased by only 0.3% in the
first quarter of 2015 (or about 1.2% annualised, and 2.4% year-on-year), this
probably overstated the slowdown in the economy. Services increased by a
moderate 0.5% in the quarter, while construction, production and agriculture
all declined. However, economic surveys both prior to the initial GDP estimate
and subsequently, as well as official data series have reported much stronger
growth than was reported by the GDP figure.

For example, the PMI survey released on 6 May showed service sector activity
rising to 59.5 in April from 58.9 in February, well above its long-term average
of 55. Moreover, the composite PMI (comprising services, manufacturing and
construction) is at a level that suggests that the underlying GDP growth rate
is nearer 3% than 2%.

Another example is the strength of labour market data as conveyed by the
ONS report on 13 May. Job growth continued to increase, rising by 1.8% over
the year to 2015 Q1, and up 0.7% quarter-on-quarter. Jobs are growing much
more rapidly than the size of the workforce (+0.5% year-on-year), with most
of the new jobs now concentrated in full-time work (+2.9%). With job growth
outpacing workforce growth, the unemployment rate continues to fall steadily,
declining to 5.5% in Q1 from 5.7% in Q4 2014 and 6.8% a year earlier. Also,
although the number of job vacancies fell slightly in the first quarter, the figures
are at their highest level for any month except two since data started to be
collected in 2001.

Reflecting the gradual tightening of the labour market, both regular pay and
total pay have been steadily accelerating over the past year. Average earnings
(ex-bonuses) increased by 2.7% year-on-year in March from 2.4% in February
and 1.6% in January. This is the strongest growth since the onset of the crisis
in 2008-09. When combined with the fall in the CPI inflation rate to -0.1% in
April, this means that real wages are starting to show meaningful increases.
Thanks to the buoyancy in the economy, the public finances are also starting
to look better. In the financial year to March 2015 the PSNB (excluding public
sector banks) was £87.7 billion (4.8% of GDP), down from the previous year,
and in April the PSNB was £6.8 billion compared with £9.3 billion a year earlier.
Although receipts from taxation and other sources have been consistently
disappointing (exacerbated by regular increases in personal allowances at
the lower end of the income scale and international companies diverting
income abroad), government cash outlays excluding interest have accelerated
to 6% over the year since March 2014 (thanks in part to the ring-fencing of
expenditures on health and overseas aid). In the mini-Budget announced for
8 July we should expect further cuts in expenditure by those government
departments not protected by the ring-fence, additional anti-avoidance
measures and the closing of tax loopholes to ensure that revenues run closer
to target.

On the monetary policy front there is no reason to expect any change in the
mandate for the Bank of England to maintain the 2% inflation target. With CPI
inflation in April well below target at -0.1% year-on-year (headline) and 0.8%
(core) it is likely that the Monetary Policy Committee (MPC) will continue to
keep interest rates unchanged at 0.5% in the near term. In the May Inflation
Report the Bank’s forecasts for real GDP growth were lowered slightly to 2.6%
for both 2015 and 2016 (down from 2.9%), due mainly to lower investment
spending but also to slower consumer spending growth. Again this reinforces
the case for no change in rates.

M4x growth remains moderate at 4.5% year-on-year (in March), broadly
unchanged from its growth rate of the past two and a half years, implying no
upside threat to the 2% inflation target. On the lending side M4 Lending
declined at -1.6% year-on-year in March. This is despite the two government
credit promotion schemes (“Funding for Lending” and “Help to Buy”), and
near-zero interest rates, and reflects the anxiety of the public to repair balance
sheets before embarking on renewed borrowing.

Although the amount of slack in the economy is diminishing, my view is that
low inflation will remain compatible with lower than normal unemployment
rates. This is a result of the decline in the equilibrium unemployment rate -- in
turn partly due to tighter enforcement of eligibility criteria for unemployment
benefits -- which should enable the MPC to delay any rate increases.

Also, although the MPC expects inflation to return to target after the oil price
declines of last autumn fall out of the year-on-year comparisons, it is unlikely
that the Bank will raise rates ahead of the Federal Reserve. This implies that
the first rate hike will likely be in the final quarter of 2015 at the earliest, though
it could be delayed until early in 2016. Thereafter rate hikes are likely to be
slower and more gradual than in previous cycles.

Under these conditions there is little danger of a surge in credit, a surge in
growth, or an inflationary outburst. On the contrary, given low money and
credit growth, the risks are currently tilted towards slower growth and deflation.
It would therefore be unwise to raise interest rates or otherwise tighten monetary
conditions. Rate increases at this stage would damage the prospects for
economic recovery, and should be delayed until the recovery is substantially
more vigorous in both real and nominal terms.

Vote by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate
Bias: To raise rates as inflation rises above target

No change to commentary from last vote.

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

There was much wailing and gnashing of teeth over the uncertainties
surrounding the election result. On the one hand many feared a Labour
minority government supported by the SNP. On the other a continued
Conservative coalition of some sort scared the euro-phile mainstream press,
CBI et al. with the prospect of a referendum on the EU.
Both sets of fears were badly exaggerated.

A Labour minority government would have been unable to pass much of the
left-wing agenda Miliband had at various times threatened. It had potential
trouble at several levels. First, if he had felt he had a chance of forming a new
government later after another election he would have wished to attract votes;
left-wing policies such as rent controls would have been attacked strongly as
making it difficult for the very people it was designed to help (e.g. to find rented
accommodation).

Second, Miliband would have had to get a majority for each of these controversial
policies; and this seemed highly doubtful or would have required a big
expenditure of political capital. Yet this would have needed to be hoarded for
mere survival.

Third, Miliband was likely to face a sterling crisis fairly early, if not at once. He
would have wished to prove his orthodoxy in financial matters by pressing
ahead with his fiscal plan, and not alarming business whose tax revenues he
would have needed.

In short if Labour had governed it would not have had the sort of strength that
allowed Attlee for upend the way the UK was organised- or for that matter
that Mrs. Thatcher enjoyed, allowing her to bring in a wide-ranging set of free
market reforms. Labour would have been constantly on the edge of collapse
and desperately seeking day-to-day survival by keeping out of controversy.
While no doubt the SNP would have goaded it into left-wing policies, it would
not have been able to supply the votes to bring them about; furthermore
Labour would not have wished to be seen as sharing the SNP’s far-left agenda,
for fear of losing the floating voters who might in future have given it power.
Anyway, all that was not to be. Now turn to the vexed question of the
Conservatives and ‘Brexit’. Those wishing to stay in the EU as it now is fear
that Brexit will mean severing all ties with the EU and going into an aggressively
hostile relationship. However this is by no means what is intended; rather it
would be a renegotiation replacing our EU membership with a new bilateral
UK-EU treaty, preserving the good aspects of the existing relationship. It would
feel quite like the old membership but without the long list of sticking points
that have soured relations for so long.

It is routine to point to the threat of Brexit to inward investment. But while
indeed investment in industries that have been favoured by Brussels
protectionism will fall off, investment in industries benefiting from the fall in
costs from ending this protectionism will expand. These industries will be
ending the ‘trade diversion’ that favoured EU markets, and expanding in world
markets outside the EU. There will be major opportunities in these markets
which investors will wish to exploit.

Another factor that should calm nerves now is the UK recovery and the world
background of stable recovery with low commodity prices. I have argued
before that there will be a long upswing in the world economy, lasting another
20-25 years, as low commodity prices stimulate investment and consumption
in developed commodity-using economies.

The official GDP figures for the first quarter of 2015 have been disappointing,
at 0.3% growth. However, they are as so often at variance with other indicators,
notably the purchasing managers’ indices (PMIs); as a result they, like earlier
weak GDP estimates, will be revised upwards. There are particular discrepancies
between the construction GDP estimate, down 1.6%, and the construction
PMI which remains strong. This usually occurs with recession figures, that
over time they get revised greatly upwards. The reason for this is that in
recessions patterns of business are forced to change because of the pressures
for survival; the ONS statisticians only find out these new patterns long
afterwards and hence inadequately sample the new places where business
has shifted to. This gives the estimates a downward bias. You might well ask
why the statisticians do not aim off for this. But to do so would require putting
forward judgements that would by definition be hard to justify with concrete
data; with the GDP figures being highly politicised they simply cannot go
beyond the figures they actually have.

Hence my view remains that the UK is continuing with a reasonably robust
recovery, even if it is not as strong as in previous recessions. The question
is when rates should rise. With the US soon to raise rates itself this question
is going to become more pressing.

It may seem odd but my biggest concern is with the quantity of high-powered
money, M0. It is annoying that the Bank has ended the publication of this
series, just as it has exploded in value- presumably this is why, which
demonstrates the periodic infantilism of the Bank. However, it is easy enough
to calculate from the Bank’s balance sheet; basically M0 has multiplied about
8 times since the beginning of the crisis. All of it, except notes and coin which
has risen moderately and in line with consumer spending, is languishing in
the Bank as bank reserves. The counterpart assets bought by the Bank,
mainly government bonds, are sitting on the Bank’s balance sheet. Their
purchase drove down government bond yields and drove up equity prices in
sympathy. The low yields on these assets is fuelling the growth of lending
outside the banking system- itself overwhelmed by the new regulation. It
concerns me that we may be losing control of the next credit boom.

I urge therefore the same mixture as before: rolling back the bank regulation
(which may quietly be going on), selling off these assets steadily (maybe at
£25 billion per month), and slowly raising bank rate. Somehow the Bank needs
to get back in control of the monetary situation and show foresight of the risks
it may be running over the next two years. People will say this is not the time
to do this when inflation is low and even slightly negative. But inflation is not
really a good major target for monetary policy as we discovered during the
boom of the 2000s; it neglects the build-up of money and credit. We need to
focus on these directly or else to shift to a target like the price level of nominal
GDP that mirrors that build-up.

Vote by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate
Bias: To raise Bank Rate in two steps, perhaps starting in August

From the viewpoint of the monetary policy maker, the main gain from the 7th
May election result was that it removed potential uncertainties about the fiscal
and monetary backdrop and meant that it was back to ‘business as normal’
where rate setting was concerned. This does not imply that there are no risks
associated with what appears to be a slowly improving international background
and, longer term, the referendum on Britain’s continued membership of the
European Union. Nevertheless, the election result itself provided no reason
for changing one’s prior view about the appropriate course of Bank Rate. This
is something that would not have seemed likely a month or more ago. It is
noteworthy that the financial markets were barely perturbed by the risk of a
left-wing ‘coalition from hell’ gaining office, despite minor markdowns in equities
and gilts on election-day itself. International investors may have been sufficiently
detached from the domestic political debate to be able to make a shrewder
appraisal of the likely outcome than home-based commentators, particularly
if foreign investors were not paying attention to the BBC. Whatever the reason,
the collective wisdom of the markets appears to have outperformed both
British political pundits and the UK polling industry. The latest available (26th
May) financial prices show that the FTSE 100 index has risen by 0.9% since
the close of business on 7th May, which is almost identical to the 0.8% hike
in the US S & P composite index over the same period, while UK gilt yields
are only trivially (around 0.1 percentage points) lower they were in the days
before the election, as has also been the case in the US.

The one variable where there has been a more marked response is sterling,
where the Bank of England’s trade-weighted index dropped from 91.3 (January
2005=100) on 30th April to 89.2 on the evening of polling day before climbing
to 92.2 on 26th May, which represents a gain of 3.5% on its election night
low-point. Changes in the external value of sterling are one of the main
transmission mechanisms through which monetary policy operates in a small,
open and trade-dependent economy such as Britain’s. This means that
currency movements have important implications for the level of activity, the
domestic price level and its rate of change (i.e., inflation). The current strength
of the pound suggests that UK inflationary pressures will remain comparatively
subdued at a time when international inflation is itself running at a very low
rate. However, a potential sting in the tail, following the Conservatives’ election
victory, is the possibility that firms were holding off capital formation and
recruitment before the election, because of the perceived political risks, but
that this pent up demand will now come through in an abrupt surge. Compilation
and publication delays mean that it will be several months before it becomes
clear in the official data whether this is the case or not. However, it adds to
the risks of economic overheating, if the monetary authorities end up doing
too little, too late.

Certainly, recent indicators suggest that there are now pockets of serious
strength where the British economy is concerned, at the same time as
inflationary pressures remain subdued. One noteworthy example is the
volume of retail sales, which expanded by 1.2% in April to give a 4.7%
increase on the year, representing the longest period of sustained annual
growth since May 2008. In year-on-year terms, UK manufacturing output
has also shown consistently positive growth since August 2013, even if this
rate of increase appears to have tapered off since last autumn. In March
alone, manufacturing production rose by 0.4% on the month and 1.1% on
the year while the first quarter saw an increase of 1.3% on the first quarter
of 2014 but one of only 0.1% on the previous three-month period. Recent
labour market statistics, which are often considered to be a lagging indicator
of the economy, also suggest that home demand remains buoyant with total
employment on the Labour Force Survey (LFS) measure 564,000 higher in
the first quarter of 2015 than a year earlier and 202,000 up on the final
quarter of last year. The LFS measure of unemployment has eased from
6.8% in the first quarter of 2014 to 5.5% in the first quarter of 2015, when
it was 0.2 percentage points down on the final quarter of last year. Claimant
count unemployment also fell by a further 7,100 in April to 487,000 (2.7%),
which compares with the 712,400 (4.0%) recorded in April 2014. However,
some of the decline in claimant-count joblessness may have resulted from
the phased introduction of the ‘universal credit’ benefit, which took 4,000
off the claimant count in April 2014 but 35,600 off this April.

However, perhaps the strongest sign of rampant UK demand was the fact
that the annual rate of house price increase, as measured by the Office for
National Statistics (ONS), accelerated from 7.4% in February to 9.6% in
March, despite the threat then posed by the possibility of a high-tax Labour
government. It will be interesting to see what happens to reported house
prices in a few months’ time when the post-election period gets included in
the ONS figures. Meanwhile, the latest figures for producer prices, as well
as consumer and retail prices, suggest that inflation is certainly dormant, if
not necessarily dead. Producer output prices, which used to be considered
a leading indicator of retail prices, fell by 1.7% on an all-items basis in the
year to April and only increased by 0.1% on the year if food, beverages,
tobacco and petroleum products are excluded. Over the same period,
producer input costs fell by 11.7%, with materials purchased down by 13.1%
and fuel costs down by 0.7% when compared with April 2014. The 0.1%
drop in the consumer price index (CPI) in the twelve months to April certainly
attracted the headline writers. But it partly resulted from distortions to travel
costs associated with the timing of Easter. The retail price index (RPI)
increased by 0.9% in the year to April, as did the former RPIX target measure,
while the ‘double-core’ RPI defined to exclude house prices as well as
mortgage rates went up by 0.4%, as did the tax and price index (TPI). The
latter is noticeably below the 1.9% increase in average earnings in the year
to 2015 Q1 (private sector 2.4%, public sector 0.2%) and suggests that the
living standards of those in employment are now unambiguously rising.

More generally, a period of falling prices has both income and substitution
effects. It is the balance between these offsetting forces that determines
whether the impact of a reduced price level is expansionary or contractionary
overall. The income effect is clear cut; lower prices increase real disposable
incomes for all those whose incomes from work or savings are fixed in nominal
terms. It also eliminates the fiscal drag that would otherwise bring more
people into the tax net. The substitution effect arising from negative inflation
is that the price of future goods and services becomes cheaper compared
to buying the same items today, theoretically leading to a reduction in current
expenditure. A falling price level also has three offsetting monetary
consequences. First, it increases the real value of money and other liquid
assets, leading to an increase in expenditure. However, the second and third
effects are that negative inflation: a) increases the real value of existing debt
burdens, and b) can lead to higher real interest rates once nominal rates hit
the zero bound. The latter can, in turn, lead to an appreciation in the external
value of a currency if the relative real interest differential in favour of the
currency is raised. Deflation alarmists tend to emphasise the substitution
and debt burden effects of a falling price level. However, these probably only
predominate when the price level is falling sharply, as in the US – but certainly
not Britain – during the 1930s. With the M4ex broad money definition having
grown by 4.1% in the year to March, which is very broadly where it has been
for a couple of years, there seems to be little reason to worry that the growth
in the supply of broad money is inadequate to fund a continued expansion
of home demand. However, the deflation-induced rise in the real interest rate
return from holding money on deposit needs watching because it could lead
to an increase in the demand for money that counterbalances the growing
money supply. Going against this concern is Britain’s continued large deficit
on its external trade in goods and services, which worsened from £5.97bn
in the final quarter of last year to £7.48bn in the first quarter of this year. This
imbalance suggests that there is already a substantial excess of home
demand over domestically produced supply.

Presumably, Mr Osborne’s forthcoming 8th July ‘mini-Budget’ will have more
to say on the economy’s supply side and hopefully back this up with serious
proposals for tax simplification, regulatory reform and increased fiscal
parsimony. As far as the 4th June Bank Rate decision specifically is concerned,
there is probably a stronger case for a pre-emptive hike than is generally
recognised, given the apparent excess of home demand over UK supply
revealed by the trade figures and the scope for a post-election rebound in
investment and jobs. However, the rise in real interest rates caused by the
elimination of inflation and the strength of sterling suggest that there has
already been some accidental monetary tightening through the back door.
Furthermore, when a rate increase is delivered after such a long period of
stasis it is important to reduce any adverse psychological shock. Holding
Bank Rate in June, and perhaps on 9th July, seems appropriate. However,
the Bank of England should be making a start on preparing the ground for
a couple of modest ¼% rate hikes, possibly as early as the 6th August
decision when a new set of Inflation Report forecasts will be available. There
is little need for British rate setters to wait for the US Federal Reserve to
make the first upwards move, which may be the current philosophy.

Vote by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by 0.25%
Bias: To raise rates to 1½% over 12 months

The decisive UK election result brings a welcome, if unexpected, clarity to
both fiscal and monetary policy. The ‘stability budget’ statement by the
chancellor on 8 July will attempt to bring the public finances back on track
during the life of the parliament. However, the MPC is in no less need of a
policy reset, despite its supposed independence from the political cycle. If
normalisation in the fiscal dimension looks something like a cyclically-adjusted
budget balance, then normalisation in the monetary dimension looks like a
real interest rate that approximates to the underlying pace of real economic
growth and broad money supply growth of at least the pace of nominal GDP.
The MPC has urgent work to do on both fronts: lifting policy rates towards
1.5% as soon as is practicable, and relaxing the regulatory stranglehold on
the banks that prevents a recovery in loan growth.

Today’s mildly negative CPI inflation rate should fool no-one. It is true that the
UK is no longer at the head of the table of EU harmonised consumer price
inflation rates. Yet it is remarkable that the UK, despite enjoying a 15% currency
swing versus the Euro over the past year, still has the sixth-equal highest
inflation rate. UK remains an inherently inflationary economy.

The forces holding back inflation are many and various. Bank lending to the
domestic private sector has been heavily constrained by the requirements on
the banks to rebuild capital and liquidity in the wake of the global financial
crisis. Consumer credit growth has revived over the past year but mortgage
lending remains extremely weak. Credit conditions continue to thaw as very
low interest rates gradually percolate through the financial system to households
and smaller businesses.

The supermarket price-war that has raged for many months is a temporary
bloodbath from which a new pecking order and new-found profit opportunities
will emerge.

Economic migrants have played a significant role in restraining unit wage
costs in a wide variety of occupations and industries. The UK has porous
borders and has only recently taken steps to limit migrant access to welfare
benefits.

The irrepressible and irresponsible expansion of global manufacturing capacity,
mostly in Asia, has also played a prominent role in suppressing goods inflation
in the UK over the past 30 years. As economic realities (the market cost of
energy, materials, labour and capital services) have closed in on the proponents
of mercantilism, the disinflationary benefits of cheap goods have diminished.
The fracking of the international crude oil cartel has been extremely influential
in the European inflation debate in recent months and the world watches and
waits to see whether OPEC can restore a semblance of price discipline after
its June meeting. The UK is a mere observer in this regard.

Finally, the extent to which international inflationary forces are experienced
in the UK is filtered by the external value of Sterling. The UK’s strategic decision
to remain outside the Euro area has resulted in some massive inflows of
financial capital during the past four years, not least into government securities.
On a trade-weighted basis, Sterling has sustained its appreciation, particularly
against the Euro and the Yen. Should the Euro area recover its economic
vigour, there is a presumption that capital will readily repatriate.

The relative strength of the inflationary pressures on the UK economy is soon
to be reasserted over the disinflationary ones. The most important judgement
concerns the rate of unit labour cost inflation. We reiterate the view that a
dramatic tightening of UK labour market conditions is about to unleash a
surprisingly powerful acceleration in employment costs. We expect whole
economy unit labour cost inflation to recover to 2.5% per annum in 2016 and
3% in 2017.

Does this scenario constitute an inflationary challenge to the Bank of England?
Does it presume a tightening of monetary policy? As far as 2015 is concerned,
the answer to both questions is most probably in the negative. What would
give members of the MPC pause for thought is an economic downturn that
coincided with wage acceleration. The non-appearance of a recovery in labour
productivity raises the stakes for the inflationary outlook and this should colour
monetary policy decisions today.

The last piece of the inflationary jigsaw is the revival of broad money growth,
whether triggered by an upsurge in private domestic bank lending (businesses
and individuals), lending to the government or the result of movements in the
external finance position. The accommodation of inflationary pressures by
the banks remains a key component of the inflationary scenario.

As the UK economy regains momentum after its pre-election lull and as house
prices surge forward anew, now is the time to bite the bullet and raise Bank
Rate, initially by 0.25%, at the June meeting.

Vote by Mike Wickens
(University of York and Cardiff Business School)
Vote: Raise Bank Rate by 0.25% and decrease QE to £250bn
Bias: To unwind QE and slowly raise rates as the economy grows

Based on fundamentals, bank rate and interest rates should have been higher
for the last year or two. The difficulty facing the MPC is that, because the
fundamentals have not change significantly, there has been no ready justification
available to the MPC to explain to the public why an interest rate rise is
appropriate. Until there is a major change in fundamentals the MPC is trapped
into too low rates. The most likely change in the short term that would allow
the MPC to raise rates is a rise in US rates.

A measure of the extent of the distortion in the MPC’s monetary policy stance
is the search for yield in the stock market that has seen stock prices rise
steadily. The ECB’s recent QE has had exactly the same consequence.
Moreover, even though sovereign risks in the eurozone have not reduced,
sovereign borrowing rates have fallen steadily – again reflecting the distortionary
effects of monetary policy.

Wage rises often provide the fundamental that leads to higher interest rates.
In the UK wage rates are on the rise. This is a reflection of rising demand
despite low labour productivity and a large increase in the supply of unskilled
labour in large part through immigration.

The low productivity has been regarded as a huge puzzle. It shouldn’t be. In
effect in the UK we have seen labour capital substitution: low business
investment leading to low capital accumulation (a low numerator in the
productivity ratio) and high immigration leading to an increase in employment
(a high denominator). Although the UK has experienced reasonable growth,
much of this is in services which has low capital-labour ratios and uses mainly
unskilled labour. Wage fundamentals are therefore unlikely to provide the
excuse the MPC needs.

Vote by Trevor Williams
(Lloyds Bank & Derby University)
Vote: Hold
Bias: neutral

No change to rationale from last month.

Policy response

1. On a vote of six to three the committee agreed to hold the Bank Rate at
its current level.
2. Two members voted for a rise of 0.25%, and one for a rise of any description.

Date of next meeting
Tuesday, 14th July 2015

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 Trevor Williams, visiting professor,
Lloyds Bank. Other members of the Committee include: Roger Bootle (Deloitte
and Capital Economics Ltd), Tim Congdon (International Monetary Research
Ltd.), Jamie Dannhauser (Ruffer), Anthony J Evans (ESCP Europe), John
Greenwood (Invesco Asset Management), Andrew Lilico (Europe Economics
and IEA), Patrick Minford (Cardiff Business School, Cardiff University), Gordon
Pepper (Cass Business School), David B Smith (Beacon Economic
Forecasting), Akos Valentinyi (Cardiff Business School, Cardiff University),
Peter Warburton (Economic Perspectives Ltd) and Mike Wickens (University
of York and Cardiff Business School). 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.

Continuing its recent trend, the Shadow MPC has voted to keep rates on hold in April.

There was a variety of reasons offered for holding. Some members felt the economy remained weak. Others felt that the economy was going well and there was no good reason to change anything. Others argued that it was difficult to justify raising rates when inflation is so far below target. One member felt there should be no change until post-General Election uncertainties are resolved.

Those advocating raising rates maintained their familiar position that rates have been held too low for two long and normalisation is long past warranted.
The SMPC is a group of economists who have gathered quarterly at the IEA since July 1997. That it was the first such group in Britain, and that it gathers regularly to debate the issues involved, distinguishes the SMPC from the similar exercises carried out elsewhere. To ensure that nine votes are cast each month, it carries a pool of ‘spare’ members.

This can lead to changes in the aggregate vote, depending on who contributed to a particular poll. As a result, the nine independent and named analyses should be regarded as more significant than the exact overall vote. The next two SMPC polls will be released on the Sundays of 3rd May and 31st May 2015, respectively.

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Vote by Jamie Dannhauser
(Ruffer)
Vote: HOLD
Bias: To hold
One year view: Bank Rate at 1%; no change in QE

UK headline inflation dropped to zero in February. The price level, as proxied by the seasonally adjusted level of the CPI, has declined in six of the last eight months. It seems likely that the inflation rate will turn negative in the months ahead. No doubt, media hysteria about the onset of ‘deflation’ in the UK will increase.

It is certainly true that the UK has seen broad-based disinflation over the last few years. This started prior to the oil price collapse and is evident is a wide range of measures of underlying inflation. It is one of the reasons why I have advocated incredibly easy monetary policy in SMPC submissions and debates. There is scant evidence, however, that the UK economy is suffering from deflation – a sustained period of declines in the price level; and even less that it is trapped in ‘debt deflation’, a scenario in which the confluence of falling asset prices and overstretched private sector balance sheets creates a self-feeding deflationary spiral that monetary policy can do little to arrest.

At a global level, there remain headwinds to growth, not least the still growing overhang of debt on private sector balance sheets. China’s credit binge in recent years is even more extreme than most of those seen before the 2007/8 collapse. Political and economic distress may emerge across the euro-area were a political accident to occur in Greece. Nonetheless, the current economic and financial market environment does not warrant an easing of monetary policy in the UK. In fact, I would expect it to be desirable to increase Bank Rate at some point over the next year, quite possibly before the year is out.

The slump in headline inflation rates is predominantly due to the fall in oil prices, a substantial global relative price shift that should be a net positive for global growth. The suggestion that this relative price shift represents a deflationary impulse is far-fetched. A (supply-driven) oil price drop shifts incomes to countries and sectors where the marginal propensity to spend is likely to be higher. There is an extensive literature suggesting that supply-driven oil shocks (as this seems to be) have a meaningful effect on output, albeit with a lag of a few quarters. I see no reason for this episode to be any different qualitatively, even if the overhang of debt in many of the beneficiary countries may reduce somewhat its quantitative impact.

In addition to the growth-enhancing oil price shock, there are also signs of a meaningful easing of credit conditions in the euro area, Britain’s main export destination. Monetary growth is being boosted directly by ECB QE; but we must also take account of the rapid and significant increase in access to bank credit that seems to have taken place in those parts of the euro area where credit constraints had previously been most extensive. Lending rates on new bank borrowing across the periphery have fallen sharply in recent months. Anecdotal evidence suggests non-price restrictions on bank credit have eased alongside the decline in loan rates.

In addition to the structural reasons for optimism about US growth, there are also encouraging signs from the monetary data. Growth of both broad money (M2 plus institutional money market fund shares) and bank lending to the private sector, which had been moving sideways in the 5-6% range last year, have accelerated quite clearly since late-’14. A host of other monetary indicators would support the following assertion: at the very least, the US recovery is well-entrenched and there is a decent chance that private sector demand growth picks up as we move through 2015/16.

UK monetary data, while not indicating an easing of monetary conditions this year, remain consistent with decent domestic demand growth. With a good chance of a cyclical bounce in the UK’s two biggest export markets, it is important that monetary policy looks ahead to prospective inflation developments, not backwards to a relative price shock that is temporarily pushing down on the headline inflation rate. Nor should policymakers be trying to ‘talk down’ sterling, as the MPC has recently been doing. Sterling has strengthened on a trade-weighted basis but its move seems eminently justifiable given the cyclical position that the economy is in relative to its trading partners.

It would be wrong to dismiss out of hand concerns that low headline inflation are problematic when the central bank’s arsenal has been partly run down. But there is scant evidence that inflation expectations are, or will become, unanchored. Fears that inflation expectations will be pulled down by (briefly) negative headline inflation should turn out to be as unfounded as the concerns expressed a few years ago when CPI inflation was “well above” the 2% target. Moreover, policymakers still have a wide array of unconventional instruments that could be deployed if a sustained period of debt deflation was upon us. It is inappropriate to talk about the asymmetry (in macro policy) of the zero lower bound on short-term policy rates.

There is no case at this stage for additional monetary stimulus in the UK. Indeed, given my base case for growth in the UK’s main export markets in coming quarters, and the ongoing robustness of private sector demand at home, the next move in policy should be a withdrawal of stimulus. The appropriate moment may well be later this year.

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Vote and Comment by Anthony J Evans
(ESCP Europe)
Vote: HOLD
Bias: Raise once inflation returns to 1%-3%

The recent dramatic undershoot of the inflation target has provided further opportunities to ask some fundamental questions about monetary policy. Firstly, given that 0% CPI has been widely interpreted as good news an obvious question is why do we have a 2% target rather than 0% target? Secondly, if we are supposed to permit such large fluctuations in CPI around the target provided they are supply driven, why not target something – such as nominal income – that allows all supply shocks to show up in the inflation rate? And thirdly, if the downward trend in inflation continues, and policymakers start to fret about deflation, is QE in its present form an appropriate way to conduct monetary policy?

One of the biggest problems with how QE has been enacted is that it’s been discretionary and ad hoc. The Bank of England’s blasé approach to the inflation target makes it hard to predict the scale (and indeed permanence) of open market operations. Why not ditch the inflation target, and then tie future QE to a clearly communicated explicit nominal income target?

M4ex continues to grow above 3% and Divisia measures remain strong. Real GDP is healthy and so it’s only the decision to set a 2% inflation target that is causing attention to switch from raising rates (and a return to normalcy) to further easing. I do not see the necessity for further easing at this stage, but hope that such discussions can take a step back and reassess the whole framework, rather than continue to make modifications to the current one.

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

Perusing the economic tealeaves at present is not easy. The spectres of deflation and/or accelerating above trend GDP growth are plausible scenarios. The latest data shows above trend GDP growth of 2.8% in 2014, thereby implying a reduction in the output gap, on the assumption of maximum potential output growth of around 2.25% per annum. However, any inflationary pressure from the narrowing in the output gap has been completely swamped by the offsetting deflationary impact from the fall in oil prices. CPI inflation reached a record low of zero (yr-on-yr) in February and could go negative. Even if the MPC looks through zero inflation or deflation as a ‘temporary’ phenomenon – and leaves monetary policy unchanged - what is the potential economic fall-out?

In the public mind, deflation and depression are seen to run hand in hand. However, the economic reality is that historically most deflations ran in parallel with economic growth – deflation is not necessarily a recipe for depression. Simultaneous deflation and depression tend to occur when the money supply implodes. The debt deflation scenario is then intensified by nominal wage rigidity - triggering higher unemployment - and a liquidity trap.

Deflation can be malign or benign, depending on whether or not it is driven by an improvement in aggregate supply (benign) or a deficiency in aggregate demand (malign). Economic theory suggests that mild deflation is optimal. Examples include the Friedman Rule and Selgin’s productivity norm. Economic theory also suggests that deflations in certain circumstances can be very damaging, cf Keynes and Fisher. The positive aspects to deflation include a risk-free, tax-free reward to holding money, equal to the rate of deflation. The negative aspects to deflation include purchase postponement, an increase in the real value of debt and higher real interest rates when nominal rates are limited by the zero bound. The impact of deflation on aggregate demand depends on whether deflation is anticipated or unanticipated. Expected deflation can reduce consumption and investment because of expectations of increasing real interest rates. It can also work by increasing the returns to hoarding money. Unexpected deflation can also reduce aggregate demand via the impact on net worth, with falling asset values.

Despite the weakness in headline M4 money supply figures (-3.2% yr-on-yr in February), other monetary statistics don’t point towards deflation undermining GDP growth. M4ex money supply (the Bank of England’s chosen target measure) rose 3.5% (yr-on-yr) in February after 4.2% (yr-on-yr) growth in January. PNFC divisia money growth stood at 13% (yr-on-yr) in March, with household divisia money up 6.2% (yr-on-yr).

As yet therefore the deflationary threat in the UK looks mild and indeed is likely to have a positive impact, given the boost to real earnings growth, when set against a background of nominal wage rigidity. The boost to discretionary spending power from weaker oil prices should help maintain GDP growth close to 2.75% in 2015. There is also the possibility of some form of relief rally and boost to business confidence if the Conservatives and/or the Coalition are returned after the General Election. However, the converse could also be the case, if a Labour Government was elected, with expectations of higher taxes, supply-side damage, reduced FDI and weaker growth. The relief rally scenario could push GDP growth above 3% this year. The converse scenario could reduce it below 2.5%. The elephant in the room remains uncertainty in the euro-zone and a potential Greek exit. However, in the absence of any Grexit, euro area growth prospects could yet surprise on the upside, in the wake of quantitative easing.

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Vote and Comment by John Greenwood
(Invesco Asset Management)
Vote: HOLD Bank Rate and QE
Bias: Neutral. Be ready to renew QE if the economy weakens significantly, or raise rates in the unlikely event that M4x surges for a sustained period.

The recovery of the British economy slowed slightly from an average of 0.7% quarter-on-quarter (2.8% annualised) in the first three quarters of 2014 to 0.5% (2.2% annualised) in the final quarter of 2014 Q4. Although this would be a respectable growth rate under most circumstances, the fact that this moderation of growth is occurring at a time when the economy is still some distance from its full potential suggests that the recovery is still vulnerable. The weaknesses are both domestic and external. For this reason any precipitate action to raise interest rates or tighten monetary conditions now – which inevitably would affect all sectors -- would likely cause a significant setback.

For every area of strength in the recovery there appears to be an associated element of weakness or vulnerability. For example, despite big improvements in the labour market, wage growth remains weak. Associated with weak wage growth, there has been an associated shortfall in tax revenues. Also, despite an 18% increase in exports of goods and services since the trough of the recession, the external current account deficit has widened alarmingly. Finally, despite a gradual improvement in the health of the banks, money and credit growth remain disappointingly low. This is the fundamental driver behind the fall in CPI inflation to 0%.

The labour market has improved notably in recent quarters. For example, LFS employment continues to rise, reaching 30.940 million in the three months to January 2015, a rise of 617,000 over the year, or up by almost two million since the recession low. Similarly, unemployment has continued to fall, reaching 5.7% of the labour force in January, or 1.86 million persons, a fall of 479,000 over the year. In spite of these favourable trends, youth unemployment among those aged 18-24, although down from its peak of 20% in November 2011, was still at 14.3% in the three months to January. More generally, wage growth remains anaemic. In the latest data average weekly earnings increased 1.6% (excluding bonuses) year-on-year in the three months to January, and by 1.8% when bonuses are included.

The weakness in wage growth for middle and lower income workers is part of a world-wide trend connected with the entry of large emerging economies such as China and India into the global trading system, and cannot be attributed to national UK policies. Although the recent UK wage increases have increased above CPI inflation at current rates, they will need to rise further to ensure sustained real wage growth when inflation picks up again.

Associated with the weakness in wage growth, tax revenues from income tax have undershot Coalition expectations, thereby causing the budget deficit to remain wider than expected, and the national debt to remain close to its peak levels. (In the Budget there was a token reduction in the overall level of national debt thanks to the sale of government shares in Lloyds Bank.)

The economy also remains acutely vulnerable to external weakness, especially in the Eurozone, Britain’s largest trading partner. In contrast to the United States where the current account has not deteriorated (as a % of GDP) since the start of the current upturn thanks to improvements in competitiveness and the exploitation of shale oil and gas, in the UK both the overall current account and the visible trade deficit are running at record levels. The UK’s visible trade balance is running at monthly deficits of £10 billion, while the current account deficit widened to £25.3 billion in the fourth quarter of 2014.

Finally, broad money and credit growth remain weak – barely enough to sustain current real GDP growth rates plus the targeted 2% inflation rate. This is despite the two government credit promotion schemes (“Funding for Lending” and “Help to Buy”), and near-zero interest rates. M4x, the sum of money balances held by households, non-financial companies and non-bank financial companies excluding certain bank-like intermediaries, is only growing at 4.3% year-on-year, while M4, a wider definition which includes the money balances of all financial companies declined at 3.2% year-on-year in February. On the lending side M4 Lending declined at 3.9% year-on-year in February, with loans to households increasing marginally, but loans to financial and non-financial companies declining.

Under these conditions there can be no danger of a surge in credit, a surge in growth, or any inflationary outburst. On the contrary, the risks are currently tilted towards slower growth and deflation. It would therefore be unwise to raise interest rates or otherwise tighten monetary conditions. Rate increases at this stage would damage the prospects for economic recovery, and should be delayed until the recovery is substantially more vigorous in both real and nominal terms.

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

The Chancellor’s welcoming a further fall in inflation to 0% as good news only days after setting a 2% “target” was a further confirmation – if such were needed – that the UK’s “inflation target” is no such thing. The Bank of England is not supposed to attempt to get inflation to the level the Chancellor sets. What they are supposed to be doing is very hard to guess, but the UK’s monetary policy framework has clearly been largely unbridled discretion for some years. Discretion is not necessarily a bad monetary policy framework for an economy as large as the UK’s. But if, at some point in the future, the government or Bank did want to introduce some binding (or at least constraining) monetary policy rule, it is difficult to imagine that it would have any credibility. Since 2007, the monetary policy credibility so sorely won in the 1980s and 1990s has been casually tossed away, as if it were nothing, as if all that “monetary policy credibility” meant was that market participants have about the same forecast for future inflation as the Bank’s target. But maybe that was right. Maybe the UK will not need credibility again in the sense of credibility where that means “sticking to your promises even when such sticking is unattractive to do when it comes to it”.

Treating the UK’s monetary policy framework as pure discretion, there is little basis for believing 0% inflation a good reason in itself for keeping interest rates at effectively zero, at the same time retarding monetary growth through excessive prudential requirements, when the economy is growing well and unemployment is down. It is also most unclear how it is morally defensible to keep the returns to savers and pensioners so artificially low without an emergency rationale.

But this is a moral battle that advocates of monetary policy normalisation lost long ago. It has been at least four years since there was really any good reason for keeping rates at 0%. In my view, having come this far, we must play the game out to the end. Nothing has made the normalisation argument any stronger for raising rates for more than a year. The economy is adapting to lower interest rates in the reasonable expectation that, unless something changes that would justify a rate rise, there will not be one. Raising rates in this environment would arguably harm economic agents that have made decisions (e.g. taking out mortgages) based upon such reasonable expectations of stability. Accordingly, it is now my view that rates should stay on hold until rising inflation (by which I mean comfortably above-“target” inflation) or, at least, accelerating broad money growth, forces us to raise rates.

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

The inflation target for monetary policy was new in 1992, when introduced here soon after our ejection from Europe’s Exchange Rate Mechanism on Black Wednesday. New Zealand had been the first to use one a few years before. The new target has been an undoubted success here in that we have had little inflation ever since its introduction; it has also been highly credible, as evidenced by little drift away from 2% in measures of inflation expectations. Its credibility and its success in keeping inflation stable and low are just two sides of the same coin, since the credibility has stopped any group from making wage settlements or setting price increases at all far away from what 2% would imply.

But, as so often when we make strides in economic policy, a further problem has been revealed about the conduct of monetary policy according to this inflation target. We have seen poor control of credit booms and busts, as illustrated by the boom of the 2000s and the bust of 2007-9. The original idea was that monetary policy would be spurred to control the boom by surging inflation and the bust by sharply falling inflation. Neither really happened. During the boom inflation stayed moderate; it actually rose during the bust as oil and commodity surged, but this inflationary surge came after the bust and so gave the wrong signal.

What we have seen here is an illustration of how if you change the policy regime behaviour changes; in this case the key behaviour that changed was the response of inflation to boom and bust. The new policy regime assumed inflation would continue to respond strongly to these but in the event it did not, for the reason we have given that people built the new regime into their behaviour and so moderated their inflation responses. So the question today is how we should repair our monetary policy target regime and how within it we should respond to an inflation rate temporarily zero and maybe briefly negative?

Take the first question of target first. It seems that what is missing from the previous regime was the old-fashioned response of monetary conditions to the business cycle: what a Fed Governor once famously called ‘taking the punch bowl away as the party gets too merry’. This element could be supplied by varying the supply of money, as in Quantitative Easing (QE), to some degree independently of inflation and interest rates. The supply of money is supposed to affect credit and interest rates charged by banks and others like them.

Another idea is to stiffen the response of Bank Rate itself by replacing an inflation target by a target for ‘Nominal GDP’, or for one element of Nominal GDP, the Price Level. Nominal GDP is defined as the economy’s Output times the Price Level. Suppose one wants prices to grow at 2% (target inflation) and output to grow at 3% (target growth). Add the two together to make 5% and record the cumulative growth of both from some initial date, say 2012. Adjust Bank Rate up or down if the cumulative total exceeds or falls short of the cumulative target. The idea is that booms typically generate several years of excessive growth and so the accumulated overshoot would trigger a progressively stronger response from Bank Rate; and vice versa with busts which typically deliver several years of below par growth and inflation. Much the same argument applies if you only did this for the Price level and excluded output from the calculation. Some experiments with these ideas on models of the economy suggest they would work quite well to restore the old party-pooping responses into monetary policy, while also maintaining the control of inflation that now exists. One could combine a QE rule with such a beefed-up Bank Rate rule.

Against this background we can consider next how to respond to current ‘deflation’ combined with strong growth in output and employment. Latest figures suggest that the economy is cumulatively not too far below a reasonable target level, and may even be moving above it, while the huge rise in QE has pushed asset prices up and encouraged peer-to-peer lending on a large scale. Yet Bank Rate is still glued to the floor and QE remains at £375 billion, a huge holding of government bonds by the Bank of England. In my view it is time to move both back slowly towards normal.

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Comment by David B Smith
(Beacon Economic Forecasting)
Vote: Hold Bank Rate until after the election; hold QE.
Bias: To raise Bank Rate by two ¼% increments in the late-summer/autumn.
1 Year View: Depends on election outcome; on no-policy change assumption, raise Bank Rate to 1½% by mid-2016 and then re-consider.

With Parliament dissolved on 30th March and the general election due on 7th May, UK monetary policy is almost certainly on hold until the late summer at least. The next official rate announcement will occur as normal on 9th April. However, the Bank of England announced some time ago that the May MPC decision will be delayed until Monday 11th May in order to avoid a rate decision being announced on election-day. With the opinion polls suggesting the strong likelihood of a hung Parliament, in which the tacit support of several parties may be required to pass legislation, the May rate announcement might well occur before a new government is in place. Looking beyond the election, there is likely to be a strong ‘relief’ rally in private investment and recruitment if the Coalition is renewed in office – current polls suggest that a Conservative government with a clear majority is unlikely – leading to ‘overheating’ concerns for 2016. In contrast, a Miliband administration (or a potential left-wing ‘coalition from hell’) could lead to major markdowns in sterling and the domestic financial markets, weaker activity and a tendency towards stagflation, confronting the monetary authority with an unpleasant trade-off between activity and inflation. Meanwhile, the recent economic indicators suggest that the three-way tension between reasonably buoyant home demand, a disappointing and worryingly weak supply-side response, and the dis-inflationary consequences of the much reduced oil price has grown worse in recent months.

In theory, the reduced price of oil and other commodities represents a relative price shock, which has had a temporary negative impact on inflation and a transitory positive one on output but contains no long-term consequences for the levels of either variable. This may be too simplistic if the supplies of money and credit respond endogenously to transitory shocks to prices and activity. However, it is probably right for the monetary authorities to look through the current undershooting of the 2% inflation target, while keeping a weather-eye open for any subsequent second-round effects. More generally, mildly negative inflation has two distinct and competing effects on activity. When nominal incomes are ‘sticky’, slightly negative inflation raises living standards and boosts consumption. This seems to have been an important reason why the British economy escaped so lightly compared with other leading countries from the Great Depression of the 1930s, for example. A potential negative, and offsetting, effect from falling prices is that people who are rich enough not to spend all their income immediately may delay discretionary purchases if they think goods and services will be cheaper in future. In addition, there is the impact of a falling price level on the real rate of interest paid by debtors. Nevertheless, with nominal rates as low as they are at present, the resulting real rate need not be out of line with the pre-2008 historic norm, for example. On balance an annual disinflation of less than, perhaps, 2% would probably be mildly stimulatory overall. However, if the price decline exceeded, say, 5% then there should be aggressive measures to boost the money supply, Technically, this would be easy to implement given the continuing large size of the UK budget deficit, which could simply be monetised for a period.

The appropriate response to the other two parts of the three-way tension, the combination of recovering demand with a weak supply-side response, would be to raise interest rates while undertaking tax cutting measures and regulatory reforms to make it more worthwhile for private agents to create wealth. The fiscal-stabilisation literature implies that this is what the Coalition should have done immediately it took office in 2010. In particular, this stabilistion literature distinguishes between ‘type 1’ fiscal retrenchments, which are led by reductions in government current spending, marginal tax rates are cut, and government infrastructure investment is not reduced, and ‘type 2’ fiscal retrenchments in which tax increases are front-end loaded, government consumption is allowed to grow and public capital formation is cut. Numerous international studies suggest that type 1 fiscal adjustments are followed by a marked recovery in national output and improved public finances, while type 2 adjustments see a poor (or negative) output response and a deterioraton in the public finances. A current illustration is provided by the recoveries being observed in those Euro-zone countries, such as Ireland and Spain, that accepted the type 1 medicine required for Germany’s support compared to Greece, which so dramatically rejected it.

Unfortunately, Mr Osborne has only implemented a ‘timorous’ type 2 fiscal adjustment during his period as Chancellor, with the predictable result that economc growth has averaged something under 2% throughout the life of the now-dissolved Parliament,while the public finances have improved far more slowly than the Chancellor expected. More generally, there appear to have been three main causes of the pressure on voters’ livng standards since the 2010 election. The first is that any economy that suffers from a high and capricous tax burden and excessive regulation will only grow slowly, if it all. This is because of the limited incentives for private agents to undertake capital investment or accept the business risk asociated with new projects. These tax and regulatory induced disincentives to wealth creation are crucial because living standards cannot grow faster than the underlying economy for long, and real GDP per head in 2014 Q4 was still 1.2% below its pre-downturn peak in 2008 Q1. The second cause of the so-called ‘cost of living crisis’ was Mr Osborne’s decision in 2010 to raise the VAT rate from the 15% he inherited to the present 20%. Returning the VAT to its pre-Crisis 17½% may have been defensible in 2010. Nevertheless, the extra increase of 2½ percentage points hit living standards directly, exacerbated and lengthened the recession, and gave a perverse signal to the private sector that, if in doubt, the government would always try to tax its way out. The final major reason for the adverse pressure on the electorate’s living standards was the attempt to re-balance the economy through the previous cheap pound policy, which was probably as much a mistake on the Bank of England’s part as the Chancellor’s. Such a policy will work if the price elasticity of demand for UK exports and imports is high and the feed through from the external value of sterling to domestic prices is weak. However, the evidence – even before this policy was implemented – suggested that the facts were to the contrary. This seems to have been confirmed by subsequent developments.

Following the 18th March Budget, the Office for National Statistics (ONS) published a major set of revisions to the national accounts on 31st March, which inter alia revised last year’s average growth rate up from 2.6% to 2.8% and ‘through-the-year’ growth from 2.7% to 3%. This is the second consecutive occasion on which the official forecasts have been rendered obsolescent within a few weeks of publication by ONS revisions – the same thng happened after last year’s Autumn Statement – and one can only presume that the forecasters at the Office for Budget Responsibility (OBR) are spitting tin tacks with rage. The 31st March ONS data have been run through the Beacon Economic Forecasting (BEF) macroeconomic model in addition to the Budget measures. When running the BEF model, the official projections for the volume of general government investment were kept but it was assumed that the volume of general government current expenditure grew at a steady 1% each year, since the official OBR forecasts were not considered realistic. Even so, our forecasts should be regarded as representing a ‘no-policy-change’ assumption, which incorporated a realistic degree of spending slippage, rather than as a simulation of the very different policies that might follow a change of government.

Some of the main results of this exercise are as follows. Firstly, the BEF projections show that economic growth is expected to accelerate from last year’s revised 2.8% to average 2.9% this year, before slowing to 2.3% in 2016 and then fluctuating around 1¾% up to 2020 (when the OBR forecast horizon ends). In the short term, this is actually faster than the 2.5% OBR growth forecast for this year, and matches the 2.3% projected by the OBR for 2016. However, our longer-term projections are weaker than the official ones, which show growth of 2.3% in 2018 and 2.4% in 2019. This is probably because the medium-term OBR growth forecasts are set ‘off model’ through a series of (arguably, over-optimistic) assumptions about potential supply, whereas the sustainable growth rate is both endogenous and heavilly influenced by supply side factors in the BEF framework. Second, CPI inflation is expected to end this year at minus 0.3% (OBR prediction plus 0.6%), before rising to 0.9% in 2016 Q4 (OBR 1.4%) and 1.3% (OBR 1.8%) in 2017 Q4. Longer-term, CPI inflation is expected to pick up from an annual average of 1.5% in 2018 to 1.9% in 2020. This is similar to the OBR forecasts, which show a gentle rise from 1.7% CPI inflation in 2017 to 2% from early 2019 onwards. The BEF predictions assume that the price of a barrel of Brent crude averages US$57½ this year, before rising to US$60 next year and going up by US$1.5 in each subsequent year. The modest turn around from negative inflation in the second half of this year to positive in 2016 reflects the fact that the 2015 oil price falls becomes part of the base for the annual inflation calculation next year.

Third, while the outlooks for growth and inflation look reasonable, the prospects for Britain’s twin deficits look anything but, even on the assumption that present policies survive the May election. Where the first twin deficit is concerned, the 31st March ONS data show that the current account balance of payments deficit was a mighty £97.9bn last year, compared with £76.7bn in 2013. The latest BEF projections indicate that the current account payments deficit will ease temporarily, to £76.1bn in this year, but deteriorate to £80.7bn in 2016, £85.1bn in 2017, £94.2bn in 2018 and £103.9bn in 2019. This contrasts with the situation in the OBR projections, where the current account deficit is predicted to fall from £79.8bn this year to £49.6bn in 2019. However, when making these projections the OBR have assumed a massive turnaround in the UK’s investment income balance from a deficit of £30.2bn this year to a surplus of £4.6bn in 2019, which seems optimistic. With respect to the other twin deficit, the latest BEF projections show underlying Public Sector Net Borrowing (PSNB) of £90.0bn in 2014-15, being followed by deficits of £77.9bn in 2015-16, £67.6bn in 2016-17, £62.4bn in 2017-18, £56.9bn in 2018-19 and £51.0bn in 2019-20. This is noticeably slower progress than Mr Osborne predicted in his March Budget statement, where the PSNB was forecast to fall from £89.9bn in 2014-15 to £75bn in 2015-16, £39bn in 2016-17 and £13bn in 2017-18 before showing surpluses of £5bn in 2018-19 and £7bn in 2019-20. However, Mr Osborne has significant form where overshooting budget deficits are concerned by now.

As far as the outlook for the financial markets is concerned, any attempt at projection is likely to be undermined by the political uncertainties. A more thorough analysis would require running several distinct scenarios, which would not be easy given the nebulous nature of many of the political parties’ tax and spending commitments. Our no-policy change projections suggest that the sterling index could remain in the high 80s and low 90s (January 2005=100) over the next few years and that Bank Rate might end 2015 at 1%, if historic relationships re-asserted themselves. This might be nearly as far as the hikes go over the next few years, with the negative real rates overseas limiting the upside risks. The return to power of the Conservatives, or a renewal of the present Coalition, might be accompanied by a, possibly short-lived, relief rally in sterling, equities and the gilt-edged market, before it was back to business as normal. Alternative and not unlikely, political scenarios might well imply the opposite, of course. However, for this month and next a tactical hold seems the most appropriate Bank Rate decision for political reasons, despite the fact that the
31st March ONS data suggest that the UK economy is stronger than was previously believed and also living beyond its means where the twin deficits are concerned.

------------------------

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate ¼%. QE restructure by £50 billion.
Bias: To raise rates to 1½% over 12 months.

In view of the extraordinary speech from Andrew Haldane (Drag and drop, 19 March), in which he attempted to redraw the landscape for the Bank Rate decision, it is necessary to revisit my objections to the decision to hold Bank Rate at 0.5% for 6 years and, a fortiori, to rule out any temptation to cut Bank Rate. Many countries – 22 at the last count – have reduced their policy interest rates since the beginning of the year. The majority of these are emerging market nations seeking to counteract disinflationary pressures. In the case of resource-rich Canada and Australia, the motivation is additionally to seek currency depreciation.

The UK does not fall into either of these camps. Domestic economic growth is quite robust, with household nominal incomes rising 5.3% and nominal GDP at market prices rising 4.3% in the year to 2014Q4. The drop in the CPI inflation rate to zero in February is insufficient in itself to change the polarity of interest rate change. There is no perceptible threat of income deflation in the UK and most recently wages have accelerated. The reluctance to raise Bank Rate demonstrates a failure to think internationally and far-sightedly about the inflation outlook.

While it is possible that breaking the taboo of 0.5% Bank Rate could provoke irrational fears and damage consumer confidence, we will never know unless we try. My conviction is that the initial stages of rate normalisation would have very mild effects on activity and employment. The first argument in favour of a rate increase is to build a buffer in time for the next economic shock: to have scope to ease conventionally in 2016-17 should the need arise.

A second argument is to guard against borrower complacency concerning extraordinarily low debt service costs. It would be wise of the Bank to conduct a real-life stress test of mortgage and corporate borrowers’ ability to withstand slightly higher interest rates.

A third argument is the risk of financial instability emanating from the excessive use of leverage in overheated property markets.

Another by-product of 0.5% Bank Rate has been the demise of the London Interbank market. At such low interest rates, commercial banks see no attraction in lending out their surplus liquidity to their competitors. The hoarding of liquidity has become an entrenched behaviour, partly as a protection against an unexpectedly large drawdown of unused credit facilities by bank customers. The normalisation of interest rates is a pre-condition for the restoration of health to the interbank market.

Another unseen cost of the low Bank Rate is the future burden of government support for savers whose capital has perished in some reckless attempt to secure higher yields on their wealth. Low interest rates poses longer–term fiscal risk.

The arguments frequently presented to defend Bank Rate passivity concern the economy’s alleged abundance of spare capacity, low real earnings growth, low inflation, stable inflation expectations, high household debt burdens, the strength of Sterling and weak money supply growth. None of these offer a robust argument against keeping rates at historical lows, much less to reduce them further.

A rise in Bank Rate is long overdue: the justifications for delay are insubstantial and the costs of delay, though largely unseen, are nevertheless serious and likely to be cumulative. My vote is for an immediate increase of 0.25%.

---------------------------

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

UK growth remains healthy. Notwithstanding concerns about falling prices, the UK should see some modest bounce-back in inflation later in the year as the oil price rise starts to fall out of the index. But with wage inflation currently subdued and price inflation likely to fall into negative territory before rising, the current level of interest is appropriate.

--------------------------

Policy response

1. On a vote of seven to two the committee agreed to hold Bank Rate.

2. Two members voted for rise.

Date of next meeting

21 April 2015

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

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

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

Those advocating raising rates have emphasized that the strategy of
maintaining near-zero rates has been damaging to real economic growth,
to productivity growth, to the pressure to achieve a sustainable fiscal
position and to longer-term financial stability. Low monetary growth has
been the result of excessively strict prudential and liquidity regulations
imposed upon banks. Monetary policy-makers should not collaborate in
such financial repression.

Votes

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

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

Vote and Comment by Anthony J Evans
(ESCP Europe)
Vote: HOLD
Bias: Raise once inflation returns to the 1%-3% range

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Vote by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate ¼%. QE restructure by £50 billion.
Bias: To raise rates to 1½% over 12 months.

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

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

Policy response

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

Minutes of the meeting of 13 January 2015

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

Chairman’s comments

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

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

International Background

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

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

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

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

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

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

Discussion

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

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

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

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

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

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

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

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

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

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

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

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

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

Vote and Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: HOLD Bank Rate.
Bias: To rise in stages and QE to be used in the event of euro crisis.

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

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

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

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

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate ¼%. QE restructure by £50 billion.
Bias: To raise rates to 1½% over 12 months.

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

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

Vote in absentia by Roger Bootle
(Capital Economics)
Vote: Hold Bank Rate. Hold QE.
Bias: Neutral

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

Policy response

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

What is the SMPC?

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

Current SMPC membership

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

In its email poll closing Thursday 2nd January, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended by five votes to four that Bank Rate should be raised on January 8th, including four votes for a rise of ½% and one for a rise of ¼%.

Those advocating a rise contended that current low inflation is the result of one-off factors (such as oil price falls) that do not change the basic story of an opportunity to normalise rates in a healthier economy.

Those that preferred to keep rates on hold noted that inflation is well below target, monetary growth is low and some contended that the real debate should be whether policy might be loosened further in the months ahead, with one suggesting he might soon favour the resumption of QE.

Votes

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

CPI inflation is considerably below target. However, it is likely that the fall will level out and reverse in the forecast period. We should not be worried that inflation is currently below target: it is important not to treat the target as a floor.

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

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

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold rates
Bias: Add more QE if required

A dominant theme in the monetary situation since 2008 is that the tightening of bank regulation has prevented banks from growing their risk assets (or even to some extent obliged them to reduce such assets), leading to very low increases in the quantity of money growth (or even stagnation/contraction of money). The low money growth/stagnation of money has in turn been accompanied by the lowest increases in nominal GDP since the 1930s, confirming the validity of the monetary theory of national income determination. The pattern has been found across the G7 group of industrial nations, although mercifully it has been less evident in those G20 nations that do not belong to the traditional G7. (The non-G7 countries can happily “do their own thing” in many policy areas, regardless of the latest follies and inanities from the world’s international bureaucracies. UK officialdom has been a champion of the tightening of bank regulation, apparently oblivious to the wider consequences of their actions in holding back recovery.)

Nevertheless, policy-makers have offset the contractionary and disinflationary effects of the low money growth/money stagnation by large-scale central bank asset purchases. Such purchases have boosted banks’ safe assets (i.e., their cash reserves in particular) and, when made from non-banks, have directly added to the quantity of money. Without these purchases, which have gone by the name “quantitative easing”, the disinflationary pressures would have been more intense.

Eurozone members will undoubtedly experience deflation in early 2015, and it is plausible that both the UK and the USA will also experience 12-month declines in consumer price indices, if not to the same degree as in the Eurozone. It might be expected that officialdom could at last put two and two together, and realize that the tightening of bank regulation and banks’ consequent restrictive attitude towards risk assets are the basic causes of the weakness in money growth and the prolonged macroeconomic malaise. But, no, at the Brisbane G20 meeting Mark Carney, governor of the Bank of England and chairman of the Financial Standards Board, secured agreement for further substantial rises in capital/asset ratios for banks that are deemed to be systemically important (i.e., “too big”, in the sense understood by the phrase “too big to fail”). According to the FSB’s new prescription (to which the banks must respond by early February), the next five years are to see the rises in the capital/asset ratios take effect.

I am not a banker and I may have misunderstood something. But my verdict is that – unless officialdom can be somehow alerted to the ineptness of its own actions and made to rethink – the prospect is for another five years of weak money growth/money stagnation. True enough, Japan has embarked on aggressive QE and other countries may go down that route, as and when macro conditions deteriorate. True also, in 2014 US banks did expand their risk assets (i.e., loans and non-government securities) and broad money growth ran at an acceptable 4% - 5% annual rate. But the impression I have is that US banks are only now appreciating the threat posed by the latest FSB proposals. (Or perhaps smaller banks are making hay, while the big banks suffer more under the regulatory cosh. I don’t know.)

Let me now focus more specifically on the UK. In the three months to November M4x rose by 0.5% (i.e., at an annualized rate of 2.0%), while banks’ loans (excluding loans to intermediate other financial corporations) dropped slightly. (In fact, this concept of lending – to be precise, “M4 lending excluding intermediate OFCs” – is at present little changed from two years ago.) Obviously, if this rate of money growth continues and prices fall by, say, 1%, real money balances rise at an annual rate of 3%, which is not out of line with the economy’s trend rate of growth. (The Pigou effect to the rescue, as some of us – not many of us, sadly – might say.) However, I am worried about the FSB’s proposals. I am in favour of no change in interest rates and my bias is to be prepared to resume QE if macro conditions disappoint in 2015.

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

In terms of the monetary policy backdrop, there have been two developments of note over the last month. The first is the continuing slump in crude oil prices; the second is the failure of the incumbent Greek administration to install its preferred presidential candidate, a turn-of-events that automatically precipitates an early general election.

The political dangers emanating from Greece should not be underestimated. Syriza, the hard-line left-wing party led by Alex Tsipras, is 3-4 percentage points ahead in the polls. It remains favourite to come out of the end-January election as the largest party, although there is considerable uncertainty as to how far it will be able to pursue its radical agenda. The leadership has toned down its inflammatory rhetoric in recent months. Nonetheless, Mr Tsipras’ party remains committed to a series of policy steps that are unacceptable to the Troika. A win for Syriza at the end of the month has the potential to re-ignite market concerns about the viability of some peripheral countries’ continuing membership of EMU. While an announcement of additional monetary easing from the ECB is expected soon, this may be insufficient to contain the fall-out from a Syriza win. Downside risks to demand in Britain’s largest export market have clearly increased.

How monetary policy should respond to the collapsing oil price is less clear cut. The direct effect of lower petrol prices is set to push headline inflation well below 1% in coming months. By the end of the November, pump petrol prices had fallen 7½% from their July peak. Given moves in Brent crude prices in recent weeks (to £36 per barrel from £53 at the end of October), petrol prices could drop by another 10%. This alone will take another 30 basis points off the headline inflation rate (which registered 1% in November). Indirect effects through domestic utility bills and other energy-intensive items in the CPI basket will also bear down on headline inflation.

But to the extent that the reduction in crude oil prices reflects an exogenous ‘supply’ shock in the oil market, rather than a hit to (actual or expected) global demand, it is likely to be supportive for real private sector spending. Because the UK is a producer of oil and gas, it will benefit less than countries without a domestic energy sector. Nonetheless, the stimulus provided by such a massive decline in crude prices should not be underestimated.

The MPC has so far been minded to ‘look through’ the collapse in oil prices, stressing the beneficial effects for the real economy alongside the drop in headline inflation. This is the correct approach. The one-off drop in price level only matters for a forward-looking inflation-targeting central bank to the extent it either alters the balance between demand and potential output or expectations of future inflation. There has been some suggestion that the zero lower bound on short-term nominal policy rates creates an asymmetry in the optimal policy response, i.e. that there is a risk is not responding to a one-off drop in price level now because of a lack of monetary ammunition tomorrow, if inflation expectations do get dragged downwards. But since additional monetary stimulus can be imparted via central bank asset purchases (and a range of other tools) it is not obvious why this asymmetry exists in practice.

Inflation expectations should be monitored more closely than usual during the coming months; but at this stage monetary policy should be at least as attentive to the growth-enhancing effects of the oil shock as it is towards the inflation-depressing effects. Risks of another Eurozone panic should not be dismissed but for now should not alter the monetary policy stance. With underlying inflation (across a range of measures) still low, the case for considerable monetary accommodation remains. Recent developments do not justify an easing of policy from here though. Indeed, given the economy’s current trajectory, some withdrawal of stimulus should be justified by year-end.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise rates by ½%
Bias: To raise

Although below target rates of inflation can have a positive impact on household’s finances and on the wider economy, they present a dilemma for policy makers in the current situation. Regrettably, it seems that ultra low interest rates have become so embedded that normalisation will only occur once the economy is obviously overheating. This has meant that a lengthy window of opportunity to make moderate rate rises has been squandered. Now that inflation has fallen to a 1% growth rate the rationale for rate rises becomes somewhat incoherent. But this may say more about the inflation-targeting regime in which we live than the correct outlook for policy.

The UK economy continues to grow at a strong rate. In the third quarter of 2014 NGDP rose by 4.7% compared to 2013, and we have experienced above 1% quarter on quarter growth rates for over a year. The Divisia monetary aggregates show strong growth and in October the broad money supply growth rate slowed, (compared to September), but remained above 3%. These all support the notion that the economy no longer requires emergency monetary policy.

There are some important threats that can be used as excuses for procrastination, such as a Russian currency crisis and a particularly delicate Greek election. But these are part of prevailing issues namely Russian geopolitical activities and the Eurozone sovereign debt crisis. If we are waiting for them to be resolved before raising interest rates, they will be permanently low. If those situations deteriorate such that growth expectations fall, then monetary policy should be eased. But it shouldn’t remain loose just in case.
I have no qualms about low inflation, or even deflation, provided nominal income isn’t falling. Indeed it is important to consider why this particular inflation rate is low. It could be as a result of low aggregate demand, or it could be the result of a positive supply shock. Events in the oil market imply that it is the latter, in which case constrained inflation is a beneficial side effect of a productivity gain.

Having said this, interest rates decisions are made within an inflation-targeting regime and this rests on credibility and communication. Whilst I believe that NGDP growth and monetary aggregates are a better gauge of the monetary stance than CPI, the interest rate decision is intended to be driven by the latter. Given that inflation expectations remain above target, I believe that there is no necessity to loosen policy. If CPI falls below 1% then any attempt to raise interest rates should be put on hold. I am also open to more QE should the economy falter in 2015. However I still believe that the balance of risks implies that greater harm is coming from low interest rates, and that the economy is strong enough to cope with a moderate rise.

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

Broad money growth (on the Bank of England’s preferred M4ex measure) fell back again to 2.9% in the year to November 2014 and lending growth (M4Lx) was just 0.5% — with the apparent spike of a few months ago now exposed decisively as a blip. The lack of any acceleration in money or lending growth despite rapid economic growth and the huge expansion in the monetary base since 2007 continues to represent (alongside the performance of the labour market) one of the two great economic mysteries of our age. Very tight capital and liquidity requirements must be a contributing factor, but that simply pushes the mystery out one stage — why do the regulatory authorities believe that setting capital and liquidity requirements excessively tight whilst keeping interest rates artificially low is a desirable policy? Calling this combination “financial repression” is just giving a mystery (or an error) a name.

Whatever the rationale, financial repression is, at least for now, proving a success in its own terms. Savers are under-remunerated; new capital projects are starved of opportunity; underlying supply growth is restricted — and yet, unemployment falls without any apparent pressure on nominal wages; GDP growth (buoyed by the rise in the labour force) continues apace; and with oil prices dropping like a stone and monetary growth nugatory, inflation is now well below target.

I continue to believe that it would have been better to edge up interest rates in 2011 when UK financial conditions stabilised, or failing that to edge them up from mid 2012 when growth resumed, or failing that to raise them in 2013 when strong growth became established. We shall never now know how holding rates at, say, 1.5% (as I would have liked) for three or four years would have worked relative to holding rates at 0.5% for six or more years. But having come this far, I am now inclined to play the game out to its (sadly, probably bitter) end. If we would not raise rates when inflation was 5%, how shall we raise them when inflation is below 1%? If we would not raise rates when GDP growth was 3% and the Eurozone crisis in abeyance, how shall we raise them when GDP growth is slowing and the Eurozone/Greek crisis back with a vengeance? Alas, having come this far I now fear we must keep rates on hold until inflation rises or some other factor forces our hand. I surrender. My vote is now to hold.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate ½% and start to reduce the stock of QE gilts
Bias: Further rate rises and more run-down of QE
One year ahead: No view

Many in the monetary policy community of the UK are still cautious about raising interest rates and withdrawing QE stimulus. Their reasons are a mixture of traditional fear that so soon after recession the economy will ‘slip back’ into recession and worries about the pace of money/credit growth which are still weak.

The first of these we can dismiss as quite inappropriate and indeed traditional: it is due to the dominance of recent memory but we know from a lot of evidence that recoveries do not generally ‘slip back’. We are now several years into recovery and over a year since we passed the original peak. During this early recovery period there was no slipping back, in spite of scares about ‘double’ and even ‘triple’ dips into recession. By now with growth close to 3% the chances of slipping back have disappeared entirely. Remarks by Mr. Cameron about ‘red lights flashing’ around the world are also wide of the mark, and presumably designed for political effect; world growth is in the 3-4% region, quite typical for this stage of a recovery and fairly healthy in the context of rather recent commodity shortages. Also we would argue that in the next decade the world’s economies should avoid the sort of credit boom that occurred in the 2000s and pushed world growth regularly above 5%.
The second set of concerns about money and credit growth are less easily dismissed. It is clear that banks in the UK are still prevented from expanding their balance sheets strongly by regulation as well possibly as internal reorganisation to prevent future meltdowns. In particular small businesses are largely frozen out of bank credit by the new regulations that heavily penalise risk, even though socially such risks are classically diversifiable. Nevertheless it is also clear that QE has driven down yields on government debt and on equities to loss levels where investors are hunting decent returns elsewhere. This has opened up new channels of lending in the form of wealth management groups or trusts and peer-to-peer lending. Statistics on these new channels are naturally hard to come by, but indicators from individual firms operating in these markets suggest rapid, even explosive, growth. Furthermore retained profits of larger corporations are swollen by recovery and the slow expansion of investment. Thus some of the lack of credit growth (viz to these larger firms) is demand-led. In short we have a situation of growing ‘shadow banking’; this is a healthy response to the flat feet of the new bank regulators.

So my judgement on this second set of worries is to point to these new channels through which monetary ease is flowing and to raise the alarm. I think that to go on pouring monetary stimulus into the economy when there is this evidence of natural substitution with recorded credit and money is unwise. It could well as in the past lead to excesses that are only recognised well after the event. It seems extraordinary that so long into our palpable recovery interest rates on safe assets are negligible. This is causing a devil-may-care attitude among investors which is dangerous and unhealthy. It goes against the precept we have gleaned from our research into past crises of the last 150 years: that what is needed is an old-fashioned monetary policy of keeping monetary conditions from either being too cool or too hot: ‘taking away the punch bowl when the part is getting merry’ and vice versa. Sadly in sophisticated modern economies there is no foolproof statistic on which we can hang our hats. Monetary policy remains an art of interpretation in such a slippery environment. While the defenders of zero rates are honest in attaching themselves to monetary statistics, we thus point to the reality of substitution which has regularly occurred for these in the past decades.

The UK outlook is good. With the contraction of high productivity sectors, including North Sea oil and banking, there is a productivity challenge. A good response by UK policymakers would be to restore a fair tax environment for the North Sea which has been bedevilled by Treasury opportunism- sad considering that the same Treasury has argued so robustly for low marginal tax rates generally; and to roll back some of the more deformative regulation on banks, one of our most profitable industries for all its recent lapses. The productivity problem seems to be partly mis-measurement by the ONS, now gradually being corrected, and partly this one-off adjustment due to these sectors’ falling off; in fact productivity growth in other sectors seems to be continuing at its usual slowish rate.

Let me end by commenting on the inflation environment. The fact is that since inflation targeting got under way in 1992 UK domestically-generated inflation has been close to the target rate of 2%. This can be put down to the massive credibility produced by the new institutions, contrary to general expectations that inflation would continue to be volatile and hard to control. What inflation we have had above and below the 2% rate can be seen now to have been due to external inflation rates, mostly from commodities, that the Bank refused to respond to. This remains true today when commodity prices are declining rapidly. What we have discovered from the inflation evidence of the past two decades is that inflation is a poor guide for monetary policy. This yet again illustrates the Lucas critique, echoed in Goodhart’s Law, that once you shift the policy basis and in particular target an aggregate, its behaviour changes and can cause you to miss your true policy targets.

Hence in conclusion I would argue that monetary policy now needs to be returned to normality for reasons of basic monetary prudence; growth is strong and the punch bowl should be slowly withdrawn. Interest rates should go up in regular small steps from now on; and QE should be gradually reversed to restore the Bank’s balance sheet to a state where it is no longer the main holder of the government’s bonds but instead merely a residual holder for reasons of open market operations.

Comment by David B Smith
(Beacon Economic Forecasting)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: To raise Bank Rate by ¼% increments every few months.
1 Year View: Depends on election outcome; on no-policy change assumption, raise Bank Rate to 1½% by late 2015.

It is unusual for an important policy event such as the Autumn Statement, the accompanying forecasts from the Office for Budget Responsibility (OBR), and the government’s main political pitch as the ‘growth-master’ of the G7 leading economies to be sandbagged within twenty days by data revisions from the Office for National Statistics (ONS). However, this happened on 23rd December, when the ONS announced an armada of revisions to the national accounts data published on 26th November, which had formed the base for the OBR’s projections. These revisions were particularly infuriating because they closely followed the official move to the ESA-2010 system of national accounts on 30th September, which had itself represented the greatest data upheaval in a generation. The 23rd December revisions to UK GDP generally extended back to 2013 Q1. However, there have been additional revisions to the general government accounts from 2003 Q2 onwards, mainly as the result of a less tendentious treatment of tax credits, plus some noticeable adverse revisions to the post 2013 Q1 figures for the balance of payments.

In the light of the new data, it now looks as if the market-price measure of real GDP expanded by only some 2½% on average last year, rather than the 3% or slightly above that most people were expecting based on the 26th November data. The relative growth pattern between 2014 and 2015 has also altered. In particular, 2015 now looks as if it could enjoy a slightly faster expansion than 2014. Previously, the consensus view was that growth would decelerate by ½ a percentage point or so between the two years. It also looks as if the prospective balance of payments outcome for 2014, together with the prospects for subsequent years, has worsened. This outlook adds to pre-existing concerns about the UK’s twin deficits; particularly, as these deficits are likely to stretch ahead indefinitely and will need to be plugged by borrowing on the international capital markets. This is potentially dangerous given the political risk now attached to investing in Britain. There would be no need for any active capital flight to cause a route in UK government bond and sterling, simply a cessation of new inflows on the scale that has been observed until now.

At the time of writing, it is not possible to know how other economic forecasting organisations have responded to the rush of pre-Christmas data releases. However, the consensus forecast could shift noticeably once the revised data have been digested and the various January forecast comparisons have been published. The revised data have been run through the Beacon Economic Forecasting (BEF) macroeconomic with the following results. Firstly, economic growth is now expected to accelerate from last year’s 2.6% to 2.9% this year before slowing to 1.8% in 2016 and fluctuating in the 1¾% to 2% range up to 2025 (when the BEF forecast horizon ends). Second, the latest monthly data show that the annual increase in the officially preferred Consumer Price Index (CPI) had slowed to 1% in November. CPI inflation is expected to reach a trough of 0.6% in 2015 Q1, and end the year at 0.9%, before rising to 1.7% in 2016 Q4 and 1.8% in 2017 Q4. Our longer-term projections show CPI inflation fluctuating between 1½% and just over 2% thereafter. These predictions assume that the price of a barrel of Brent crude averages US$70 next year, compared with US$57.9 on 29th December, before rising by US$1.5 in each subsequent year. All macroeconomic forecasters tend to agree that predicting the price of oil is impossible. These numbers are simply a reasonably bland forecasting assumption. Numerous aspects of the forecast would shift if different assumptions for the future price of oil were employed.

Third, while the outlooks for growth and inflation look reasonable, the prospects for Britain’s ‘evil’ twin deficits look anything but, even on the assumption that present policies survive the May election. Where the first evil twin is concerned, the latest BEF projections indicate that the current account payments deficit was some £96.3bn in 2014 (it was £73.8bn in the first three quarters alone). The current account gap is expected to ease temporarily, to £86.3bn in 2015, but deteriorate to £94.2bn in 2016 and £100.8bn in 2017. Where the other evil twin is concerned, the latest BEF projections show Public Sector Net Borrowing (PSNB) of £93.4bn in 2014-15, being followed by deficits of £85.3bn in 2015-16, £78.5bn in 2016-17 and £73.9bn in 2017-18. This is much slower progress than Mr Osborne predicted in his 3rd December statement. However, even the BEF projections assume a tight spending control by historic standards. This assumption of parsimony could clearly be invalidated by a change of government. A final fiscal comment is that an ‘urban myth’ appears to have developed that Mr Osborne’s spending plans represent ‘a return to the 1930s’. A rebuttal was published on the Politeia website (www.politeia.co.uk/) immediately before Christmas for anyone who wants to investigate these issues further.

As far as the outlook for the financial markets is concerned, any attempt at projection is likely to be undermined by the political uncertainties. As with the price of oil, a more thorough analysis would require running several distinct scenarios, which would require far more space than is available here. Our no-policy change projections suggest that the sterling index could strengthen slightly over the next few years – this is essentially because the relatively large fall in domestic inflation has raised the real interest differential in favour of the pound – and that Bank Rate should end 2015 at around ¾%. Presumably, the return to power of the Conservatives or a renewal of the present Coalition would be accompanied by a relief rally in sterling, equities and the gilt-edged market and the unleashing of capital investment plans put on hold because of the political uncertainties. This could confront the Monetary Policy Committee (MPC) with a reverse ‘stagflation’ situation in which the pound was strong and inflation weak while home demand was threatening to boil over. A Labour government, or a Labour dominated coalition, would presumably have the opposite consequences, forcing the MPC to choose between the inflationary effects of a weak pound and a desire to stabilise the domestic bond market and equities.

In the past, financial markets have often proved astute at anticipating political developments with the result that market prices have discounted the electoral outcome before the event. However, the recent emergence of multi-party politics in Britain means that few political experts have much feel for the prospective election result at present. Where the MPC is concerned, the main problem now is that the election is well within the lag between cause and effect where rate setting is involved. It would require a miracle for the Bank Rate set on 8th January to be appropriate to the economic conditions that will be prevailing after the election. One specific cause for caution has been the recent slowdown in the yearly growth of the M4ex broad money from 3.8% in September to 3.3% in October (the November data will be released on 2nd January, after this submission has gone to press). On balance, and without any strong conviction, a modest ¼% rate Bank Rate increase in January seems marginally preferable to a further hold, even if ‘no change’ seems the almost certain outcome, not just this month but throughout most of the first half of 2015.

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

Since the plunge in the crude oil price, economic forecasters have pushed back their views on the timing of the first rate increase towards the end of 2015. It is commonly asserted that there are no costs to leaving UK Bank Rate ‘lower for longer’. The longer that this experiment is sustained, the greater is the likelihood that these underestimated costs will be revealed. There are financial stability costs, frictional costs in the money markets, costs relating to the inefficient allocation of borrowed capital and to moral hazard in the household sector.

Financial stability costs arise when an industrial sector or type of borrower exploits the easy availability of credit to indulge in an over-expansion of productive capacity or final demand. Energy exploration would be an example of an industrial sector and car buyers, an example of the latter. Credit defaults will mount even in a near-zero interest rate climate.

Frictional costs arise in the money markets at very low interest rates as liquidity is hoarded rather than lent into the interbank market. There is a gain to economic efficiency when excess money balances are pooled.

There is empirical evidence to suggest that, although only a minority of small and medium-sized businesses use external finance, the reallocation of credit within the SME sector is stymied in an environment of very low interest rates. It is the pressure of market interest rates that drives capital away from poorly performing businesses towards those with greater dynamism and better prospects.

The longer that mortgagors enjoy untypically low loan rates, the greater is the risk that they will be incapable of servicing their mortgages when rates eventually normalise. As disposable income is reallocated from mortgage payments to other uses, the harder it will be to reverse the process when the time comes.

The latest NMG Consulting survey on households, conducted on behalf of the Bank of England and published in the Bank’s Quarterly Bulletin, confirms that most homeowners could cope with a rate rise. Even their worst case scenario (in which Bank Rate rises immediately by two percentage points and is passed through to households in full), only lifts the proportion of vulnerable mortgagors marginally higher from 1.3% to 2.5% of all households, well below peak levels. Under their alternate scenario, where household income also increases, the share of households with a mortgage debt service ratio above 40% (which has been identified as a trigger point for rising mortgage arrears) remains below its long-run average. Encouragingly, the Bank believes that these estimates may even overstate the true impact of a rate rise since they assume an immediate pass through to both fixed term and variable rate mortgages. In reality, around 50% of mortgagors would avoid the initial impact, thereby slowing the transition into the ‘vulnerable’ camp. Moreover, the structure of interest rate futures suggests that Bank Rate will reach 2.5% in 2019, five years later than the survey presumes.

Positively, the proportion of mortgagors experiencing problems in servicing their loans has continued to fall, from 19% in September 2013 to 14% in September 2014. Regardless of this, borrowers have remained cautious, with around a quarter reporting that they had cut spending as a result of concerns about debt. Promisingly, accordingly to the survey, those with higher debt service to income ratios had reduced spending by more, were more inclined to avoid taking on additional debt, and were seeking additional employment. Although this could be interpreted as a reflection of households’ incomes already being under pressure, any action in anticipation of rate rises is surely commendable.While there is a great deal of uncertainty around the likely distribution of future household income growth, workers in London and the South of England (where property price to income ratios tend to be most stretched) are currently enjoying faster wage growth than the UK average. This should help to offset the disproportionate downward drag from Bank Rate normalisation that the South is expected to suffer due to its generally higher household debt. All in all, even if the Bank hiked rates by the full two percentage points tomorrow, those most vulnerable to debt delinquency would account for less than 2.5% of all households, equivalent to around 600,000 homes.

The Monetary Policy Committee is in danger of missing its best opportunity to break the 0.5% Bank Rate taboo. Surely, there can be no better time to test out the hypothesis that a small rate increase will destroy confidence and bring the recovery to a grinding halt. Once tested and refuted, then the UK can make further tentative steps towards rate normalisation. A rise in Bank Rate is long overdue: the justifications for delay are insubstantial and the costs of delay, though largely unseen, are nevertheless serious and likely to be cumulative. My vote is for an immediate increase in Bank Rate of 0.5%.

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

UK economic conditions continue to suggest, broadly speaking, a slowing economy with diminishing inflation pressure. To be sure, the ease in the pace of economic growth still leaves it at an above trend rate, with no signs at this point that it will drop below this. Even a downward revision to the Q4 annual pace of growth from 3% to 2.6% leaves the UK one of best performing of the major developed economies. But the global headwinds to growth are persisting: stagnation in the Eurozone, recession in Russia, continuing issues in the Middle East and slowdown in China. Together, these indicate that policy should stay loose.

If inflation indicators are taken into account, the case for leaving rates on hold is even stronger. Easing commodity prices will add nearly 1% to global GDP in time, but in the short term are lowering price pressures, allowing official monetary policy to stay on hold for longer. This would have been an opportunity to tighten policy if growth was at an above trend pace at the global level but as pointed out, it is not. Instead, the drop in oil prices gives a chance for some economies to get a boost that they badly need and does not warrant tighter policy stances.

In the UK, price inflation will fall well below 1% in the next few months, and stay there for some time. While wage inflation is above 1% now, we should not get carried away with the risk this entails for inflation in the medium term. For one thing, it is well below the long run average and the real rate is barely positive. In addition, any upside risk to long run inflation is modest as economic growth is moderating to a sub 3% range.

Money and credit trends do not suggest any worrying issues, other than that business in particular continues to repay debt. This suggests a continuing risk to growth from low productivity, albeit medium term. Looking to 2015, the big picture is of UK annual growth settling around 2½%, accompanied by a tighter fiscal stance. This means that financial market bets that official rates will not rise until well into the second half of 2015 at the earliest are not inconsistent with current economic date. With that backdrop, I would leave rates on hold and the APF at £375bn.

Policy response

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

Date of next poll
Sunday February 1st 2015

What is the SMPC?

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

Current SMPC membership

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

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

Those advocating a rise contended that more rapid economic growth is an opportunity to normalise rates. Some emphasized that such normalisation should be combined with a relaxation of bank capital and liquidity requirements so as to encourage more market-oriented lending. Others noted the political uncertainties associated with the 2015 General Election. Several noted that recent very low inflation is driven by one-off factors that may reverse and policy acts with a lag.

Those that preferred to keep rates on hold noted that not only is current inflation below target (indeed, perhaps there may even be a Governor letter soon), but pipeline inflationary pressures are also low, as are wage growth, money growth and credit growth. For them there remains inadequate reason to raise yet.

It is noteworthy that two of those advocating a rise suggested they might revert to a hold or cut position in forthcoming months (either because of a Eurozone crisis or weak monetary growth) whilst one of those advocating a hold indicated he might soon switch to voting for raising rates if stronger economic growth continues.

Votes

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

Headline UK inflation has been below the Bank’s 2% target throughout 2014. The latest reading (for the year to October) placed it at 1.3%. In an accounting sense, lower food and energy price inflation explain a sizeable chunk of the downward shift in UK inflation. The CPI food sub-index, for instance, showed food prices down 1.2% over the last twelve months, the biggest annual decline since 2000.

Broad-based weakness in global commodity prices in the second half of 2013 has been an obvious depressing factor on UK inflation this year, given the usual lags in global supply chains. Over the last six months, food and metals prices have declined further, suggesting additional disinflationary pressures from imported raw materials. But the most conspicuous factor set to hold down future UK inflation is the recent collapse in the oil price. In sterling terms, the cost of Brent crude oil has slumped by 25% in the last three months. Indeed, more than half of this fall has happened since the MPC last released its economic projections in which CPI inflation was expected to drop to 1% early next year. As such, it is all but certain that Mark Carney will have to write a letter to the Chancellor within the next few months explaining why inflation has dropped more than 1% below the Bank’s target.

How should the MPC respond? In the past, the MPC has ‘looked through’ upward spikes in global commodity prices, arguing, quite reasonably, that such ‘cost shocks’ had little bearing on medium-term inflation. For much of the 2010-2012 period, UK inflation was well above the 2% target because of imported price pressures. The MPC judged that such forces would have a one-off effect on the level of consumer prices but no lasting effect on the inflation rate. That view turned out to be the right one. One might assume that today the committee should once again ‘look through’ an imported cost shock and the (temporary) prospect of uncomfortably low inflation. But for many MPC members, the existence of the zero lower bound on short-term interest rates cautions against a symmetric response. Indeed, the latest Inflation Report effectively validated an asymmetric reaction to the recent move in commodity prices, especially oil.

Whether such asymmetry is justified is far from clear. The zero-bound is not an effective constraint on monetary stimulus given the toolkit of unconventional measures that the central bank could undertake. Moreover, if recent declines in global commodity prices are supply-driven, as it seems they are to a large extent, they may well be a net positive for UK domestic and external demand, through their effect on domestic and foreign consumer real incomes and consumer confidence more generally. With UK inflation expectations well anchored, as all available indicators point towards, the case for a monetary response is unproven. Indeed, just as the first signs of a slowdown in UK consumer demand emerge, these developments should provide a material fillip to household sentiment.

The greater concern is the weakness of underlying inflation in the UK. There is enormous uncertainty about the degree of slack in the UK economy, the sensitivity of inflation to that slack and even the extent to which the inflation process is affected by our current notion of spare capacity. But what is clear is that a wide array of measures, which act as proxies for underlying, domestically-generated inflation, remain markedly below levels consistent with the Bank’s inflation target. ‘Core’ CPI inflation (excluding government administered prices) was 1.4% in October, its lowest level since early 2009. Price pressures in consumer-facing services, where domestic forces play an even bigger role in price determination, remain very weak by the standards of the pre-crisis (1992-2007) era. The same message emerges when one looks at broader measures of inflation across the private sector (for instance, the market sector value added deflator).

It is the weakness of underlying inflation, not the prospective downward pressure on non-core items in the CPI, that justifies the case for exceptionally accommodative monetary policy, despite the likelihood of ongoing solid real GDP growth. Downside growth risks from developments in Britain’s trading partners are growing; but these are potentially offset by the boost that lower oil and raw materials prices will provide for private domestic demand. If there is evidence of even greater weakness in underlying inflation, a case for additional monetary stimulus might be made. But for now it is right to look through the price-level effect that lower commodity prices will cause in the near-term. Indeed, given the expected evolution of the economy, it is still likely to be desirable for some withdrawal of policy stimulus within the next year.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold rates
Bias: Only raise rates if money and credit growth move into double digits

The UK economy has continued to recover, but the pace of recovery has slowed slightly in recent months. Even so, contrary to the view recently expressed by the Prime Minister that the warning lights on the dashboard of the economy were flashing red, the UK private sector is steadily healing and the only real dangers are from a re-emergence of a Eurozone crisis or from a major conflict in the Ukraine leading to a shut-off of oil and gas pipelines to western Europe. On the other side, the US economy continues to make solid progress as reflected in the recent upward revision of real GDP growth in the third quarter to 3.9% on a quarter-on-quarter annualised basis. This will provide major support to most of the economies of the developed world.

Furthermore, the delay in closing the UK budget deficit - although disappointing - is not a threat to the economic upswing. In summary, with inflation well below target and still ample available slack in both the labour force and the productive capacity there is no need to be raising interest rates yet.

Comment by Andrew Lilico
(Europe Economics, IEA)
Vote: Raise Bank Rate by ¼%
Bias: To raise further; QE neutral
1 Year View: 1¾%

UK growth is strong and has shrugged off Eurozone weakness over the past year. There has long since ceased to be a weak-growth-based justification for keeping interest rates so low.

However, the growth rate of broad money has been remarkably weak, given strong real-terms economic growth, an extremely strong labour market, zero interest rates, solid business investment prospects and the huge increase in the Bank of England’s balance sheet via QE and other measures. Bank of England statistics give the twelve-month growth rate at just 3.9% for broad money (M4 excluding intermediate OFCs) and 0.7% for aggregate lending (M4Lx excluding intermediate OFCs). The failure of broad money growth to pick up despite the improving economy must go down alongside the eccentric performance of the UK labour market as one of the two great economics conundrums of recent years.

To the backdrop of these weak underlying inflationary pressures from monetary factors, over recent months one must add (or subtract) the deflationary impact of commodity price falls. These have dragged short-term inflation below target and may even threaten what would once have been treated as the “lower bound” of the Bank’s inflation target — the 1% threshold below which the Governor must write letters to the Chancellor explaining why inflation is so low.
Does an undershoot of the 2% target or the 1% “lower bound” really matter? Once upon a time one would have thought it did. In those days it was thought that the inflation target was 2% and the +/-1% thresholds was the range of discretion the Bank had to “see through” short-term fluctuations from factors such as commodity price movements. But since April 2007 (when inflation was first revealed as having reached 3.1% and the first Governor’s letter was written) the inflation target has been redefined such that the +/-1% thresholds were not a constraint upon the Bank’s freedom to allow short-term fluctuations from target. Interest rates were not raised to prevent inflation reaching 5% in 2008 or 2011. Indeed, it is doubtful whether a single MPC decision since April 2007 can be regarded as having been in any material way constrained by the desire to meet the 2% target or to stay close to it.

It is tempting, therefore, simply to ignore current low inflation, declaring that what’s sauce for the over-shooting goose should be sauce for the undershooting gander. Yet there remain good reasons to wish that the inflation target could be restored as a genuine constrained upon MPC policy-making and therefore to be at least somewhat constrained by it. A large inflation undershoot does matter for the Bank’s credibility and should be avoided if it can be.

This is doubly so in the current environment in which the behaviour of the monetary data is so confusing — indeed, sufficiently mysterious that if it continues I, for one, will eventually regard it as a threat to my theoretical paradigm. The inflation target gives us something to steer by when other data are mysterious and our theoretical understandings fail. For now, I shall continue to assume that, eventually, underlying monetary growth must accelerate when economic growth is so strong and monetary base expansions (QE etc) has been so enormous. I therefore maintain my recommendation of a 0.25% rise in rates. But if monetary growth does not accelerate within the next few months I shall need to revisit that recommendation.

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

Even a stopped clock gives the right time twice a day and we may be fast approaching the situation that in the event of another euro crisis the Bank would commit interest rates to remain on hold for even longer in addition to a further bout of QE. Events in the Eurozone have increased the likelihood of another euro crisis but the return of a euro crisis is not news. The Eurozone will go through periods of crisis and calm for the foreseeable future and possibly for decades to come but that does not mean the UK interest rates should remain on hold while Europe sorts itself out. Interest rates have to be normalised to rebalance the economy and for the reasons articulated in previous submissions. There is still time to act now to raise the base rate in ¼% stages so that if the Eurozone crisis flares up later than sooner a cut will be effective. Nothing has happened to change my position from the previous period. Interest rates should rise by 0.25bp in stages and QE to be held in reserve in the event of a euro flare up.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate ½% and start to reduce the stock of QE gilts
Bias: Further rate rises and more run-down of QE
One year ahead: No view

In the past month we have seen the equity market drop on fears- about what? The end of Quantitative Easing by the US Fed; Ukraine’s fallout on the Eurozone, especially Germany; China’s excessive indebtedness and overcapacity; ‘secular stagnation’ suggestions and more besides. Equity prices are now recovering again, as the sky did not fall in when the Fed announced the immediate end of QE and then the Bank of Japan suddenly decided to have another large tranche of its QE. So it goes on from day to day, with news buffeting what has actually been a steadily rising stock market.

For some market-watchers it is only loose monetary policy that is keeping equities going and price-earnings ratios have risen too high. For others we are on a growth and recovery path so that equities are discounting better future prospects.

In Cardiff we have been doing work on the world economy, looking at the last 150 years; and there are two key factors we find one should look at: money and commodities. The big underlying picture is of the commodities Long Wave, whereby the commodities cycle of investment in capital and technology lags behind the main cycle of world spending and production; periodically world production overtakes commodity capacity and there is a crisis, and then after a recessionary pause commodity capacity, boosted by the period of commodity scarcity and high prices, overtakes world production again and there is another long world boom as production benefits from low commodity prices. The cycle is then repeated; but it is a long one, of roughly 30 years from trough to trough.

We are now some five years from the last trough (2009) which implies that a run of 25 good years lies ahead. That then brings us to the second factor which if handled well can stop the Long Wave becoming unstable- money. There are two bad monetary episodes that stand out as ‘Lessons in what not to do with money’: the 1930s and the 1970s. In the 1930s the world’s central banks, mainly the Fed, allowed the money supply to contract sharply with huge numbers of bank failures. The result was prolonged world slump, lasting throughout the 1930s. In the 1970s world central banks responded to surging commodity prices by printing money rapidly (growth rates went into double digits) in order to keep down unemployment: the result was a sharp rise in inflation, and this prolonged the slump of the mid-1970s into the early 1980s because inflation had to be brought down by a sharp monetary squeeze.

What then is the current monetary outlook? The answer is that it is a varying mixture of partially offsetting factors depending on exactly which parts of the world you look. Poorly thought-out regulation is clobbering banks in the developed world, especially the Eurozone where the euro crisis has worsened the banks’ already weak balance sheets. But in some developed countries the credit-killing effects of this bank-clobbering have been mostly offset by massive QE programmes- again the exception is the Eurozone where QE has not yet occurred because in its usual form (ECB buying government bonds) it is actually illegal. QE has bypassed the banks and fed straight into the equity market: central banks have bought government and private bonds, driving down their interest rates, and the sellers have bought equities, driving up their prices, as the yield on bonds became less attractive. While this has not led to more credit to firms, because the banks have barely expanded it, it has made firms attractive to private investors through the peer-to-peer (P2P) lending channel (via the internet). This last credit channel seems to be expanding very fast though statistics on its total are hard to generate.

Hence on balance in the developed world money is supportive, unlike the 1930s, but because of the unintended effects of bank regulation it is also not strongly expansionary, unlike the 1970s. On balance money is in a tolerable middle zone- even if this is more the result of luck than good management. As for the developing world it is also a mixture of situations; some countries in disarray (Russia), others doing well (Singapore), and then the big ones, China and India, somewhere in the middle, with problems that do not prevent continuing moderate growth.

We therefore currently have world growth in the 3-4% range which is a good range to be in. The prospects longer term look good and there is no madcap boom as recovery proceeds. Some Keynesians, like Olivier Blanchard the chief economist of the IMF, constantly fret when growth is not at some maximum speed. But this perspective is a bad one: growth needs to proceed at manageable rates that do not threaten to get out of hand and threaten a bigger crisis when the pause has to happen. The challenge for the developed countries who dominate the worlds’ money and banking is to move towards an environment where bank lending resumes under a market-friendly regulative system and where money growth is controlled to prevent the type of credit/money boom of the mid-2000s.

How can we manage this re-entry? First the regulatory vice on banks must be eased. Second, we must restore interest rates to more normal values, as the SMPC has been urging for a long time. Third, we need to restore central bank balance sheets to normality too: this means that they sell off their huge stocks of mainly government liabilities.

For this to work well all three steps are needed. Unfortunately what is happening is that there is no action on any of them; the lack of joint action on all three effectively prevents action on any one of them. For example with the banks inert under the pressure of regulators, central banks fear that stopping low interest rates or reversing QE will stall the economy. Yet under pressure from public opinion governments fear loosening bank regulation.

In the absence of any action my prediction is that the banks will increasingly be bypassed by P2P lending and that the near-zero interest rates and continued QE stock will then prove to be far too loose a monetary environment. We will create another credit boom, P2P deposits will count as another near-money and will grow in line, and world growth will move back to high rates in the 4-6% region. This will shorten the time to the next commodity crisis.

My preferred course of action is therefore still for interest rates to be raised, in small steps of 0.25%, until they get back to say the 2-3% range; for QE to be steadily unwound; and for the banks to be quietly released from some of the more draconian curbs on their lending activity.

Comment by David B Smith
(Beacon Economic Forecasting)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: To raise Bank Rate by ¼% increments every second month or so.
1 Year View: Depends on May 2015 election outcome; on current policies, raise Bank Rate to 1½% to 2½% by late 2015.

In the absence of major global shocks, UK monetary policy is generally expected to be on hold until after the general election, with the financial markets apparently not anticipating any rate change before the autumn of next year. As a consequence, the main macroeconomic focus between now and the election will be on fiscal policy. In particular, there are only Mr Osborne’s 3rd December Autumn Statement and next year’s spring Budget still to come before the Thursday 7th May 2015 election. The monthly figures for the governmental finances during the first seven months of fiscal 2014-15 suggest that Public Sector Net Borrowing (PSNB) could turn out even higher than the £97.5bn deficit recorded in 2013-14. The excess of the cumulated PSNB during the first seven months of the current fiscal year, when compared with the corresponding figure for 2013-14, is running at an annualised rate of £6.2bn. This suggests that the total PSNB in 2014-15 could exceed the politically-sensitive figure of £100bn; this statistic will be published shortly before the election in April 2015.

The projections from the Office for Budget Responsibility (OBR), which will accompany Mr Osborne’s Autumn Statement, will be unusually important because they will be the first OBR forecasts to incorporate the new ESA-2010 national accounts. These were generally introduced on 30th September although the government figures were switched one week earlier. The 23rd September ‘Public Sector Finances Statistical Bulletin’ released by the Office for National Statistics (ONS) contained a comparison of the new ESA-2010 figures with the previous statistics back to fiscal 1997-98. These contained some gob-smacking revisions. In particular, General Government Net Borrowing (GGNB), which is a preferable measure to the PSNB because it excludes a number of idiosyncratic financial transactions, was revised up by £22.6bn in 2000-01 and by £42bn in 2012-13. There was also an upwards revision of £5.6bn to the 2013-14 GGNB. In addition, the monthly Excel spread sheet released the following day contained revisions to individual government spending and receipts items back to the mid-1950s or earlier. The size of these changes indicates that most of the political debate on tax and spend issues since the Coalition took office has been based on an unduly optimistic view of the public finances.

However, the issues are complex because much of the political debate is concerned with the share of government taxes and expenditures in money GDP, which has itself been revised up by more than £100bn, a re-definition that would have reduced the reported share of government spending in GDP substantially on its own. In addition, a new item has appeared in the government spending identity ‘VAT and Gross National Income based EU contributions’, which picks up money paid directly to Brussels. The effect of the changes involved has been to raise the previous figure for total general government expenditure in 2013-14 from £707.7bn on the old measure to £726.9bn on the new ESA-2010 definition. However, the increase in money GDP on the new definition means that the ratio of total spending to basic-price GDP dropped from 49.1% to 47.2%, a fall of 1.9 percentage points. Likewise, the cash value of total receipts in 2013-14 was raised from £611.6bn to £625.8bn as a result of ESA-2010; the main reason was that the taxes paid directly to the EU are no longer excluded. However, the ratio to basic-price GDP dropped from 42.5% to 40.1% as a consequence of the switch – a drop of 2.4 percentage points.

There has been a longstanding, and politically highly-charged, debate on ‘tax and spend’ issues in Britain ever since the 1970s. During this debate certain rules of thumb have become widely accepted – e.g., that the growth maximising share of government spending in GDP is around 20% to 25%, the welfare maximising share is around 30% to 35% and that the upper limit on taxable capacity is around 38%. Nearly all of these ratios, which are derived from studies for a range of countries over many years, refer to shares of the market-price measure of GDP – usually as compiled by the Organisation for Economic Co-operation and Development (OECD) – calculated employing earlier generations of data. These rules of thumb now need to be lowered by some 1½ to 2½ percentage points (or more) if they are to be applied to today’s definitions. With the entire European Union (EU) having been mandated to adopt ESA-2010 this autumn, the consequences of the new accounting practices are not just a British concern. Indeed, it was the result of earlier changes to the estimated size of GDP throughout Europe that led the EU to demand an extra £1.7bn from the UK, and reduced contributions from Germany and France, enraging Mr Cameron in the process. However, this impost appears to have been triggered by the revised measurement conventions introduced last year, which raised Britain’s money GDP and cut the measured government spending and tax burdens by some ¾%. Unfortunately, this year’s £100bn plus upgrading of UK national output will probably generate a further £1¾bn EU demand in late 2015.

As far as the 4th December Bank Rate decision is specifically concerned, the news content of recent data releases suggests that there is little need to change previous judgements, irrespective of whether one is a holder or a hiker. The purely domestic indicators suggest a reasonably well entrenched recovery, albeit one that may be losing a bit of momentum. However, the outlook for the Eurozone core appears to be deteriorating, most worryingly in Germany. Nevertheless, there are indications that the harsh fiscal measures imposed on the peripheral Eurozone members as a pre-condition for German backing are now bringing their returns in the form of an improved performance. This improvement in Spain, Ireland and even Greece is consistent with the fiscal stabilisation literature, even if that might seem paradoxical to unreconstructed British Keynesians. The unfortunate irony is that Germany itself has been backtracking on the earlier Schroeder reforms, as a result of the coalition bargaining between Angela Merkel and the SDP. However, the recent fall in the price of a barrel of Brent Crude oil to US$ 79.7 on 24th November, compared with the US$108.1 averaged in November 2013, and the more modest 3.5% drop in The Economist’s US$ index of non-oil commodity prices over the past year, should prove both dis-inflationary and expansionary in an analogous way to a cut in indirect taxes. This development might cause the strength of the world economy to surprise on the upside in the second half of 2015. Unfortunately for Mr Osborne, this potential boost would probably occur too late to benefit the Conservatives electorally.

There seems to be little in recent UK broad money indicators to suggest that there is a serious monetary reason not to raise rates. The annual increase in the M4ex broad money supply was a respectable 3.9% in the year to September, although underlying credit growth was somewhat lower, at 0.7%. The recent easing in annual UK consumer price inflation to 1.3% in October – the uptick from 1.2% in September was probably a random wobble – has had two distinct monetary effects. First, it has raised the real short-term rate of interest, boosting the demand for interest-bearing broad money. Second, it means that, at any given rate of nominal broad money growth, the expansion in the supply of real broad money balances has accelerated. This combination of countervailing monetary forces helps to explain the conjunction of a relatively strong pound – sterling is sensitive to the real interest differential in favour of the pound compared to other countries – and strong private home demand where the real balance effect may be the stronger of the two. The acceleration in the annual rate of house price increase, on the ONS measure, from 11.7% in August to 12.1% in September confirms that the overall monetary stance is expansionary, as has the 4.3% rise in the volume of retail sales in the year to October.

An increasingly important monetary consideration is that the 2015 general election date is now well inside the lag period between the announcement of a Bank Rate change and the effect of the change working through to the wider economy. This would not matter if the putative policies likely to be implemented by the various political groupings after next May were similar. The range of possible outcomes could then be conceived of as following a broadly normal distribution. However, the acute policy divergences between the different political parties, the probability of a hung Parliament, and the possibility of bizarre multi-party coalitions emerging subsequently, suggest that the ex-ante probability distribution of possible scenarios after the election looks more like the Bernese Oberland. As a result, it is impossible for today’s rate setters to pursue a monetary course that would be appropriate for the range of different political and economic circumstances that might prevail by the time their decisions take effect on the wider economy. The Bank of England has already stated that the post-election rate announcement will be postponed from the preceding Thursday until Monday 11th May. However, whether a new government will have been formed by then seems debatable given the strong likelihood of a hung Parliament. On balance, and without any strong conviction, a modest ¼% rate Bank Rate increase in December still seems better than a further hold, even if ‘no change’ seems the almost certain outcome.

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

The Monetary Policy Committee is in danger of missing its best opportunity to break the 0.5% Bank Rate taboo. Annual growth of the services sector, representing 78.4% of the whole economy, reached 3.4% in September 2014. For business services and finance, the annual growth was 4.6%, for distribution, hotels and restaurants, 4.2%, and for transport, storage and communication, 4.1%. Surely, there can be no better time to test out the hypothesis that a small rate increase will destroy confidence and bring the recovery to a grinding halt. Once tested and refuted, then the UK can make further tentative steps towards rate normalisation.

Sterling has slipped from US$1.71 in July to US$1.563 in late-November, signalling that foreign capital is getting a little bored by the MPC’s failure to act in the face of overwhelming economic provocation. Observable holdings of gilts by the overseas sector have stagnated in the past 12 months.

The prevailing GDP growth rate of 3% is well above any estimate of medium-term sustainability. How long can the good news last before gravity takes hold? The fall in the quarterly growth rate for Q3, to 0.7%, may signal that the process is already underway, but more evidence is required to confirm the validity of that judgement. While the UK’s non-financial sector credit impulse remains positive, much rests on the take-up of credit in the housing context. With the advent of the Mortgage Market Review and the Financial Policy Committee, the expansion of mortgage credit will remain subdued. Furthermore, the Help to Buy and Funding for Lending schemes that played a significant role in releasing household credit constraints are likely to be curtailed. FLS has already had its wings clipped.

The Monetary Policy Committee has been surprised and embarrassed by the explosive growth of employment over the past 18 months: unemployment has fallen by more than half a million in the past year, equivalent to the adult population of Cornwall. A 7-2 split on the MPC does not necessarily bring a Bank Rate increase any closer, but it proves at least that there is now a healthy debate around tightening. While it is possible that breaking the taboo could provoke irrational fears and damage consumer confidence, we will never know for sure until we try. My conviction is that the initial stages of rate normalisation would have very mild effects on activity and employment.

A rise in Bank Rate is long overdue: the justifications for delay are insubstantial and the costs of delay, though largely unseen, are nevertheless serious and likely to be cumulative. My vote is for an immediate increase in Bank Rate of 0.5.

Comment by Mike Wickens
(University of York, Cardiff Business School)
Vote: Raise Bank Rate by ¼% and decrease QE to £250bn
Bias: Start to unwind QE and slowly raise interest rates as the economy grows

The markets do not expect the MPC to change interest rates next month and the MPC aims not to disappoint the markets. It would therefore be surprising if rates were raised. Nonetheless, the case for a small increase remains, as it has for several months. This is based on the widespread judgement - shared by the MPC - that growth, and hence inflation and wages in the UK, are expected to increase over the next two years, and on the arguments of an earlier incarnation of the MPC that the evidence showed that it takes between eighteen and twenty four months for changes in interest rates to have an effect.

The main factors that appear to be currently influencing the MPC are falling market bond yields, a continued weakening of output in the Eurozone countries and a fall in inflation. The yields are interpreted as reflecting a portfolio shift from riskier assets which have resulted in market expectations of lower interest rates. Given that UK consumption and investment demand are still growing above trend, it is not clear that such greater risk aversion is justified by fundamentals. The recent temporary blip in stock prices may have had a part to play by undermining confidence.

The weakness of the Eurozone is a genuine threat to the UK economy as it is such a large market for UK exports. The MPC says that this weakness is reflected in the lower external demand than it anticipated. In contrast, the US, a dominant force in world economic activity and hence of trade outside the Eurozone, has continued to grow strongly.

Much has been said about the supply side of the UK economy which remains a puzzle to many: whilst employment continues to grow and unemployment to fall, productivity and wages have been flat. This has been interpreted as indicating continuing spare capacity in the economy and the lessening of price pressures. The most likely explanation is that there has been a fall in the capital-labour ratio brought about by a long period (until recently) of low investment expenditures and by rapid growth in the labour supply due to high (and rising) immigration. The recent increase in investment, which reflects growing confidence in future demand, suggests that the economy no longer has much spare capacity. It also suggests that wages, and hence prices, may start to rise before long.

Most, but not all of the signs, therefore, indicate a future rise in inflation and the need to anticipate this by starting to raise interest rates sooner rather than later. As the signs are not all one way, the MPC continue to have a difficult decision. This is not helped by the pressure not to raise rates before the coming election. The MPC should not just emphasise the negatives on inflation but, given the publicly announced expectation by several members, including the Governor, of having to raise rates before long, it should reflect more on the time lags in the effects of policy.

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

Looking that the economic data released in November, the MC should leave rates on hold. If capacity pressures were building, and incipient inflation pressure forming as a result, we should be seeing it by now. But we are not. The reason we are not seeing such signs, in my view, is because, even on a 2 year horizon, it is not happening. Although consumer price inflation rose to 1.3% year-on-year in October from 1.2% in September, that is still well below the 2% target. Core inflation (CPI ex food and energy), also ticked up in October, to 1.6% from 1.5%. Producer input price inflation, however, fell 8.4% in the year to October, accelerating from a 7.4% decline in September. Producer output prices dropped 0.5% in the month from 0.4% in September; a clear signal that price pressure remains downward. Shop prices, measured by the British Retail Consortium (BRC), fell by 1.9% in the year to October from 1.9% in the preceding month, supporting this bias. House price inflation continued to ease back slowly, with the Halifax’s three month year over rate down from 9.6% in September to 8.8% in October.

As for wage inflation, there was a lot of commentary around the fact that the 3 month rise in average weekly earnings over the same period of the year before picked up to 1.3% in September from 0.9% in August, 0.1% above the inflation rate for the CPI in the same month. Less was said of the fact that if bonuses are included - surely the right measure - the same month showed an annual rise of 1% in pay; admittedly up from 0.8% in August, but 0.2% below the equivalent CPI rate in September.

Meanwhile, the unemployment rate stayed at 6% on the ILO basis and 2.8% on the claimant count measure. The pace of employment gains appears to be easing, albeit with employment growth in the three months to September at 112, 000 versus an abnormally low 46,000 in the previous three months. The claims count fall in unemployment was almost steady at 20,400 in October against a drop of 18,600 in September. The point about the labour market data is that they do not look like we are on the verge of an inflationary cycle for pay. Indeed, the latest data from the Annual Survey of Hours and Earning (ASHE) from the ONS, showed that, adjusted for inflation, real weekly earnings were 1.6% below their level in 2013. According to the Labour Force Survey (based on a different sample and more upwardly biased), since then nominal weekly earning was £482 in the 3 months to March, £481 in the 3 months to June and £481 in the 3 months to September.

Industrial production recorded a 1.5% annual rate in September from a 2.5% pace in August. Manufacturing had a 2.9% annual increase in October versus a 3.9% pace in the prior month. The services PMI was 56.2 in October from 58.7 in September; the manufacturing PMI was up from 51.6 to 53.2; the construction PMI was 61.4 against 64.21, leaving the composite index lower in the month. This is consistent with an easing of capacity pressure not an increase. Third estimates of GDP showed left the Q3 rise at 0.7% and the annual rate at 3%. The detail showed that business investment in the quarter fell by 0.7%, following a rise of 3.3% in Q2. However, the annual rate was still a solid 6.3% pace in Q3, though down from 11% in Q2. Too much can be read into the figures as even quarterly data can be volatile and figures for Q2 were unsustainably strong - some unwind was to be expected. The overall investment number was still a solid 1%, only slightly down from 1.3% in Q2. What the data do suggest is that achieving a sustained rise in productivity remains a very difficult task for the UK.

The wider picture is that global growth is maintaining its pace, notwithstanding worries about Europe, little changed from the previous quarter. Money supply growth was 3.5% on the ex IOFCs, three month year over basis in September but the headline monthly rate was down by 0.7% and the year over rate was minus 2.5%. The pace of money is not accelerating, suggesting a lessening of momentum in the wider economy and a weakening of inflation pressure. Alongside a lower oil price (with further falls likely), no signs of wage inflation, omens from the UK’s recent fiscal data that a tight stance can be expected in the next Parliament, continued global uncertainties and still leveraged balance sheets; Bank rate should remain on hold and the Asset Purchase Facility at £375bn in December.

Policy response

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

Date of next poll
Sunday January 4th 2015

What is the SMPC?

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

Current SMPC membership

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

At its meeting of Tuesday 14th October, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended that Bank Rate should be raised by ¼% on Thursday 6th November.

Those urging a rate increase took the view that there was still a window of opportunity to raise rates, despite low inflation and the risk of a new Eurozone crisis. With GDP still growing rapidly and unemployment low, and with emerging evidence that salaries for those in work having been outstripping inflation for some time, the economy should be sufficiently robust for some modest normalisation in rates. Some felt that the risk of a downturn at or around the medium-term horizon strengthened the case for a rise now, as it would be a serious policy error to go into a new downturn with rates still effectively zero.

Those urging rates remained unchanged felt there was no inflationary imperative to raise rates and hence no reason not to explore to what extent there is still significant potential for output to expand significantly to replace growth lost during the recession. “Later” and “wait and see” remain the key mantras for this group.

---- Minutes of the meeting of 14th October 2014 ----

Attendance: Roger Bootle, Jamie Dannhauser, Anthony J Evans, John Greenwood, Andrew Lilico (Chairman), Kent Matthews (Secretary), David B Smith, Peter Warburton, Trevor Williams.
Apologies: Tim Congdon, Patrick Minford, Akos Valentinyi.
Chairman’s Comments

The Chairman requested that committee members be timely in their submissions as frequently he has found that by the Friday of the week before production he has not got the commitment for a full set of votes. He would like to complete commitment before the Friday of the week before submissions and votes be submitted by the Monday of the week of production.

Andrew Lilico asked Anthony J Evans to commence his presentation.

---- Monetary situation -----

Anthony J Evans distributed a paper of charts and tables to the committee on the ‘Monetary Situation’ for reference. Beginning with domestic money and financial markets Anthony J Evans said that domestic monetary trends had shown no major changes over the 24 months to September. But narrow measures such as private non-financial divisia, MA (Currency and Demand deposits) and household divisia all showed robust growth. It was commented that traditionally narrow money growth is a good coincident indicator of nominal GDP growth. On the currency markets major currencies are back at pre-crisis levels with a tendency for a weakening euro and strengthening US dollar. Sterling continues to strengthen from mid-2013. Production and manufacturing is recovering but still unlike services, is well below pre-crisis levels. Gilt yields continue to slide since the summer but standard variable rates have hardened. The stock market has fallen sharply in recent weeks but remains at similar levels to spring 2007.

Turning to output and the labour market, employment data show a continued improvement in the year and unemployment continues to fall reaching 6.2% in May-July. Pay growth remains moderate at 0.7% but this figure has been affected by changes in the composition of the labour force that has had temporary effects. Average earnings growth could show a rise in the near future.

Large revisions to the National Accounts show a smaller peak to trough drop in 2008/9 which has been revised down from 7.2% to 6.0%. The level of GDP in 2012 is now estimated to be 6.2% higher largely due to the reclassification of R&D from intermediate production and the inclusion of the sex and drug industries. All sectors have shown steady growth driven by services. Domestic demand growth is driven by investment rather than consumption. Business investment is 10% up on the year but consensus forecasts are for a slowing down in 2015 as also indicated by the composite leading indicators. Weakness in the Eurozone economy and the strengthening of sterling has taken its toll on exports. However, in terms of the fundamentals nominal GDP growth has returned to normal – a 4% annualised growth from 1997 shows actual nominal GDP is approximately at this level in the most recent quarter.

Turning to costs and prices, the data shows that CPI inflation is muted and declining on the back of falling oil and input prices. Factory gate prices are falling and surveys suggest that inflation expectations are well anchored. While still high, house price inflation may have peaked with smaller annual increases in September than in August. However, nominal house prices have only just reached the 2007 peak, and real house prices are well below it.

On the international front, the latest forecasts by the IMF anticipate a global recovery in 2015 after an expected slowing in 2014. The IMF’s advocacy of infrastructure spending to boost capacity reveals one of two interpretations. One view is that depressed aggregate demand has created a reduction in potential GDP. Another view is that realising that a lot of pre-2008 growth was due to over-capacity followed by a series of negative supply shocks, means that the world economy faces a supply-side problem. USA and UK output growth is above 2011 levels and leading the pack in terms of growth performance. However, threats to the global recovery come from another Eurozone flare up, a slowing Chinese economy, geo-political tensions in the middle-East and Ukraine, stock market volatility and Ebola outbreak.

The ECB has provided national governments a breathing space to resolve its respective fiscal problems but significant supply-side problems remains. A failure to properly deploy a European QE has meant an undershoot of the inflation target due to monetary timidity. In the far-East, China is tightening credit growth and is set to undershoot its implicit monetary target, based on a long-term growth rate of 10%, inflation of 4% and velocity of -2%. A slowing down in China will be transmitted to the world through a slowing in trade, commodity prices and financial flows. In addition political tensions from the Hong Kong protests add to the air of overall uncertainty.

In conclusion Anthony J Evans said that monetary policy was very loose and even after a rise in the base rate monetary policy will remain loose. Strong domestic demand conditions provide a window of opportunity for the process of normalisation and rates should rise by 0.5bp.

-----Discussion-----

Andrew Lilico thanked Anthony J Evans and opened the meeting out to general discussion. There followed a short discussion of where the view that increased potential output growth would lead to a widening output gap came from. Trevor Williams said that the idea was being pushed by Larry Summers and the IMF. Peter Warburton said that the IMF assume that multipliers of 2.5 for advanced economies and at the zero lower bound the multiplier is even higher has been extended to developing economies. The predictions for the world economy are based on models of advanced economies.

Kent Matthews said that the presumption of tightening in China is based on the assumption of a 10% underlying growth rate. He said that even official Chinese sources do not expect anything like this. Trevor Williams said that a recent meeting with Chinese officials they said that growth rates of less than 7% is likely, given over investment in cities’s infrastructure over the last few years John Greenwood said that he also felt that underlying Chinese growth was considerably less than 10%. He contended out that Anthony Evans’ -2% estimate of velocity was incorrect; he calculated that China’s M2 velocity had declined at an average annual rate of 3.5% p.a. since 1996. Roger Bootle asked about the influence of a slowing China on the rest of the world through the effect on commodity prices, particularly oil. John Greenwood said that oil is less important to China than people think. Most of its energy needs are met by coke and coal, and these prices had declined steeply.

Andrew Lilico observed that Anthony J Evans had not discussed the risk of a rise in UK rates having a feedback effect into the Eurozone and tipping it into recession and crisis. Anthony J Evans said that since this represents an uncertainty it should not be used to paralyse policy. He said that he favoured a policy action followed by a wait and see period. He said that UK domestic demand is strong and that the Bank cannot wait for the Eurozone to correct itself otherwise it could wait forever. The window of opportunity is provided by the nominal GDP growth of 4%.

John Greenwood said that the ECB expectation that growth will recover next year and inflation would rise displayed a misunderstanding of the business cycle. Inflation normally slows in the first two years of recovery and Eurozone M3 growth had averaged only 1.2% p.a. since 2010, pointing to deflation (which he had forecast from two years ago) in 2015. He said that major divergences in global bond yields are very infrequent but clearly something is happening now with German 10-year bond yields, which could fall below JGB yields in 2015. Andrew Lilico said that three Eurozone factors provide the backdrop for the policy setting in the UK; first the reassertion of sovereign bond problems; second the effect on UK exports to the EU, and third QE in the Eurozone.

Peter Warburton said that central banks are positioning themselves to be more powerful and interventionist. Trevor Williams said that the ECB had set out its stall for a return to its 2012 position regarding balance liabilities and so needs to use asset backed securities as part of its armoury. Jamie Dannhauser questioned the effectiveness of ostensibly degrading the ECB balance sheet. David B Smith said that Germany has been providing the ECB credibility by underwriting unusual debt instruments.

Roger Bootle said that the Eurozone crisis is returning because of its ‘inherent contradictions’. The ECB is being taken to the European Court of Justice and may not be able to engage in policy as the Court could tie it up in the immediate future. While the French would want a relaxed monetary policy it is not likely that Germany would agree. David B Smith said that there is an established link between UK growth and world growth through net trade which constrains the UK economy.

-----Votes-----

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

Roger Bootle said that the growth rate of the economy has indeed been impressive. He said that in certain ranges of the economy expansion leads to lower unit costs and lower inflation because of increasing returns to scale. He expects quite a strong period of growth with low inflation. However, the looming election and the inevitable fiscal tightening that will follow make him cautious on interest rates. The impending cataclysm in the Eurozone will stay the hand of the MPC. There is an argument for interest rates to rise, but not now. He said that basically, we don’t know what is going on and therefore attention should be paid to current price and wage inflation. Similarly, the monetary aggregates are also distorted. He voted to hold interest rates with a bias to hold.

Comment by Jamie Dannhauser
(Ruffer LLP)
Vote: Hold Bank Rate
Bias: No change
1 Year View: Bank Rate at 0.75%; No asset sales

Jamie Danhauser said that a couple of months ago he would have expected by now to be in favour of an interest rate hike. Recent events have pushed back the likely date of a rate hike. Although the private sector is growing strongly (with major revisions to the data having changed the picture even further), the global backdrop is far less not encouraging than it was a few months back. Eurozone weakness is not a surprise; persistently sluggish growth in emerging markets is, however. While the US economy is still growing robustly, downside risks to global growth are becoming more material. Domestically, there is uncertainty about the amount of slack in the UK economy; but the marked downward trend in domestically-generated it is clear that inflation is trending downwardsover the last year should give greater confidence that past judgements about considerable slack were reasonable. One can add to this the downward lurch in commodity prices in recent months. and it is not just the effect of commodity prices. With fewer fears that the supply side is not as weak as it might have been, the potential weakness of previously thought but is connected to world growth which itself is looking weak. He said that he wouldcalls for rather adopt a ‘wait and see’ policy. If the world economy comes out of this soft patch unscathed and the US expansion remains solid, there will be a case to begin the process of gradual rate hikes.

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

Anthony said that he had made his position clear in the presentation. He said that relatively strong domestic demand provides the window of opportunity to begin the process of normalisation and that the Bank should act now when growth has returned to normal rather than wait for it to rise sharply.

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

John said that he was in agreement with Jamie that GDP growth was surprisingly strong. Mainly this has come about through an increased number of jobs but at low pay levels. So there remains a question about the quality -- and hence productivity -- of the increased UK employment. The recovery is therefore fragile and remains vulnerable. Strong growth in broad money would be helpful given the ending of QE. There has been some reduction in the savings rate even after the redefinition of savings in the national accounts. Despite the clear strengths he said that he was not in favour of raising rates as a weakening of the economy could occur (as it had in Sweden). Inflation will be below 1.5% and the Governor may have to write a letter. Broad money and credit growth does not indicate runaway demand. Nominal spending is unlikely to change much in the short term and the economy may weaken. Moreover, Draghi’s policies will fail to boost the Eurozone economy. He voted to hold rates with no bias.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ¼%
Bias: To raise Bank Rate further
1 Year View: 1¾%

Andrew Lilico said that after a long period of voting for a ½% he had to change his vote. He said that it was a mistake not to have raised the base rate in the past, but that since he opposed looking through short-term spikes he could not ignore inflation approaching 1% now. He voted to raise rates by 25bp in stages towards and eventual pause at just under 2%.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%
Bias: to raise in stages. QE to be used only in the event of euro crisis

Kent Matthews said that he was impressed by Anthony J Evans’ analysis that the conditions appear right for a base rate raise but that his arguments are more microeconomic than macroeconomic. In many ways the situation is reminiscent of the old debate of Liquidity Preference versus the Loanable Funds theory. He asked how long interest rates can be depressed before the allocative inefficiencies of financial repression begin to override macroeconomic considerations. His view which he has repeated at previous meetings was that low rates were subsidising the wrong type of enterprise while badly needed bank credit was not flowing to the right enterprises. Recent research suggests that small firms are using trade credit as a substitute for bank credit in the absence of bank financing, increasing the fragility of the economy. Real interest rates have to return to being positive so that the economy can rebalance and that credit markets be allowed function efficiently. Not since the 1930s has bank rate been constantly at a low rate and negative real interest rates for this length of time are unprecedented.

It seems inconceivable that investment decisions made for a medium term horizon would be affected by a 25bp rise and investment decisions that are conditional on interest rates remaining at these low levels should not be made at all. While there are negative macroeconomic pressures a rise in base rates will create on the exchange rate and potentially on domestic demand, the microeconomic gains have to weigh against the macroeconomic losses, which is why base rate should be raised cautiously and in small steps. The inevitable return of the euro crisis will require a tractable monetary response in the form an interest cut and additional QE. If interest rates are not at a position to be cut the Bank will regret not having raised rates earlier.

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

David B Smith said that he was still trying to digest the Office of National Statistics (ONS) figures released on 30th September. There had been huge changes to the scale and composition of the ONS GDP figures, which had substantially invalidated previous views about the UK economy. ( Editorial Note: A detailed analysis of The UK National Accounts After the 30th September Data Avalanche is available on request from xxxbeaconxxx@btinternet.com.) The changes to the ONS data were so substantial that scientific model-based prediction had become almost impossible at present. As a result, he admitted that he had almost no feel for what was really going on. However, the UK could not escape its historically close links with the wider world economy. Many of the adverse issues in the Eurozone stemmmed from the inability of Germany to enforce sufficient fiscal discipline on the rest of the euro economy. The UK inflation rate was currently being dominated by transitory effects. In the short-term, the much reduced prices of oil and non-oil commodity prices would drive prices lower but this would become part of the base for the annual inflation calculation in a year’s time. In the medium term, domestic inflation was connected to global inflation via changes in the external value of sterling. With global inflation low and sterling reasonably strong, he was not too concerned about any upside risks to inflation over the next year or two. He commented that the tax and price index (TPI), which was relevant to the alleged cost-of-living crisis, had risen by 1.8% in the year to September. In these circumstances, he felt that a moderate ¼% rise in Bank Rate was appropriate for November, with further upwards adjustments being gradually phased in in subsequent months.

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

Peter Warburton said that the actual MPC was stuck in a rut on monetary policy and they were mistaken if they thought that the Financial Policy Committee can do soft tightening in its place. The evidence from Israel is that the economy reacts to interest rate rises. Raising the base rate is the correct decision. A downturn is coming in two years’ time and to go into it at rock bottom interest rates is highly regrettable. Given the recent appreciation of sterling, he said that inflation is surprisingly high. We are running out of time to raise Bank Rate. The Bank has created a mentality that even a small rise in the rate is destabilising. He said that rates should rise in stages to a target of 1.5% over the next year.

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

Trevor Williams said that growth performance has been good but industrial production is still 5% below its pre-crisis level. Similarly construction is 13% below its pre-crisis peak. The strongest sector performance has come from services, and, even with the new data, this broad pattern is unchanged. We should not be surprised if the recovery now slows further because the UK is an economy that is open to global shocks like Europe, and productivity growth is still too slow. The fall in global inflation is saying something about the disinflationary forces at large, and the weakness of growth impulses. Domestically, there is no wage inflation to speak off and real wage growth is negative. The supply of labour is expanding and profit share in GDP is increasing. Annual consumer price inflation will likely slow even further, to below 1% by the end of the year. We have talked about the slowdown in China but not about the same phenomena in Russia (recession), Brazil (recession) and India where there is growing evidence of the need for substantial structural change and surety it will be delivered despite an electoral majority that makes it doable. In the event of a global down turn, there is indeed little monetary policy could do to help but tightening now will heighten the risk of a more severe downturn.

------Policy response------

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

What is the SMPC?

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

Current SMPC membership

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

In its email poll closing Friday 3rd October, the Institute of Economic Affairs (IEA) Shadow Monetary Policy Committee (SMPC) recommended by six votes to three that Bank Rate should be raised on October 9th, including five votes for a rise of ½% and one for a rise of ¼%.

Those advocating a rise felt that although inflation is low and monetary growth weak, current growth strength and falling unemployment provided an opportunity for some normalisation in rates.

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

Votes

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

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

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

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate and QE
Bias: To raise rates in 2015
1 Year View: No view

Early 2014 started quite well for the British economy. In contrast with the Eurozone with its paralysed banking system and very low broad money growth, and with severe tensions between the member states, the UK has its own currency. It has therefore been able since the Great Recession to organize monetary policy according to the needs of its own economy. Money growth is positive, at a rate which is about right, and demand and output have been growing steadily for some quarters.

However, in the last three months M4x (the appropriate aggregate to monitor in current circumstances) has increased by just under 0.8%, with an annualized growth rate of 3.1%. Arguably, this is a bit on the low side. The recent growth of M4Lx (i.e., the credit aggregate that corresponds to M4x, lending by banks to the non-bank private sector excluding the awkward “intermediate other financial corporations”) has been even less. Moreover, several companies have reported a slowing of business, relative to expectations, in the weeks since staff members have returned from the summer holidays. This slowing of business may be related to the stresses and strains in the Eurozone rather than any meaningful weakening in the UK’s own demand conditions. All the same, the dip in Eurozone demand matters to the UK economy and cannot be ignored. Also important is that commodity prices have been falling recently, with the oil price down $20 a barrel from a $115-a-barrel peak earlier in the year, very depressed prices for natural gas and coal, a slump in the iron ore price and lower prices of most agricultural commodities.

The Eurozone is heading for outright deflation in early 2015. In the UK the annual increase in the consumer price index should go under 1% later this year and may even go negative next year, as in our neighbours, depending on energy prices from here. 2015 should be one of the best years for UK consumer spending since the onset of the Great Recession, but the latest developments argue that the housing market is cooling down after a busy phase in early 2014. I have decided to reverse my recent conversion to an interest rate rise. Bank Rate should be kept at ½% for the time being, although I do expect to advocate moves towards interest rate normalization (i.e., towards a Bank Rate of at least 2%) in 2015.

Comment by Jamie Dannhauser
Vote: No change in Bank Rate or QE
Bias: No bias
One year view: Bank Rate at 0.75%; QE unchanged

Tentative evidence has emerged that UK growth is soon to peak. Nonetheless, the outlook for growth over the next 6-12 months is still positive. Recent momentum has been considerable. Major revisions to the National Accounts, especially to the profile for business investment, have altered the historic picture somewhat; but rapid growth over the last six quarters is still evident in the last vintage of the GDP data. The preferred measure of UK economic activity – market sector real gross value added – has expanded at an annualised rate of 3.6% over that time period, despite the persistent contraction in financial sector output. Broadly speaking, non-government activity has been growing far quicker than the pre-crisis average since the middle of last year.

This surge of activity partly reflects the release of pent-up demand. Such growth rates are unlikely to be achieved in the next 4-6 quarters. But on the basis of forces originating in the domestic economy, most obviously monetary developments, expected growth should be solid.

Inflation trends remain weak. Headline inflation is comfortably below the 2% target, core inflation a little lower. In part, this is down to sterling’s appreciation over the last year, the effects of which will be felt through next year as well. But there is little evidence that domestic price pressures are building. Given the speed of the turnaround in the UK economy, this provides some confirmation that past beliefs about significant slack in the economy (and/or effective supply failures keeping prices higher than they otherwise would be) were reasonable. Some survey data suggest marginal wage growth is rising; but a host of other indicators of domestically-generated cost and price inflation remain depressed. Intense price competition within the UK retail sector is another factor likely to be holding down underlying inflation as we move through 2015. In addition to this, global commodity prices have taken another lurch down.

On balance, it has not been reasonable to withdraw monetary accommodation over the last few months. It seems even less reasonable today. Inflation in the UK and elsewhere is surprising on the downside. Market inflation expectations have turned down markedly. Similar trends are evident in surveys of household expectations as well. The eurozone recovery appears to be stalling. At a global level, there are some signs that the growth cycle has peaked: for instance, leading indicators of world industrial activity suggest a slowdown as we move into Q4.

As the UK economy moves closer to its underlying potential, the need for higher interest rates will arrive. That moment is not here yet. It is likely to come in the next twelve months but the case for a gradual withdrawal of stimulus is strong. In terms of balancing prospective policy errors, it still seems wise for monetary policy to err on the side of doing too much at this stage.

Comment by Anthony J Evans
(ESCP Business School)
Vote: Raise rates ½%
Bias: Further rises

Given that the period of “emergency” monetary policy has become so firmly entrenched, it is no surprise to see fear regarding tentative steps towards a more neutral stance. However there is evidence that the public, as well as many economists, are getting somewhat bored by the waiting game. The August release of the Bank of England/GfK Inflation Attitudes Survey suggests that the public are factoring in rate rises. A fifth of people surveyed believe higher rates would benefit the economy (compared to 14% who think they should go down), and more people believe they would be better off from rate rises than worse off (23% compared to 22%). On the surface, this supports the idea that things should stay as they are. However those economists who do agitate for a rise, point to dangers that are building up for as long as rates remain low. It isn’t like a diver waiting for the water to calm down before making their jump. The act of waiting is making the jump more difficult and perhaps contributing to the imperfect conditions. Low interest rates can cause low growth (by retarding capital formation), but they can also cause bubbles (by encouraging capital consumption). The main danger of the waiting game is that we alternative between these outcomes. The conditions for a cautious rate rises should be based on whether the economy is reasonably robust, and whether public expectations are broadly in line. Forward guidance has intended to reduce uncertainty about when rates will rise, but has less impact on the uncertainty surrounding their impact. It might be worthwhile to deal with this head on. To the extent that lenders have already begun to factor in rate rises, and that they could (and should) be interpreted to signal higher medium term growth, a rise could provide a boost. Ultimately we don’t know, but we experimented with emergency policy, so it’s unlikely we can exit without a little experimentation as well.

Whilst M3 growth remains a concern other monetary aggregates continue to grow strongly. The Divisia measures are high and broad money is growing. However, there is a little concern about August’s figures. The household measure of Divisia ducked slightly below 8% in August, and M4ex has fallen from 3.8% in July to 3.4% in August (using non seasonally adjusted data). Ideally we would want to see these pick up again, but even though they’re not sending a clear signal of loose monetary conditions, they’re not suggesting tight ones either. Similarly, CPI seems to have settled slightly under target and RPI is not causing any inflationary alarm. But it seems to underline the change in reference over the last few years if these figures are considered “low”. Inflation expectations certainly don’t imply that we’re heading off target. Ordinarily I would include a discussion of the National Accounts and in particular NGDP growth. However the recent changes have dented confidence significantly. We entered into the Great Recession with confusion and uncertainty about what our main monetary aggregates were telling us. It appears that our output measures where sending similarly misleading figures. Perhaps the best response is to take a step away from a myopic study of official data and focus more on the underlying, long-term causes of prosperity. The goal of monetary policy should be to prevent interest rates from fluctuating from their natural rate.

Although I think monetary policy is too loose I don’t think any surprise action should be taken on QE. The main argument against it was the ad hoc way in which it was introduced, and the removal needs to be carefully communicated and follow a normalisation of interest rates. Indeed there is a convincing argument that the influence of the central bank relies on control of the monetary base, and therefore the Asset Purchase Facility should replace Bank Rate as the main policy tool. But the prospect of impending tightening (or rather, less loose monetary policy) is generating enough uncertainty for now.

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

Lending growth may have flattered to deceive in June and July. In the three months to August, lending growth (on the M4Lx excluding intermediate OFCs measure) fell back to 2.3% from the heady 4½% figures of June and July. That is still stronger growth than over much of the past five years but no longer signals a step change in lending. August inflation was down to 1.5%. There seems to be no immediate inflationary threat or rapid monetary growth that would force interest rates to rise.

Yet, to repeat a familiar refrain, it is a mistake to believe that the purpose of rate rises at this stage should be responding to inflation. When there is no compelling reason for stimulus or tightening (and there is no compelling reason for either at present), the proper tendency should be for rates to drift back to their “natural” or equilibrium level. For the UK that level is somewhere between 3% and 5% at present. That does not mean that rates should be instantly raised to 3% or more. It does mean that they are clearly far away from their equilibrium level. Keeping rates greatly distant from their equilibrium level induces damaging distortions in economic activity and expectations, damaging medium-term growth.

UK GDP in the second three months of 2014 was up 0.9% on the first quarter and up 3.2% on a four-quarter over four-quarter basis. Unemployment continues to fall. The banking sector (though lending remains poor) has been relatively stable for some time. The stock market is healthy. The corporate bonds market is liquid. There is undoubtedly scope to raise rates. Such rate rises will of course have implications for some heavily indebted households and may also further accelerate the rise in the international value of sterling (up around 15% on a trade-weighted basis in the fifteen months to July 2014). But such implications are, by and large, an economically desirable element of the economy’s returning to a sustainable equilibrium position with interest rates at their natural level. We have a chance to raise rates. We should take it.
Comment by Kent Matthews

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

There is a credible argument to keep the base rate at its current position until evidence of a hardening of the labour market appears. Certainly the weakness in broad money growth and coincident indicators of nominal GDP growth such as narrow money or retail deposits, give no grounds for concern about a sudden increase in inflation. The assumption behind this policy is that there is sufficient capacity in the economy to accommodate a policy of continued cheap money. The problem is that is no good measure of capacity and what little we know suggests that it is now less than what we thought it was. A famous economist once said that the ‘lags are long and variable’ and the same economist is supposed to have said that there is no such thing as macroeconomics; all economics is microeconomics. It is the microeconomic argument that prevails in the recommendation that interest rates should start to move upwards. Evidence from past financial crises suggests that GDP growth does not always return to trend because of capacity destruction. Therefore given the state of the current UK recovery, the economy may be below capacity or as suggested by various business surveys, it may be at capacity – we simply do not know. But we do know that the lags are long and variable.

However, the argument for a rise in the base rate is not macroeconomic but largely microeconomic. The long period of low interest rates has stifled the process of capacity rebuilding by hindering the mechanism for the re-allocation of resources from the low productive sectors surviving on cheap credit to high productive sectors starved of credit. It is true that a reversal in the current state of financial repression will take time for capacity to be re-built and for the supply-side to respond. This is why interest rates have to be raised slowly. There are macroeconomic arguments also for raising rates. At current rates monetary policy has lost all traction. The euro crisis has abated but not resolved. At some point in time this might flare up again and at 0.5% there is no space for interest rates to fall. The economy needs to get back to equilibrium at a positive real rate of interest. Raise rates by ¼ %. Hold QE in reserve, Bias to raise further in short steps.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate ½% and start to reduce the stock of QE gilts
Bias: Further rate rises and more run-down of QE
One year ahead: No view

It seems hard to argue that central banks were the central factor causing the banking crisis. Yet consider this argument put forward by Anthony de Jasay in a recent book (Economic sense and nonsense — reflections from Europe 2008-2012): the total value of sub-prime mortgages were in the range of $400-600 billion and the losses on them could be gauged at some percentage of this, at some tens of billions. Compare the latest fine just levied on the Bank of America of about $17 billion; not to speak of previous ones on Bank of America and ones of similar order on many other banks levied by the various US regulators. These have made but a dent in current bank profits and are a tiny percentage of total bank assets. So how could sub-prime losses have brought down the world banking system? De Jasay argues that they could not; and he must be right about that, simply because the amounts are far too small. What brought down the banks was the effective closure of the world’s interbank market, so that banks could not borrow from each other to carry out their normal day-to-day operations. This in turn happened because central banks failed in their key duty: to keep open the world system of liquidity of which this interbank market was a central component. The market closed because of a lack of trust between banks: bank A did not know whether bank B had a sound balance sheet, fearing it might be a major holder of sub-prime assets. So it refused to give it credit on the interbank market. This became general. Yet central banks are supposed to stand behind such systems and assure member banks that they will maintain the creditworthiness of participating banks. They did not do this, particularly for foreign banks on the market; for their own banks they may have been willing to offer such assurances but this was not enough. So they failed to coordinate their support of the system.

Instead de Jasay argues that central banks allowed officials in government to spread doubt about banks’ solvency and start at once on a tightening of regulation. The initiative moved to bureaucrats who have a vested interest in new controls that enhance their power. They put it about that banks had overreached themselves and that many of them were insolvent. Once this had occurred central banks lost control. When Lehman could not raise money in the marketplace, the Federal Reserve could not persuade enough banks to help it provide the necessary funding. Part of the problem was the unwillingness of the Bank of England to support Barclays’ desire to buy a big chunk of Lehman. This again bears witness to a central bank failure of coordination- had the Bank of England been acting as part of a cooperative team confronting the Lehman threat it could have helped avoid the collapse. As it turned out this collapse was the trigger for the crisis proper, leading to a dramatic fall in world trade and GDP over the succeeding six months. So we got a story in which a small global loss spiralled into a snowball that brought down the world banking system. Of course after the collapse of the system bank losses also spiralled in the recession, so apparently validating the bureaucratic claims of massive over-extendedness. But the appearance is highly deceptive.

Replaying history like this might be too simple; there could have been other factors, such as the slowing of the world economy, that were creating broader losses for banks than just on sub-prime mortgages. In our Cardiff research on the crisis we have found that the world business cycle was indeed in trouble, as evidenced by the huge peaks in oil and other commodity prices. It looks as if there was too much credit in the previous boom, allowing it to get rather out of hand and so feed the following bust. However recessionary tendencies are one thing; collapse of world banks is another. We have had plenty of recessions in the post-war period but only in this one have we had a major banking collapse. It points the finger straight at central banking failure. If this is correct, then the huge rise in regulation since the crisis looks quite unjustified. Instead governments should have improved central bank international coordination, and reviewed their ability to support world liquidity. They should have looked at ways of restraining money and credit directly in the boom stage of the cycle. They should also have looked at better rules for managing interest rates. More work we have done suggests that with such rules and firm central bank support of markets economic stability could be hugely increased; intrusive regulation of banks both is unnecessary and sabotages the credit mechanism. As for all these fines levied by all the different, competing US regulators, they too are a damaging bureaucratic intrusion on the banking market. The US itself, having once been supposedly the home of free markets, has become a major intervener in markets worldwide in pursuit of political objectives such as sanctions and popular retribution, with the Dodd-Frank Act too a source of an ever-growing interference in the banking system.

We must hope that this regulative backlash produces its own horrified reaction. It seems that this has happened earliest in the UK where we have had attempts to alleviate the worst effects of regulation with schemes like Funding for Lending and Help to Buy. Our newfound recovery may owe a lot to these attempts. In the US the existence of state and local banks has helped credit to start flowing in spite of the problems of the large money-centre banks. Still the US is suffering from a stuttering recovery which seems closely related to a sharp rise in political uncertainty about future intervention, with a President keener on it than any predecessor.

As for the Eurozone it is a tragic tale of the overweening ambition of a small elite who forced monetary union on reluctant nations and then has followed it up in the crisis with measures that have put the preservation of that union above the interests of the union’s citizens, on the pretext that abandoning it would ‘create chaos’. Sadly the citizens have bought the lie but their misery is untold. Their banks have had to absorb huge amounts of government debt; and ironically that very debt is undermining their credit status. EU bureaucrats are busy condemning them as ‘capital insufficient’ which in turn wrecks the credit mechanism of the Eurozone. Its growth has stopped, deflation is moving in, and the crisis is worsening again. The hope is that ‘reform’ will trigger growth; yet without credit it is impossible to turn reform into growth because the new firms and industries encouraged by reform cannot obtain the means to invest. Just as Japan effectively has ceased to be an element in world growth over the past two decades, wrecked by a cocktail of deflation, lack of competition and low productivity growth, so the Eurozone is imitating it now. It looks as if it will be written out of the world growth script over the next decade at least. The UK in particular has had to turn to other markets and that will continue. As the FT writer Wolfgang Munchau has frequently observed, the UK may be agonising over in-out referendums on the EU but it has already de facto left. It remains to formalise the new relationship and tidy some difficult loose ends like totally free EU immigration and aggressive EU financial taxation. World and UK growth will survive the EU’s problems, just as they have survived Japan’s problems. Our Cardiff forecasts remain positive for the survivors. Indeed the very fact that some countries’ growth is weak makes it easier for other countries to grow in a world dominated by periodic resource shortages.

For a long time now I have argued for a return towards normal interest rates and open market operations. But of course this is only possible if the regulatory authorities are doing their proper job. Clearly they are not in the Eurozone. Instead they are aggravating the shortage of credit. In the US the competition from regional banks seems to be a saving grace. Here in the UK there are signs of a return to a more balanced approach, money growth has reached 4% and credit is finally growing, if only slightly. Certainly the economy is growing strongly and core inflation is close to 2%. Wage growth is still weak but inflation can rise with weak wage growth if capacity tightens and margins rise; also the labour market is now tightening quite fast and this will start to push up real wages fairly soon. House prices are rising at over 10% a year and rather than quietening this market with direct regulative interventions, I would argue monetary policy should do it indirectly. This is no longer a fragile recovery; the risks of higher inflation are rising while the risks of slowing the recovery by a slow move towards normalisation are falling. In my view normalisation should have begun some time ago and I continue to press for it now: because of delays I suggest a 0.5% initial rise in base rate, together with resale of gilts to the open market at a rate of around £25 billion a quarter (which would imply elimination of QE over a period of 4 years). Further rises in base rate will be needed but the pace at this stage is hard to foresee.

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

There is a neglected aspect of monetary policy which concerns the regulatory and penal strictures applied to the banks. News that UK banks face additional fines totalling above £10bn in respect of LIBOR and foreign exchange rate rigging raises doubts over their willingness to lend freely to the private sector. If the banks suspect, as they must, that these fines amount to a de facto international tax regime, then they will continue to operate with undue caution. The long overdue increase in UK Bank Rate is the appropriate expression of monetary tightening, rather than the ad hoc plundering of bank profits by international regulators.

The annual growth of M4 money stock, excluding intermediate other financial corporations, has slipped back from 5% a year ago to 3.5% in the year to August. This weakening is entirely attributable to wholesale deposits, since the growth of retail deposits (M2) is 6.1%. Now that money supply growth has been restored to an acceptable range, consistent with nominal economic expansion, this poses no obstacle to the raising of Bank Rate. M4 lending, excluding IOFCs, continues to register very low (1%) annual growth.

Profound revisions to the UK national accounts, principally to reflect the capitalisation of research and development expenditures, make it even harder to justify the inactivity of the MPC. The assertion of a negative output gap is even less convincing on the re-casting of the statistics. Essentially productivity growth has been downgraded for the decade 1995-2005 and raised thereafter, reducing the contrast with the post-2009 experience. Tightening labour market indicators confirm the inflationary dangers associated with staying on the present policy course. At 1.5%, the UK still has the joint-highest inflation rate in Europe. The private sector components of the retail price inflation rate are still running above 3%, as against sub-2% prior to 2009.

A rise in Bank Rate is long overdue: the justifications for delay are insubstantial and the costs of delay, though largely unseen, are nevertheless serious and likely to be cumulative. My vote is for an immediate increase in Bank Rate of 0.5%.

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

UK economic growth is slowing from an above quarterly trend rate of around 0.8% to below trend at 0.6%, assuming a trend rate of 0.65%. In latest data from the ONS, the economy grew by 0.7% in Q1 2014 and 0.9% in Q2, leaving the H1 average at 0.8%. But latest estimates from NIESR suggest that growth in the quarter to July and August was 0.6%, respectively. This suggests that growth in the second half could be 0.6%. The most obvious sign of this slowing is shown in the manufacturing data, where not only is the PMI slipping but so is actual production. Manufacturing output appears to have been flat in Q3. This trend is a sign that the effects of a strong pound and weakness in our key export markets in Europe, compounded by slow growth in global trade, are leading to an easing in the pace of activity in the UK economy. Admittedly, retail sales and domestic confidence levels amongst households and business remain elevated so domestic demand is not slowing as much, as shown by our widening current account deficit.

Although this slowing is of course no reason in of itself not to raise rate - that would depend on inflation trends as well – especially as the ONS revisions now show that the economy is 2.7% above its pre crisis peak, rather than 0.2% as suggested in the previous data. But money supply growth is weaker, as is the pace of wage inflation. Annual headline M4 growth was minus 1.5% in September, while M4ex IOFCs on a three month annualised basis was 3.1%, down from a downwardly revised 3.4% in August (from 3.8% previously) and 4.5% in June. Average weekly earnings inflation was just 0.6% year over year in July, with the rate ex bonuses at 0.7%. There is no inflation pressure here. Nor do leading indicators suggest this is about to change any time soon, from pay settlements to pipe-line inflation trends. Producer prices inflation on the input basis was minus 7.2% year over year in August and output prices were down 0.2% on the same basis. Actual CPI inflation was 1.5% in the year to August, with current trend suggesting it could bottom out at between 1 and 1 ¼% later in the year or early 2015.

None of this is to suggest that the economy is about to slip back into weak growth, it is not, but it does show that the pace of growth is losing momentum. Moreover, this is occurring at time when inflation pressures are still subdued. Think what would have happened to price inflation if official rates had been raised to 1 to 2% a year ago? Those MPC members that voted for a rate hike cited above trend growth and a narrowing output gap for wanting to see higher rates as they saw an inflation threat to pay and then to prices. Well, there appears little of that at present, not least because output gap estimated cannot be trusted, as shown by the re-writing of history by the latest ONS data revisions. Growth seems higher but inflation is still where it was and productivity is no better or worse.

Moreover, looking ahead, growth looks like it will stay at trend or below and inflation muted for the next few months at least. No doubt, a rate rise will be necessary at some point in the next 6 to 12 months but that point is not now in my view. I would leave rates at 0.5% and the APF at £375bn.

Policy response

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

Date of next poll
Sunday November 2nd 2014

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

Votes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Policy response

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

Date of next poll
Sunday September 28th 2014

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

Minutes of the meeting of 15th July 2014

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

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

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

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

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

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

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

Monetary situation

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

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

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

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

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

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

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

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

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

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

Discussion

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

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

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

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

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

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

Votes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Votes in absentia

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

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

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

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

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

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

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

Policy response

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

Date of next meeting
Tuesday 14 October 2014

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

Votes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

At the same time, can one discern in the confusion created by the Governor’s many conflicting comments on future monetary policy that there is a hardening of the MPC’s approach to interest rates and QE? I hope so and for long have been arguing that it is high time to ‘normalise’ monetary policy. The economy is picking up rapidly at a time when the best estimate of spare capacity is quite low; the labour market is buoyant and not far from the 5% unemployment rate at which, roughly, full employment prevails. It seems rather clear that the economy is no longer in the intensive care that justifies emergency low rates and a massive overhang of official liquidity.
 
It is usual in these situations, when memories of the recession are still fresh, for many people to argue against ‘premature tightening’. However, this is also a dangerous time to listen to such arguments. The strongest point in their favour is the slow growth of the money supply and the glacial growth of credit that is associated with this slow growth. The problem is to interpret these developments. There has been a wave of new regulation which has impacted massively on bank behaviour, forcing banks to shrink their balance sheets aggressively. Now we seem to be entering a phase when firms are finding ways of substituting away from bank credit; the surge in the mortgage market is the only vibrant part of the credit scene, and ironically in view of all the concern being expressed about housing is also low risk-weighted in bank regulation.

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

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

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

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

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

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

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

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

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

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

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

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

The new recommendations of the FPC appear quite innocuous, confirming that it is not the Bank’s intention to hit the economic recovery on the nose. The limit of 15% for the proportion of high (more than 4.5 times) loan to income multiples is far from a binding constraint. The stipulation that new mortgages should be stress-tested for a 3 percentage point rise in Bank Rate is reasonable enough, considering that it does not lay down what assumptions should be made for the spread between Standard Variable Rate mortgages and Bank Rate. A narrowing spread as interest rates normalise would be a reasonable assertion. Also, lenders are free to assume faster growth of borrowers’ incomes to help them through the stress test.
 
The inflationary side effects of this experiment in delayed interest rate reaction will not be far behind. What passes for patience on the part of the MPC is a neglect of duty. The cost of unsettling inflation expectations will be felt very quickly in the Sterling fixed interest market and the absorption of the UK still-massive debt issuance programme may soon become problematic. The weakening of the overseas bid for gilts could readily bring Sterling down from its high perch and the UK’s benign inflation dynamics would be turned upside down.

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

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

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

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

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

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

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

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

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

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

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

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

Policy response

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

Date of next poll
Sunday August 3rd 2014

 
What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

Votes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Policy response

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

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

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

Date of next poll
Sunday July 6th 2014

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

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

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

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

Minutes of the meeting of 15th April 2014

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

Retiring Chairman’s Valedictory Comments

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

New Chairman’s Comments

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

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

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

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

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

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

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

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

Discussion

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

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

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

Votes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Policy response

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

Date of next meeting
Tuesday 15 July 2014

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

More fundamentally, Forward Guidance II reveals a continuing faith in the US-inspired Conventional Theoretical Macroeconomic Model (CTMM) in which the output gap – however defined – plays a central role. However, the CTMM is horrendously flawed as a description of an open, trade-dependent economy, with a large government sector, and extensive financial regulations impinging on the supplies of money and credit. As a result, the CTMM is a misleading intellectual framework for central-bank decision makers. The CTMM was also responsible for the undue complacency of the US Federal Reserve and the Bank of England ahead of the financial crash, which a more traditional central bank approach would have ameliorated if not obviated (Editorial Note: the reasons were set out in David B Smith’s May 2007 Economic Research Council Paper, Cracks in the Foundations? A Review of the Role and Functions of the Bank of England after Ten Years of Operational Independence (www.ercouncil.org)).
It is noteworthy also that Mr Carney hardly mentioned inflation in his Inflation Report address, apart from noting the recent undershoot. The Governor also seemed to regard the exchange rate as a nuisance variable that distorted the relationship between the output gap and inflation – rather than as a key part of the monetary transmission mechanism in an open economy – and did not mention the money supply once. Mr Carney argued that the first phase of Forward Guidance had helped the stronger pattern of activity in the second half of last year. However, an alternative explanation is that it reflected the acceleration in the annual growth of M4ex broad money from some 2¾% in the first quarter of 2012 to just over 5% or so in the first half of last year – in which case, the slowdown to 3.7% in the year to December may be a cause for concern about the continuing strength of the recovery.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

Minutes of the meeting of 14th January 2014

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

Chairman’s Statement

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

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

Economic situation

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

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

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

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

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

Discussion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Policy response

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

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

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

Date of next meeting
Tuesday 15th April 2014.

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

Minutes of the meeting of 15th October 2013

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

Proposal to the Committee

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

Economic situation

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

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

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

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

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

Discussion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Policy response

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

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

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

Date of next meeting
Tuesday 14th January 2014.

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Broad money continues to grow at around 5%, and narrow money supply measures are even faster. The economy is not booming but low interest rates are a reason why. Given that the aim should be to normalise monetary policy as soon as possible, there is not sufficient fragility to shy away from this. There is little doubt that an unexpected increase in interest rates would cause immense confusion and be destabilising to the economy. Nevertheless, in voting for an increase in rates, it also has to be assumed that this decision would be communicated effectively.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no more QE.
Bias: To raise Bank Rate further, and soon.

The past couple of years have seen a steady pickup in monetary growth. In the final three months of 2011, the Bank of England’s standard measure of broad money growth (seasonally adjusted M4ex) had an annual growth rate of well below 2%. In the latest numbers available at the time of writing (June 2013) that rate is around 5%, where it has been throughout 2013. That is still, perhaps, somewhat below the 6% to 8% one might estimate would be compatible with CPI inflation of 2% and 2.5% or so real GDP growth rate in the long run. Nevertheless, given that the sustainable growth rate for the UK economy is probably only in the 1% to1.5% region at present, 5% monetary growth is about appropriate. Recent months have also seen a distinct pick-up in the UK macroeconomic data. GDP is estimated to have grown at 0.7% in the second quarter of 2013. Since then, most survey data has suggested a further pickup. Quarterly growth numbers pushing 1% seem plausible for the second half of 2013 in a way that few commentators would have dreamed only six months ago.

The detail of the GDP growth figures implies a broad-based pick-up, including accelerations in investment and net trade, rather than just household consumption. Absent downside risk scenarios materialising (discussed in more detail below), there should be further scope for an expansion of non-oil net trade, especially if the situation in the Eurozone stabilises. Business investment may finally be responding to a combination of intrinsic pressure from long-postponed projects and the desire to shift from financial into real assets to gain greater protection from erosion by inflation – which has been endemic over recent years and likely to accelerate over the next couple.

International events in Syria, and the possibility of their spilling over into a wider conflict, constitute a threat both to international trading conditions and to oil prices. An oil price spike could have implications for inflation down the line. However, it is appropriate for monetary policymakers to await events for the time being. The more intrinsic threat of inflation for the UK comes from the likelihood of a large further acceleration in broad money growth. The danger, here, is that the large injection of monetary base via QE becomes leveraged into broad money as the economy recovers and the banks becomes less distressed. The extended nature of the 2011 and 2012 ‘double-blip’ soft patch in growth has not changed fundamentally the dynamics of the inflationary impact of QE on exit from recession, merely delayed it.

Absent further international events derailing British recovery, the underlying pressures should be expected to assert themselves, as follows. The first stage is that a huge increase in monetary base should translate into rapid broad money growth – increased capital requirements notwithstanding – and thus inflation down the line. Anticipating that inflation, investors and companies will exit from cash and financial assets into real assets in a distinct spike in business investment. Next, that spike in business investment will be associated with a rapid pick-up in GDP growth over a few quarters. Faster growth, in turn, will make the balance sheets of banks appear much improved temporarily. These stronger bank balance sheets will then facilitate a rapid pick-up in lending. Once this scenario is in play, the Bank of England will have neither the will nor the tools to control it fully. It will lack the will because the measures required to cap such rapid monetary growth will entail driving the economy back into recession; the Bank will not be willing to do that until it feels we have comprehensively escaped the previous recession. The consequence will be even higher inflation than the UK experienced in 2008 or 2011 – perhaps much higher.

When that inflation comes, workers will seek to protect their real wages by seeking rapid pay rises. When the Bank of England is, at last, willing to cap inflation, workers will not believe its promises and the consequence will be many workers stranded on excessively high wages who then become unemployed. The key problem with losing credibility on inflation is not the inflation – the inflation comes from the money growth, not the expectations. The key problem with losing credibility on inflation is the unemployment that will be the consequence.

The key near-term issue liable to derail the scenario above is, as it was in 2011, the Eurozone crisis. That is by no means resolved, though considerable political progress has been made. Eurozone policymakers are finally acknowledging that the Eurozone will only work as a transfer-union; without debt pooling but with annual payments made from richer to poorer regions of the Eurozone via a greatly expanded version of the EU’s current structural funds arrangement. A transfer union of that sort can only be delivered in combination with political union – the establishment of the EU Federation. The Euro was always going to imply the creation of a Single European State. For Britain, that EU Federation will have political and economic consequences within just a few short years but, for now, managing the great volatility likely to be associated with exit from the current recession is the priority for monetary policymakers. The Bank has missed each opportunity since 2010 for raising interest rates. It should not be missing yet another now.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE by £25bn per month.

The revised estimate of GDP growth in 2013 Q2 comes as a relief to UK economy-watchers. A quarterly increase of 0.7% is at last appreciable, if still not strong, growth. Is this a sudden onset of recovery? Not entirely, as the service sector has had growth averaging 1.6% per annum for the past two years. However, services expansion was overlaid by the weakness in manufacturing, a collapse in construction, a banking implosion and a decline in North Sea oil. Gradually those negative elements have dissipated. With North Sea oil, the government has been in talks with the major companies to give proper assurances that there will be stability in the tax regime for oil; previously, the North Sea was treated like a cash cow, with tax being used to collect ad hoc levies. Naturally, this produced a decline in new projects. In banking, there have been the two FLS schemes and, since the Budget, the Mortgage support scheme for first-time buyers. The latter has encouraged lending, especially for housing. In addition, there seems to be more awareness among ministers that bank regulation can be excessive for the good of the economy. Commercial bank profitability has risen and the Lloyds share holdings by the government are being readied for partial sale. In short, banking may be turning around.

Then we turn to the housing improvement, which has been spurred by the recent rise in house prices, apparently reflecting the mortgage subsidy scheme. This has put new life into construction prospects; and construction has at least stopped declining for now. Finally, manufacturing is picking up as the Eurozone flattens off into a slower decline and exports are being diverted elsewhere where growth is much stronger.

Looking back at the string of disappointing growth figures since the recovery began in late 2009, it seems clear that a key element has been the new regulative approach to banking. This has caused chaos in the banking sector and blocked the credit channel. It has been justified by the need to prevent future crises. However, the evidence supports the view that the crisis was brought about by much wider factors than banking, even if banking problems made it worse. After twenty-five years of breakneck world growth, there was bound to be a downturn as the world ran out of commodities. So, the new bank regulation will not prevent future such crises of capitalism. However, as we have seen, it can be lethal to growth both by attacking the UK’s key growth industry and by killing credit growth. Fortunately, now that the coalition politicians appear belatedly to have woken up to this – witness the outburst of Vince Cable about the ‘capital Taliban’ at the Bank of England – there may be more backpedalling on the new regulative miasma that has swept the British establishment in the wake of the crisis. This has over-compensated for the monetary and regulatory authorities previous failure to control the economy and banking boom of the earlier 2000s.

The trouble about the government’s approach to this backpedalling is that it is entirely ad hoc. The Mortgage support scheme has unlocked lending to housing, and mortgages are up, as are house prices. This unlocking will mean that recovery will include the housing sector, as it would have absent the credit blockage; construction of housing will pick up, as it should. Nevertheless, lending to Small and Medium Enterprises (SMEs) continues to crash, as banks are heavily penalised for lending to them because of the expensive extra capital they need to raise to back this up. Hence the two FLS schemes seem to have bombed out in respect of SME lending. How easy, after all, to ‘increase lending’ by lending you would have made anyway, so claiming the FLS subsidy, while continuing to cut back in aggregate lending to SMEs. The latest introduction by the Bank of England of the extra ‘leverage’ capital requirement is particularly clumsy and crass, coming as it does on top of the already cumbersome and damaging capital requirements related to risk-weighted loans.
What needs to be done is a severe cutting back of these new regulative capital requirements in favour of a return to a self-regulating regime. The Bank should then act as chief monitoring agent, in the same way as existed prior to the ‘Tripartite regime’ introduced mistakenly by Gordon Brown in 1997. Formulaic approaches to capital needs are crude and essentially arbitrary. Also, when risk-weighted, as in the Basel III agreement, such capital requirements penalise lending to SMEs even through collectively these are no more risky socially than lending to blue chips.

A second need is to focus monetary policy back on its old task of ‘taking away the punch bowl when the party gets merry’ (the classic, if now clichéed, description due to McChesney Martin at the US Federal Reserve). This could be achieved by reintroducing money supply or credit growth targets into the conduct of monetary policy, in addition to the long-term inflation target. The problem with inflation targeting on its own has been that inflation does not respond much in the short run to excess credit growth, because of the power of belief that it will be subject to the target. Yet as we have seen, when a credit boom takes hold, it can cause a banking problem to be super-imposed on a recession brought about by the normal forces of capitalism.

With a new Bank governor having just arrived, who has the confidence of the Chancellor, it may be that gradually policy will move in this direction and hence growth will be less restricted by the failure of the credit process. My forecasts assume that something of this sort will happen and hence I have growth staying in the 2% to 3% range from now on. So, coming finally to the monetary judgement, it is suggested that we need a gradual normalisation of monetary conditions. Contrary to the misguided forward guidance given, I would like interest rates to start being raised now, with a ¼% rise this month, with QE gradually being reversed, by £25 billion each month. At the same time, the FLS schemes need to be reformed to deal exclusively with SME lending (and for now mortgage lending; but Help to Buy will probably be enough to keep house lending unfrozen after the end of this year). Regulative targets for risk-weighted capital and leverage should be delayed for at least five years. Longer term, the regulative system needs to be rethought along the lines above.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up state-dependent banking groups before privatisation; raise Bank Rate to 2½%, and maintain QE on standby.

The emphasis placed on the Labour Force Survey (LFS) measure of unemployment as the trigger for re-considering whether a Bank Rate increase was justified in the Bank of England’s 7th August Monetary Policy Trade-offs and Forward Guidance paper appeared at first glance to represent a reversion to a static 1950s Phillips curve model of inflation in which the long-run Phillips curve did not shift vertically upwards with rising inflation expectations and there were no horizontal shifts in the ‘natural’ rate caused by institutional factors such as the replacement ratio of benefits to post-tax earnings. As such, it seemed to ‘un-learn’ all the knowledge that policymakers and economists had acquired over the past half century.

However, a more considered view is that the Bank’s economists were trying – perhaps, subconsciously – to rescue the Contemporary Theoretical Macroeconomic Model (CTMM) which originated in the US and became the accepted policy framework for the US Federal Reserve in the Greenspan era. The CTMM was pushed by American economists who wrongly wanted to take the money supply out of theoretical models. Its intellectual dominance explains why international policymakers were indifferent to the behaviour of the banking sector before the global financial crash; put crudely, if money did not matter, then neither did the behaviour of banks. A major weakness of the CTMM is that it requires a reliable measure of the Keynesian concept of the pressure of demand – i.e., the ‘output gap’ – if it is not to fall to bits. This is because the CTMM can be reduced to three equations in its simplest text book form: one for the output gap; another for the rate of inflation, and a third for the nominal rate of interest, with both the latter pair including the output gap as an important explanatory variable.

Ahead of the global financial crash, the author attacked the CTMM and its dangerous policy implications in his May 2007 Economic Research Council paper Cracks in the Foundations? A Review of the Role and Functions of the Bank of England After Ten years of Operational Independence (www.ercouncil.org). The full criticisms of the CTMM made therein will not be repeated here. However, it is possible to regard the Bank’s paper as an attempt to rescue the CTMM by substituting a labour-market measure of the output gap for the previous GDP-based one, which is now admitted to be un-quantifiable. One reason is uncertainty as to how far the shortfall of activity below its pre-2008 trend reflects a supply withdrawal as opposed to a demand shock. (A personal view is that it is indeed largely a supply withdrawal caused by the big government policies of the ‘Brown terror’ but that is too weighty a subject to be covered here.) Another is that the Bank’s economists now regard the GDP figures produced by the Office for National Statistics (ONS) as too unstable to be of any practical utility – a sentiment with which one totally concurs.

However, the fatal weaknesses of the CTMM are not eliminated by the Bank’s use of an unemployment threshold. First, a stationary variable such as the output gap or unemployment can only explain the rate of change of inflation not the rate of inflation for time series reasons. Second, the CTMM is a closed economy model without a government sector. However, both overseas developments and government spending and the tax burden are massively important in an open and highly socialised economy, such as Britain’s. Third, the exchange rate is only considered as a short-term source of temporary shocks. In a small open economy, such as the UK, one would expect the domestic price level to eventually equal the overseas price level less the exchange rate when expressed in logarithmic terms. This issue should have been confronted in the Bank’s paper. Finally, there does not seem to be a single mention of the money supply in the forward guidance report. This is an amazing lacuna in a central bank publication, even if one accepts that the velocity of circulation can vary significantly with the opportunity cost of holding broad money balances.

Perhaps fortunately, central bank officials can outdo Hollywood lawyers when it comes to get out clauses. The various ‘knockouts’ and other qualifications mean that the Bank of England can largely do what it likes in practice – complete discretion being the covert goal of most central bankers, almost regardless of whether they have the practical intelligence, operational competence and forecasting ability to use it wisely. Indeed, this represents a weakness of the whole forward guidance approach. It may be credible but otiose because the official forecasts are consistent with the consensus and proved broadly right after the event. Alternatively, officials may be overtaken by events so that the Bank has to give back word and further damage a credibility that has already been shredded by its consistent failure to achieve its inflation targets. There is also the problem that using a lagging indicator of the business cycle, such as unemployment, as a trigger means that rate setting is either dependent on accurate forecasting over a long-time horizon or is likely to end up ‘behind the curve’ and be de-stabilising in control-theory terms.

Furthermore, reducing the uncertainty about the future short-term rate of interest may exacerbate uncertainty about other important variables such as prices and output. This is likely to occur if the populace believes that policy is likely to end up doing too little too late – or too much too late – and risks creating accelerating inflation or worsening boom-bust cycles. The latter appears to have happened in the first decade of the twenty-first century in the US and Britain. A personal view is that it would have been better to have adopted the carefully-considered methods originally proposed for the European Central Bank by Otmar Issing and his Bundesbank colleagues ahead of European Monetary union (EMU) instead of forward guidance. In particular, the adoption of a formal monetary ‘second pillar’ would have led to more stabilising policies in both the boom and the bust of the 2000s.

As it is, the latest figures for the M4ex definition of the UK broad money stock showed a rise of 5% in the year to June, compared with 5.2% in May. The current monetary growth rate seems appropriate on a medium-term perspective given the rather subdued outlook for the growth of potential supply. One concern is that the government is crowding out the productive private sector from access to credit through the financial repression caused by excessively onerous regulations. The lending counterpart to M4ex declined by 0.7% in the year to June, for example. There is a serious risk that misguided additional regulatory shocks lead to a renewed downturn in money and credit, pulling the rug from under the nascent recovery.

Annual CPI inflation rate eased to 2.8% in July, although the old RPIX target measure was still 3.2% up on the year and the ‘headline’ RPI and the new RPIJ showed annual rises of 3.1% and 2.6%, respectively. Core producer price inflation accelerated from 0.9% to 1.1% between June and July, and annual house price inflation on the ONS measure accelerated slightly from 2.9% to 3.1% between May and June. The adoption of LFS unemployment as the trigger for re-considering Bank Rate means that the labour market statistics have acquired a new importance. There is an interesting discussion on the merits of the various labour market indicators in the Bank’s paper. The LFS measure of joblessness has been largely constant at 7.8% during the five quarters ending in April-June although the claimant-count unemployment measure eased by 2,900 in July to 145,400 down on a year earlier. Nevertheless, overall wage pressures remain weak and economy-wide earnings in April/June were only 2.1% up on the corresponding three months of 2012.

There are three main reasons for wanting a Bank Rate increase of ½% in September, accompanied by no further increase in QE. First, British interest rates will have to be normalised at some point and it is less disruptive to start the process early, and in small steps, rather than leave it too late and then have to slam on the brakes. This is the late Lord George’s famous ‘stitch in time saves nine’ (i.e., a Bank Rate of 9%) criterion which contrasts markedly with Mr Carney’s approach of holding Bank Rate until well after the recovery is firmly established. Second, the upwards revision to UK GDP in the second quarter announced on 23rd August, which meant that non-oil GDP rose by 1.7% on the year and 0.7% on the quarter – which represents an annual equivalent rate of 3% – suggests that the recovery is gathering momentum. Third, the continued large deficit on the current account balance of payments, which amounted to 3.8% of market-price GDP last year and 3.6% in 2013 Q1, is a prime face indicator that domestic demand is running ahead of aggregate supply, at least in a relative sense compared to our main trading partners.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; no extension of QE.
Bias: To raise Bank Rate.

On Wednesday 7th August, the Bank of England’s MPC responded to the Chancellor’s Budget-time request to assess the merits of forward guidance. In so doing, it has made the most significant adjustment to its monetary policy framework since 2009 – pledging to keep Bank Rate and the size of the asset purchase programme at least at current levels until the UK’s unemployment rate falls to below 7%. Currently, the rate stands at 7.8%. It is evident from the Bank’s communiqué that it remains wedded to the notion that there is a high degree of slack in the economy. The assertion of unused economic capacity has been a consistent theme in Bank of England Inflation Reports over the past five years. During this time, inflation has been as high as 5% and persistently higher than the inflation target of 2%. Lacking a satisfactory measure of economic slack, it is impossible to test the assertion. Many survey measures of industrial capacity utilisation are close to regaining, or have already regained, the levels that pertained before the credit crisis of 2007 and 2008. The assertion of spare capacity presumes that the crisis damaged demand capability significantly more than supply capability. On the contrary, the evidence suggests that the potential growth rate of the economy has been reduced and the justification for further demand-side stimulus is invalid.
The LFS measure of the unemployment rate that forms the basis of the new policy framework gives only an approximate measure of the tightness of the labour market and notably fails to capture the extent of under-employment. The achievement of a 7% unemployment rate could be attained in a wide variety of economic circumstances, corresponding to different combinations of: labour participation (the proportion of the population of working age that is economically active); labour productivity (the output achieved by a unit of labour input), and labour intensity (the average length of the working week). The unemployment rate has a very loose connection to the MPC’s concept of economic slack.

Within its own paradigm – the post-Keynesian sticky price model – the new policy framework is flawed and over-complicated. For those of us that reject the paradigm, the criticisms go deeper still. It is remarkable, twenty years after the global supply chain revolution, that macroeconomists still have ‘slack’ as their central concept and domestic slack at that. Better to junk the whole concept of slack and work from the premise that domestic supply adjusts rapidly to global demand conditions. What business can afford to hoard productive capacity or excess inventory when the real cost of capital confronting it is positive? Unused capacity is under intense pressure to be scrapped or sold. The notion that businesses have mothballed commercially relevant spare capacity for four or more years is ridiculous. Supply chains and networks are managed such that supply conditions at the top of the chain are permanently tight. When demand disappoints, the pace of supply adjusts extremely quickly, since the storage capacity for inventory has also been managed lower over the years.

The Bank of England’s new framework makes a strong assumption about the supply response of the UK economy which conflicts with recent experience. Rather than a cyclical improvement in productivity, the outlook is for on-going stagnation or decline as overstated productivity gains in the pre-2007 period continue to normalise and as employment growth is concentrated in low-productivity jobs. In other words, the economy is rebalancing towards structurally lower average productivity. By implication, it may be possible to reach an unemployment rate of 7% quite quickly. As an aside, when the 2011 Census estimates of the UK population (roughly 1 million higher) are incorporated into the LFS, there could be an abrupt fall in the unemployment rate.

What starts out, within its own paradigm, as a clearly-defined framework of path-dependent interest rate and asset purchase guidance descends into confusion and chaos by the end of the statement. Three ‘knockout’ clauses are added, relating to inflation, inflation expectations and financial stability. In the case of the latter two clauses, no means of calibration are offered and hence no parameters on which market expectations can be based. Arguably, the remaining clause, which stipulates that the unemployment threshold will be scrapped if CPI inflation eighteen to twenty-four months ahead is more likely than not to be above 2.5%, is also notional. For years now, the MPC’s inflation expectations have been overly optimistic, resulting in consistent inflation overshoots. In the ten years, the MPC has not included a central expectation of inflation on a two-year horizon that breached 2.5%. This projection has been used, essentially, as a signalling device.

The coup de grâce is the admission that neither the 7% unemployment threshold nor any of the knockout clauses represent trigger points for MPC action. Far from knockout clauses they are pulled punches. The MPC retains discretion over the appropriate course of action. The whole rationale for forward guidance is that pre-commitment exerts traction over the rate curve. To the extent that pre-commitment is retractable, no traction will be exerted.
Also worthy of note, is the absence of any mention of an exit strategy. In the question and answer session that followed the statement, it was stated that a rise in Bank Rate would be the first manifestation of policy tightening rather than asset purchase tapering or asset sales. In fact, the MPC goes to great lengths to emphasise that, in contrast to the Federal Reserve, tapering of asset purchases is not on the policy agenda. Indeed, the MPCs selected economic threshold of 7% unemployment rate is not expected to be reached until after 2016 according to its central projection. This is beyond its forecast horizon. This rather pessimistic projection, especially as the UK economy gathers momentum, looks to be an overt attempt by the Committee to steer the financial markets to the timing of the first rate increase.

The announcement of the UK’s forward guidance framework has coincided with the approaching timetable of tapering of asset purchases by the US Federal Reserve. So far, it is the unwinding of leverage in the US bond market, with a concomitant rise in bond yields, which is the dominant influence on the UK yield curve also. The MPC faces a terrible dilemma. Does it scream at financial markets that their interest rate forecasts are all wrong and hope to change the outcome? Or does it follow up the statement on forward guidance with an asset purchase programme designed to prise apart the short end of the UK and US curves? It is unlikely that the MPC will wait long before tinkering further.

Against a background of sluggish potential GDP growth and stagnant productivity, even a modest improvement in the growth outlook must be regarded as an invitation to begin the painful task of normalising the short-term interest rate. The era of ½% Bank Rate should have ended in 2010; instead it lingers on. The first steps towards rate normalisation – which might only be as far as 2% – should not be delayed. My vote is to raise Bank Rate by ¼% and to keep on going.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold Bank Rate; no increase in QE.
Bias: To raise Bank Rate sooner rather than later (i.e., a rising forward curve) and winding down QE.

Mr Carney has quickly made his mark on the MPC by ushering in a change in the Bank of England’s conduct of monetary policy: the introduction of forward guidance. This raises a number of questions some, but not all, of which are addressed in the Bank’s accompanying paper Monetary Policy Trade-offs and Forward Guidance of August 2013. The main issues here are as follows. First, is this a good idea in theory? Second, how does the Bank’s proposed implementation compare with what theory suggests should be done? Third, has its implementation elsewhere improved the impact of monetary policy? Finally, is it likely to improve UK monetary policy, worsen it or make no practical difference?

In theory, forward guidance aims to influence the market’s expectations about future short rates. In other words, it aims to affect the forward yield curve and long rates and, through these, economic activity, including inflation, output and unemployment. Instead of trying to infer current and future monetary policy from past behaviour, and so making mistakes, forward guidance, by signalling future policy intentions, attempts to align the market’s views more closely to those of the Bank and so better implement monetary policy and enhance macroeconomic performance. It follows that a simple test of forward guidance is whether the forward yield curve accords with interest rate announcements.
Such additional information is, however, only beneficial if it is correct. The danger is that policy in the future differs from the forward guidance. This could be because economic conditions have changed unexpectedly, or because the policy objective has changed, for example, by switching from strict inflation targeting to flexible inflation targeting in which output or unemployment or financial stability become additional targets.

In an attempt to minimise these problems, in the accompanying notes the Bank of England has tried to spell out the conditions under which it would change interest rates in the near future; it calls them ‘knockouts’. The two main knockouts are a fall in unemployment below 7% and an unexpected exogenous positive shock to inflation, such as imported inflation. In the future, the Bank would need to develop a new communications strategy in which it spelled out how these conditions were being changed over time, and how it was altering its policy targets.

Forward guidance was first introduced in New Zealand and Norway. Subsequently, it has been used by the US Federal Reserve. No harmful consequences have been found for New Zealand and Norway. Nevertheless, the counterfactual of whether outcomes would have been different had they not used forward guidance is difficult to assess. The initial experience of the US was that market forward rates seemed to have been little influenced by the Fed’s forward guidance, and so the experiment was dropped. More recently, it has been reintroduced, but now accompanied by QE, which makes assessing the influence of pure forward guidance more difficult. This evidence suggests that forward guidance has done little or no harm, but neither has it produced any discernible benefits.

In the UK, the forward guidance seems to be little more than a restatement of the policy being followed by the Bank, though not made explicit. Perhaps this is why MPC members known to favour the previous system have not opposed its introduction and were happy to let Mr Carney show publically his influence on monetary policy.

Nonetheless, the announcement muddies the waters of what monetary policy is trying to achieve. The Bank of England Act of 1997 and the accompanying memoranda states that the aim of monetary policy should be to keep inflation within 1 percentage point of a target value – 2% for CPI inflation – and only subject to achieving this should it aim to support the government’s other objectives in output and employment. The wiggle room for the Bank was in how quickly it aimed to bring inflation back on target once it had breached the bands. The recent recession has shown that the Bank has interpreted this as indefinitely – or as long as inflation expectations are not being affected. The announcement of forward guidance has made explicit the new ingredient it has added to its policy objectives, namely, that the rate of unemployment is also a target. In other words, the Bank has formally shifted from being a strict to a flexible inflation targeter. This is despite the clear message from economic theory, which was widely accepted – including by most senior members of the MPC – that macroeconomic welfare is higher under strict rather than flexible inflation targeting. The difference is most pronounced when higher inflation is due to supply rather than demand shocks.

Coupling inflation and the rate of unemployment has a disastrous history as witnessed by the demise of the Phillips curve which it turned out only held if monetary policy is accommodating. Even if the Bank does not take the view that targeting unemployment is in order to achieve its inflation objectives – which was how the Phillips curve was used – it is not clear whether the Bank thinks that by holding interest rates down it can reduce unemployment, or whether it intends to hold interest rates down until unemployment falls as a result of factors not under its control. The knockouts only add to the confusion as they are determined by the Bank. In effect, they give the Bank complete discretion in setting monetary policy, as in the past.

For some time, given its remit, the Bank’s conduct of monetary policy has been a puzzle and contrary to accepted theory. Commentators have had to infer from its actions what the Bank’s objectives are. The announcement of forward guidance has the merit of making these objectives more explicit. In effect, it has also given the Bank an additional policy instrument to accompany the short rate, namely, the long rate. For forward guidance to be effective it will be necessary to communicate its strategy for setting the long rate in a transparent way. To sum up, the best that can be said for forward guidance is that it makes the Bank’s departures from its remit more explicit but it does not affect the Bank’s room for discretion. As the raison d’être of forward guidance is to improve market expectations, it will be necessary either to forego the use of discretion or to communicate any change of strategy very clearly.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

UK growth is on the up, with the revised figures showing that real GDP advanced by 0.7% in the second quarter. So far, the leading data for the third quarter – such as the PMIs for manufacturing, services and construction – suggests that growth in July/September will be similar to that recorded in the second quarter. The detail for the second quarter GDP data showed that services activity was robust, at plus 0.6% on the quarter (compared with plus 0.5% in 2013 Q1). Perhaps surprisingly, however, this was matched by strength in industrial output (plus 0.6% in 2013 Q2 compared with plus 0.3% in Q1) and outdone by construction (plus 1.4% versus minus 1.8% in Q1). The latest PMI’s suggest that, with construction at 57.0, services at a ten year high of 60.2 and manufacturing at 54.6; growth is starting the second half on a strong and sustained note. Services are benefiting from a pick-up in household activity, manufacturing from better prospects in Europe (or at least a bottoming out of the downturn) and the US recovery, and construction from the revival in demand taking place in the residential housing sector helped by FLS and the prospect of Help to Buy.

Of course, the ONS pointed out that GDP was still 3.3% below its Q1 2008 peak. And private sector investment is 34% down from its pre-crisis high. Therefore, economic growth has a long way to go before it can be called robust. On top of that, it appears that it is consumer and government spending that are leading the recovery, which is hardly consistent with net debt to income ratios for households of over 140%. If business investment does not step up soon to lead the recovery, it will surely peter out or at least face significant enough headwinds to stall. We do not know what might lead to a serious shock in consumer or business confidence, it could be a crisis in Europe or some other event that by its nature we cannot forecast. However, recovery based on renewed household debt has to be seen as potentially resting on shaky foundations.

Still, the monetary statistics are supportive of a continued recovery and price inflation is slipping back. Core CPI inflation edged down to 2.0% for June, from 2.3% in May. On average, it has been around these levels for the past year, roughly in line with the trend seen in 2009. On a three-month annualised basis, the growth in M4ex broad money was 4.7% in June, up from an upwardly revised 4.4% in May and ending a fall to a low of 2.8% in 2013. This means that the economic recovery is likely to persist. However, this will probably be at a pace that means that inflation is not a threat and that continued spare capacity in output and the labour market will last for some time. Despite financial market perceptions to the contrary, it is not clear that LFS unemployment will fall to 7% even in two years’ time. Not least is the fact that very weak productivity, which if it picks up, say based on increased company investment and higher participation rates, means that unemployment might not fall much if at all.
Higher long term interest rate might also persist – despite forward guidance – unless action is taken by the Bank of England. The improved UK economic figures; the evident recovery in the US, and hence the prospects of tapering by the US Federal Reserve, are serving to drive up longer term rates. In my view, validating the financial markets’ expectations now with a rate rise is simply inappropriate. Bank Rate should stay on hold at ½%. Indeed, if the MPC is serious about forward guidance, given the challenge from financial market moves in the opposite direction to that intended by the official rate setters since its announcement, further QE cannot be ruled out.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 9th July, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 1st August. Five SMPC members wanted an increase of ½%, another voted for a ¼% increase, and three voted to hold Bank Rate.

This vote distribution implies a ½% increase on normal Bank of England voting procedures. Although opinions differed on many issues, there was broad agreement on the shadow committee that over-regulation of the financial sector was a clear and present danger to the UK economic recovery.

The six that wanted to raise rates cited a variety of reasons. Broadly, one was that monetary policy was ineffective with interest rates at these levels and a rise was required so that a cut to help ward off a future crisis, such as one in the euro area, would be possible. Another reason was that with inflation exceeding its target for so long, the Bank of England ran the risk of being seen to be not serious about the inflation objective.

This is linked to the point that inflation was the Bank’s target not growth, and if the latter was the target, then the policy had not worked since the recovery remained feeble. The third broad final point of those wanting a rate rise immediately was that monetary policy cannot solve the real problem of the economy, which is a supply side one. The three dissenters argued that the time was not yet right for a rate rise and the risk of triggering a further crisis was simply too high at this point. Forward guidance was seen by some as a target and not as policy, and there were doubts about how effective it would be without some supportive policy action from the Bank of England.

Minutes of the meeting of 9th July 2013

Attendance: Philip Booth, Jamie Dannhauser, Joanna Davies (Observer - Economic Perspectives), Anthony Evans, Graeme Leach, Tim LeFroy (Observer – IEA Intern), Andrew Lilico, Kent Matthews (Secretary), David B Smith, Peter Warburton, John Webster (Observer - IEA Intern), Trevor Williams.

Apologies: Roger Bootle, Tim Congdon, John Greenwood, Patrick Minford, David Henry Smith (Observer – Sunday Times), Akos Valentinyi

Chairman’s introductory comments

The Chairman said that he would be unavailable to help with the production of the Minutes as he was attending his son’s wedding in Vietnam and said that Trevor Williams would substitute for him in his absence. He also said that the revision to the national accounts announced shortly before the SMPC gathering had noticeably affected the value figures as well as the volume figures, and that the revised data went back to the start of 1997 only. The ONS has promised the revised historic database sometime after July 31 following the publication of the Blue book.

He then invited Peter Warburton to present his analysis of the global and domestic trends.

Economic situation

Peter Warburton distributed a pack of charts and tables for reference. He began by observing global private sector credit trends, noting that bank lending was undergoing a recovery – albeit insipid. Outstanding corporate sector bond debt was accelerating, while financial institutions were on the cusp of re-leveraging as growth in debt edged above nominal GDP growth for the first time since Q4 2009. Overall, he noted that there had been a gradual improvement in private sector debt growth, but it remained feeble enough – at just below 5% per annum – to keep central banks fully engaged. He observed that surging corporate credit issuance had not displaced bank lending.

Referring to the charts and tables of global monetary growth Peter Warburton observed a similar profile to that of global credit. Global broad money growth of just above 7% per annum reflected a mixture of modest acceleration in developed economy money and gradually decelerating emerging market money. The trends in broad money growth were sufficient to support a faltering recovery in the advanced economies. US bond yields had surged in the past month with implications for debt service and future fiscal policy. Recent US research shows that QE had positively impacted high net worth households but had not improved the net worth of other, less wealthy households. Global nominal GDP growth had slowed materially in the past two years but had steadied since the middle of 2012 and improved slightly in Q1.

Adoption of path-dependent QE in the US, QQE (quantitative and qualitative easing) in Japan, and with hints of forward guidance on interest rates by the ECB and Bank of England, meant policy imparted a reflationary bias to the global economy. However, there were three headwinds to consider. First, the difficulty the US Federal Reserve had encountered in the communication of its QE tapering message suggested that bond yields would announce actual monetary tightening long before the Fed does. Second, the deliberate liquidity squeeze and recent clampdown on shadow banking activities in China might spark a greater slowdown in economic growth than intended. Third, the disinflationary effects of Yen depreciation on other economies’ export pricing in the region.

In contrast to the stubbornly high rate of unemployment in the advanced economies, the unemployment rate in emerging market economies had been falling. This was primarily a reflection of the strength of domestic demand, since world export growth remained very subdued, even among emerging nations. Manufacturing Purchasing Managers Indices (PMIs) for Japan had seen an improvement but China and India were disappointing. World inflation, on a GDP-weighted basis, remained moderate at just over 2%, but on a population-weighted basis, which took greater account of high food weightings in populous emerging nations, inflation was much faster at 6.5%.

Turning to the UK, Monetary Financial Institutions (MFI) negative net lending growth indicated that the Funding for Lending Scheme was struggling to reach its desirable 5% to 9% growth band. All past attempts to boost the housing market had not succeeded but the latest policy, ‘Help to Buy’, appeared to be bearing fruit with housing transactions showing an encouraging rise, backed up by a rising UK construction PMI.

The revised figures for GDP showed a disturbing downturn in capital expenditure. However, on the plus side the manufacturing PMI had maintained its solid second quarter performance. Domestic market conditions had improved while overseas demand had strengthened. The PMI service sector had accelerated to its highest level since March 2011 and there was some improvement in consumer confidence.

The decomposition of retail price inflation revealed a stubborn underlying private sector inflationary trend. The labour market paradox remained with a rising employment rate and increasing weekly hours worked and yet very weak annual growth of the wage bill. There was a suggestion in the data that labour incomes were pushed forward into Q2 to benefit from the lowering of the top tax rate. The worsening of the UK’s current account deficit had continued and the outlook for Sterling remained unsettled ahead of Bank of England policy announcements in August.

Discussion

David B Smith thanked Peter Warburton and opened the meeting out to general discussion. Andrew Lilico began the discussion with a reference to Simon Ward’s work on the M1 narrow money/nominal income relationship and suggested that they should consider which monetary measure was the appropriate indicator in this economic climate. There followed a discussion as to whether M1 was a leading or coincident indicator. Jamie Dannhauser and David B Smith said that M1 was a coincident and not a leading indicator.

There was a discussion about the implications of forward guidance but Andrew Lilico said that the Bank had no credibility for sticking to targets and that forward guidance would have no effect on expectations. He said that any lenders that were making loans to borrowers conditional on interest rates this low had no business doing that. He added that the worry was that nominal income growth would raise the balance sheet of banks, which would lead to an increase in bank lending, and the cycle would restart with inflationary growth.
Graeme Leach discussed the sustaining of the higher than normal zombie companies on the commercial banks books. Andrew Lilico said that an upturn in nominal income growth would see zombie companies being wiped out, as typically more companies die off early in recoveries than during recessions.
Trevor Williams said that normally lending would rise with an improvement in balance sheets but with on-going delevering and the leverage ratios being imposed this might not happen to the same extent. Andrew Lilico was sceptical that the Bank of England would maintain its hard stance on leverage ratios in the upswing. David B Smith said that George Osborne was thinking in terms of the political business cycle not the wider public good.

Peter Warburton said that some supply side adjustments were occurring. He said that real wage growth had fallen and hours worked were growing. David B Smith said that the ONS was trying to do the impossible by measuring intangibles such as software in the process of development in the capital expenditure figures.

Andrew Lilico asked if the rise in bond yields were the result of withdrawal of QE or rising expectations of growth. Trevor Williams and Jamie Dannhauser said that the bond market in the UK was heavily influenced by the US bond market and the influence from QE was likely to be smaller than that from global capital flows.

David B Smith called on the committee to make their comments on monetary policy. Philip Booth said that since we would not get unanimity on a change in interest rates he asked if the committee would make a united stand on the negative effect of bank regulation on the ability of the banks to fuel the recovery. Jamie Dannhauser said there was an anti-commercial-bank culture within the Bank of England.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate ½%.
Bias: To raise, and neutral on QE.

Philip Booth said that inflation had been above target for four years. The Bank of England was given the task of targeting inflation. Growth being high or low was the result of other policies of the government that had affected the supply-side and which monetary policy could not address. The existing situation pointed to a tightening of monetary policy. Philip Booth said that the underlying problems were on the supply-side. He said that the productivity problem could not be solved by monetary policy and that Bank Rate should be raised by ½%, given the forecast for inflation, and that there should be no further QE.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate.
Bias: Monetary easing.

Jamie Danhauser said that he was encouraged by the recent data. The PMI surveys were pointing in the right direction and monetary growth was trending back towards reasonable rates. However, the revised indicators showed that output was even further below the pre-recession peak. There was considerable slack in the economy. He said that it was hard to believe the productivity collapse that the data was indicating. He said that he was also concerned about the hysteresis effects of the recession, and that euro issues were still around. With the global economy still weak, there was a strong case for the maintenance of the current monetary position.

Comment by Anthony Evans
(ESCP Europe)
Vote: Raise Bank Rate ½%.
Bias: To raise.

Anthony Evans said that he was concerned about the reverence given to the new Governor. He said that there was little scope at this point for monetary growth to generate real growth, and was disappointed that the Governor seems to have placed forward guidance as a more important issue than nominal GDP targets. He recognised the danger of early tightening but rates were too low and if it is a choice of rising rates too early or too late it was better to be too early. He acknowledged that the economy was fragile but believed that current policy was making it even more fragile. The squealing noises that came out following the Fed moves was all the more reason to start the process of normalisation. There was so much uncertainty about how markets would react to a rate rise that it was almost worth doing as a controlled experiment to test reaction.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and hold QE.
Bias:Neutral.

Graeme Leach said that he has been forecasting an L shaped recovery for some years but broad money growth and a wide range of other indicators now point to a recovery somewhere between L and V shaped. Growth in M4ex at around 5% suggested that GDP growth could be 1½% this year. M4ex was providing a tailwind, which suggested that economic prospects were better than at any time since the financial crisis began. However, significant headwinds remained. Firstly, from continued deleveraging in both public and private sector debt. Secondly, from balance sheet adjustment by the banks and tight regulatory capital controls. Thirdly, from the squeeze on household real income from inflation running ahead of earnings. The household consumption squeeze was being compounded by the relatively low savings ratio at this stage of the economic recovery. Fourthly, the ever-present threat of resumption in the euro crisis. Finally, the reality that any recovery will contain within it, the seeds of its own destruction, due to a potential normalisation of interest rates at both the short and long end – although the other headwinds meant that this threat was relatively benign at present.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate ½%; hold QE.
Bias: To raise rates.

Andrew Lilico said that he had no faith in the pronouncements of the Bank of England and that forward guidance was only a target forecast. Why should anyone believe that interest rates will stay at ½%? There was an intrinsic impetus to the UK economy caused by the timing of projects. Capital spending projects had been delayed and there was an opportunity for a catch-up. The euro crisis may well return, or some other euro crisis arise, so it was forlorn to hope for a “good moment” to raise rates. Mortgage lending to borrowers that depended on rates being so low should not be made.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate; ½%; hold QE.
Bias: To raise. QE to be used only when the euro crisis returns.

Kent Matthews said that in January he voted for a ½% rise largely because of microeconomic issues. These issues remained. The loanable funds market was not allowed to operate efficiently because of Bank Rate remaining low for so long. He reminded the committee of what he said at the previous physical meeting concerning the support of zombie companies. Risk was being ‘under-priced’ for the zombie ‘insiders’ whereas it was probably ‘overpriced’ for the outsiders who faced a bank credit crunch. The Schumpeterian process of ‘creative destruction’ only worked if credit markets were well functioning and exceptionally low interest rates for this length of time have generated a misallocation of resources to the low areas.

Unlike Andrew Lilico he did not think that forward guidance was ineffective because of the lack of credibility of the Bank. On top of the micro issues he said that there were considerable macroeconomic dangers from forward guidance which was meant to influence expectations. The potential for the building up of inflationary expectations and macroeconomic instability followed the analysis of Friedman’s critique of pegging the rate of interest. Sterling had already weakened on the prospect of interest rates remaining low for some time. Since nobody knew with any certainty the size of the output gap, and OECD and IMF estimates had been reducing it over time, the next thing we will observe is inflation rising and moving away from the target. Interest rates had to start rising now to help in the process of rebalancing the economy.

The inevitable return of the euro crisis would require a tractable monetary response in the form of an interest rate cut and additional QE. An interest rtate cut would have no effect at current levels.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate ½%. Hold QE.
Bias: To raise Bank Rate.

David B Smith said that the history of the 21st century had been about the wrong type of supply-side policy. Supply withdrawal was treated as a demand withdrawal. A tax-and-spend induced supply withdrawal could not be offset by monetary policy. Long-term interest rates were distorting monetary policy to allow the housing market to be sustained. Forward guidance was pointless because either the authorities would pursue the policies that they would have done in any case or they would have to break their commitments. The vogue for nominal GDP targets ignored the fact that nominal GDP can easily generate perverse policy signals. One reason was that just over 48% of GDP was in the public sector whose behaviour can be very different to that of the non-bank private sector on which monetary policy operates. Another was that imports were a negative item in the GDP identity whose cost rose if sterling fell, perhaps because of an unduly lax monetary policy.

Weaker sterling had not had the stimulatory effect that was expected by UK officials. The main effect had been to push up prices. However, the Tax and Price Index was only up 2.2% on the year in May and real earnings had not been squeezed quite as much as one might deduce from the CPI and RPI. It was increasingly difficult to use the data produced by the ONS for prediction, as it was so unstable.

He added that he was surprised that there had not been more discussion of the extent to which European politics will be influenced by the outcome of the September elections in Germany. The German population was already restless about the fiscal burden that was being asked of it. The ECB had been utterly politicised and the German taxpayer had every right to feel angry and misled. Angela Merkel was desperately trying to paper over the cracks in the short term but the celing could well come down in late September.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate ¼%; no extension of QE.
Bias: To raise rates conditional on growth.

Peter Warburton began by stating that he was doubtful of the efficacy of forward guidance in the UK in the context of rising US government bond yields. The impressive effect of calendar-based forward guidance in the US in the first half of last year was opportunistic and probably not replicable in the UK. Peter Warburton said that, in any case, there was a stronger case now for tightening as business and consumer economic confidence was rebuilt and output growth became more robust. He still preferred to begin with an increase in the rate of interest of ¼% as even a small rise would have a negative psychological effect. However, the UK private sector remained more vulnerable to inflationary pressures compared to other large European countries and the Bank of England could not afford to ignore persistent breaches of its inflation objective, much less embark on a new policy of monetary relaxation. There were compelling reasons to diversify some of the £375bn of existing QE into a portfolio of other assets, including securitised property, infrastructure and possibly even SME (small and medium-sized enterprises) assets as a means of lowering the regulatory burden of the banks that relates to these loans. The fact that the ‘Bad Bank’ debate had revived in recent weeks was a reminder of how little structural progress has been made to restore health to the UK banking system.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold.
Bias: Neutral.

Trevor Williams said that the revised data of the economy showed how risky it was to draw firm policy conclusions from recent data. The latest figures could therefore prove to be a ‘false’ positive in terms of the pace of the recovery, despite the bigger output gap indicated by revised figures. The underlying picture was of a ‘wrong’ type of growth, unsustainable at the H1 pace. Household gearing was going up again after dropping to just above 142% of annual disposable income in Q4 last year, at a time that real wage growth was negative. The expenditure mix could be wrong for a sustainable upturn in the economy, as consumer spending was driving growth at a time that household budgets were under pressure. Continued slow European growth would be a drag on UK exports in 2013. As such, the state of the real economy did not justify a rise in the rate of interest. A real risk was that a rise in the Bank Rate would increase the frequency of household defaults and corporate failures, hitting confidence, one of the bedrocks of the recovery.

Policy response

1. On a six to three split the committee voted to raise Bank Rate in August.

2. Five of the SMPC members voted to raise rates by ½% and one voted to raise it by ¼%.

3. In consequence, it was recommended that Bank Rate should be raised by ½%.

4. All six members that voted to raise interest rates indicated a bias to raise rates further.
5. There was unanimous agreement that excessively onerous financial regulation was hindering the efficient working of the banking sector.
Date of next meeting.
Tuesday 15th October 2013.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

In its most recent e-mail poll, which was finalised on 25th June, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 4th July. Four members of the shadow committee wanted an increase of ½%, while one advocated a rise of ¼%.

This split vote for a rate hike would imply a rise of ¼% on normal Bank of England voting procedures. However, four SMPC members believed that Bank Rate should be held at its present ½% for the time being. Most members of the shadow committee saw no immediate justification for adding to the stock of Quantitative Easing (QE). Nonetheless, it was felt that the international economy was not yet out of the woods and that all monetary tools needed to be kept available on a standby basis.

Most SMPC members thought that the UK economy was showing signs of a modest recovery and that growth probably accelerated in the second quarter. However, there was less agreement as to whether recovery would continue or, alternatively, peter out in the second half of this year. One reason for wanting to raise Bank Rate in July was the belief that it was less disruptive to make the necessary rate hikes early and in a number of small increments than to leave it late and then possibly be forced to make a more abrupt move.

There was a strong concern that ill-considered financial regulation was impeding money creation and credit extension to the private sector. However, current UK broad money growth was sufficient to sustain a non-inflationary recovery. The SMPC poll was completed before the 26th June Comprehensive Spending Review and a major re-working of the UK national accounts to be published on the 27th, which might introduce substantial revisions to the current data.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Hold Bank Rate for next three months and use rate setting and QE to achieve growth in broad money of 3% to 5%.

My last note for the SMPC opened with the sentence, ‘The regulatory blight on banking systems continues in all the world’s so-called “advanced” economies, which means for these purposes all nations that belong to the Bank for International Settlements.’ As I explained in the next sentence, the growth of banks’ risk assets is constrained by official demands for more capital relative to assets, for more liquid and low-risk assets in asset totals, and for less reliance on supposedly unstable funding (i.e., wholesale/inter-bank funding). The slow growth of bank assets has inevitably meant, on the other side of the balance sheet, slow growth of the bank deposits that constitute most of the quantity of money, broadly-defined. Indeed, there have even been periods of a few quarters in more than one country since 2007 in which the assets of banks, and hence the quantity of money, have contracted.

The equilibrium levels of national income and wealth are functions of the quantity of money. The regulatory blight in banking systems has therefore been the dominant cause of the sluggish growth rates of nominal gross domestic products, across the advanced-country world, that have characterised the Great Recession and the immediately subsequent years. Indeed, the five years to the end of 2012 saw the lowest increases – and in the Japanese and Italian cases actual decreases – in nominal GDP in the G-7 leading industrialised countries for any half-decade since the 1930s.

It is almost beyond imagination that – after the experience of recent years – officialdom should still be experimenting with different approaches to bank regulation and indeed contemplating an intensification of such regulation. Nevertheless, that is what is happening. The source of the trouble seems to be a paper given at the Jackson Hole conference of central bankers, in August 2012, by Andy Haldane, executive director for financial stability at the Bank of England. The paper, called The Dog and the Frisbee, argued that a simple leverage ratio (i.e., the ratio of banks’ assets to capital, without any adjustment for the different risks of different assets) had been a better pointer to bank failure than risk-weighted capital calculations of the kind blessed by the Basle rules. The suggestion is therefore that the Basle methods of calculating capital adequacy should be replaced by, or complemented by, a simple leverage ratio.

For banks that have spent the last five years increasing the ratio of safe assets to total assets, or that have always had a high proportion of safe assets to total assets, the potential introduction of a leverage ratio is infuriating. A number of banks have been told in recent weeks that they must raise yet more capital. Because it is subject to the new leverage ratio, Nationwide Building Society has been deemed to be £2 billion short of capital. That has upset its corporate plans, to say the least of the matter, and put the kibosh on significant expansion of its mortgage assets. And what does one say about George Osborne’s ‘Help to Buy’ scheme, announced with such fanfare in the last Budget and supposed to turbocharge the UK housing finance market?

The leverage ratio has been called Mervyn King’s ‘last hurrah’, since there can be little doubt that King has been the prime mover in the regulatory tightening that has hit British banking since mid-2007. He is soon to be replaced by Mark Carney, who may or may not have a different attitude. Carney has been publicly critical of Haldane and his ‘Dog and Frisbee’ paper, but that does not guarantee an early shift in the official stance. Indeed, it is striking that – of the bank’s top team under King – only Paul Tucker, generally (and correctly) regarded as more bank-friendly than King or Haldane, has announced that he is leaving the Bank once Carney has taken over.

My verdict is that the regulatory blight on UK banking is very much still at work. Further, without QE, the quantity of money would be more or less static. As before, I am in favour of no change in sterling interest rates and the continuation of QE at a sufficiently high level to ensure that broad money growth (on the M4ex measures) runs at an annual rate of between 3% and 5%. My bias – at least for the next three months – is for ‘no change’. It is plausible that I will be advocating higher interest rates in 2014. However, much depends on a realisation in official quarters that overregulation of the banks is, almost everywhere in the advanced world, the dominant explanation for the sluggishness of money supply growth and, hence, the key factor holding back a stronger recovery. Major changes in personnel may be in prospect at the Bank of England now that Mervyn King is leaving, but the Treasury – which I understand from private information will be glad to see the back of him – has failed to prevent the growth of a regulatory bureaucracy led by King appointees.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Additional QE and a rebalancing towards non-gilt assets.

The near-term outlook for UK growth has improved somewhat. The composite UK Purchasing Managers Index (PMI), based on monthly reports covering the manufacturing, construction and private service sectors, has climbed to its highest level since March 2012. Sub-indices covering new orders across the three main parts of the economy have picked up even more sharply – the composite balance is at a three-year high. Little hard data for the second quarter has yet been published but there are early signs of relatively solid growth. The momentum going into the second quarter is marked, with activity in April already some way above the first quarter average. The strong retail sales and new car registrations in May suggest that consumers continue to show some resilience, despite very sluggish wage growth. The labour market continues to firm. Robust growth in vacancies in the three months to May better represents recent developments than the flat-lining of employment volumes.

A moderate recovery in UK output is emerging. This could amount to an argument for laying the foundations for a withdrawal of monetary accommodation. The persistence of above-target inflation into 2014 supports a more hawkish stance. There are, however, several arguments for keeping the monetary stance unchanged and also maintaining a bias towards additional ease. First, the UK recovery is not assured. Private domestic demand – although growing and supported by rising house prices – will be held back for some time by several factors, including insufficient broad money growth, fiscal tightening and balance sheet repair. External threats, meanwhile, remain considerable, as evidenced by the recent shake-out in financial markets on the back of, arguably, grossly exaggerated fears about the tapering off of QE by the US Federal Reserve. Major global imbalances continue to restrain the recovery in world demand. In ‘debtor’ economies, there has been very little reduction of excessive private and government sector debts. ‘Creditor’ nations show little willingness to undertake the policies necessary to boost domestic demand. Although output in the Euro area may stabilise in the months ahead, sustained growth is a way off. A dip back into recession may still occur. More broadly, the Eurozone crisis is far from resolved.

Risks to growth are still firmly on the downside. Inflation risks are more balanced but the recent data flow has pointed to greater disinflationary pressures than previously thought, if anything. Regular wages have barely grown over the last year – with average hours worked up by around ½% over the same period, nominal hourly pay has effectively been stagnant. Near-term and medium-term household inflation expectations are now at their lowest point in a year. Even the actual inflation data themselves have surprised on the downside. Excluding the effects of the 2012 tuition fee hike, ‘core’ inflation has been below 2% since last December. Consistent with this, UK retailers’ price expectations (for the next three months) have dropped to their lowest level since November 2009.

Additional monetary stimulus at this stage would incur costs but there are good reasons to believe that it would provide a boost to demand and asset prices. The benefits of QE still outweigh the costs in my mind. There remains a case for switching towards non-gilt assets, if additional stimulus is needed. That time has not arrived. However, it may yet do so.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

For the first time in five years, the possibility of a tightening in monetary policy is being seriously mooted. This is being driven by a number of factors. First, there is the potential tapering off later in 2013 and ultimately the ending, possibly in the first half of 2014, of central bank purchases by the US Federal Reserve. Second, there is the prospect of an improved UK GDP performance, which is probably better than at any time since recovery began; this has been signalled by the recent pick up in the growth of M4ex broad money to around 4.5% to 5% year-on-year. Third, there is the combination of an improved growth outlook with above target inflation. The May Consumer Price Index (CPI) was up 2.7% on the year with the prospect of a higher figure in June. Finally, minds are turning towards the potential 'normalisation' of monetary policy and what that means for the Bank Rate and gilt yields.

This leads to two questions. Will there be a tightening in monetary policy? Should there be a tightening in monetary policy, and if so how?

With regard to the first question, the immediate prospect of a tightening appears slim. The outgoing Governor was outvoted in each of his last five meetings. However, this was a vote against a further expansion in QE, not for a reversal in policy. Moreover, with the arrival of a new Governor, inclined towards explicit forward guidance, some form of internal debate within the Bank of England is likely to ensue. Admittedly, the Governor is a member of the MPC, not the MPC, but some attempt at forward guidance is likely to occur. In addition, given that CPI inflation has exceeded the 2% target for eighty one of the past ninety-six months, the current excess is unlikely to alarm the Monetary Policy Committee (MPC).

With regard to the second question, one can remain sceptical that any immediate tightening in policy is required. The new Prudential Regulation Authority (PRA) is signalling that the banks need to raise a further £27 billion of capital, with the attendant consequences for the money supply. But possibly of greater significance is the lack of debate thus far as to exactly how any future tightening should occur. Should it start at the short or the long end? Are there circumstances in which it could involve competing effects, such as a tightening at the short end combined with further expansion in QE? At present, there is not sufficient clarity on these issues and so a neutral bias seems appropriate. Furthermore, the recovery has within it, moderating effects, due to the recent global jump in bond yields – stemming from speculation about and the prospective reality of the withdrawal of asset purchases. The jump in yields also threatens a resurrection of the Euro crisis.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To raise Bank Rate.

Things are definitely looking up for the UK economy in the short term in internal terms. Multiple surveys indicate a pick-up in growth. At the time of writing, ten-year gilt yields have risen by around 100 basis points from their early May trough, reflecting the stronger growth outlook and diminishing expectations of further rounds of QE. The government has finally got around to starting serious spending cuts – though these will have to go on for many years and more will yet need to be announced. There is an underlying back-log of private sector investment projects delayed or foregone during the Depression of recent years. A mere reduction in the risk of things getting worse should be sufficient to release some of that investment potential and spur short-term growth.

However, circumstances are still very fragile, and could easily be derailed by external events. The worsening of the credit crunch in China; escalating war in Syria; the Greek coalition collapsing and precipitating early elections and a Euro exit; the collapse of other UK banks – any or all of these could be sufficient to further retard the flowering of that investment potential. Nothing can be guaranteed. So there will not be a ‘convenient moment’ to tighten policy for many years. To wait for such a moment is to doom the economy to excessively low interest rates and chronic above-target inflation for the foreseeable future, with the consequence being a lower-than-necessary average growth rate.

As noted in the recent Bank for International Settlements annual report, all that an accommodative monetary policy can do is to buy time for households and governments to deleverage and for structural reforms to be made that protect and increase the average growth rate of the economy. Loose monetary policy itself cannot make economies grow faster over the medium term – it can only, if done to excess, make them grow slower. Nonetheless, the UK government and households have used very low interest rates as an excuse for delay, not a means to smooth transition. They still hope that ‘something will turn up’ rather than their needing to bite the bullet on serious deleveraging. Slightly higher interest rates would give households slightly less temptation to delay, encouraging slightly faster deleveraging. Let us start with a half-point rise and take it from there.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

When the history of the Great Recession comes to be written, it will be clear that it was only to a minor extent the fault of ‘greedy bankers’. Yes, of course there were plenty of those but since when have people not been greedy? ‘Greed and fear’ goes the weary summary of business and market behaviour; what is new? The fault will be seen to lie with monetary policy’s obsession with inflation targeting, to the exclusion of maintaining general monetary stability, which had been the traditional task of policy. It was the failure to keep monetary conditions stable – for which read ‘keep the money supply on a reasonable growth track’ – that allowed the great credit boom of the 2000s to take hold. Inflation targeting was so successful in stabilising inflation expectations that inflation hardly moved however much or little interest rates were moved. As a result, interest rates and bank reserve injection were given latitude to ignore monetary excesses – because inflation was so well controlled.

Out of that failure, there came the Great Regulative Backlash that followed the crisis when the credit boom crashed. This backlash produced a massive tightening of monetary conditions via the sledgehammer of excess regulation hitting the nut of weakened banks. It has proved impossible to loosen monetary conditions sufficiently to generate a proper recovery, against the contraction engineered by this regulative excess. Official interest rates have been lowered to the zero bound and QE has injected fabulous quantities of excess reserves into the banks, with no perceptible effect on credit growth and a collapse of the money multiplier.

When we have the right models to analyse these events, we will be able to simulate a counterfactual world in which monetary policy targeted money growth and a credit boom was avoided in the 2000s. Then when the slowdown occurred due to global productivity growth slowing (for this read ‘the world hitting a raw material shortage, forcing commodity prices skywards’), the banks would not have been exposed as badly as they were, nor would households have overbought houses. Yes, we would have still had a bad recession but it would have been possible to have a normal recovery, absent any regulative mania developing. Commodity prices would have fallen back, against a background of a lower cumulative level of GDP at the time of slowdown, and recovery would have been brought about by monetary loosening -– falls in interest rates accompanied by injections of bank reserves.

Ultimately, we should blame us economists not the politicians, because it is we who failed to have these models in time. As Keynes said, the policymakers are merely echoes of the researchers who taught them. We had models in which there was no money, only (official) interest rates being used to target inflation; they also contained no interest rates on credit to small businesses and households, the key channel the banks give us. The crisis has taught us now to allow for the imperfection of the monetary channel system; there are channels and they do not communicate perfectly with each other. Money growth is an indicator of what is going on in the credit channel and what is therefore happening to credit rates to small businesses (which we observe very poorly due to the mass of accompanying charges and conditions, such as arrangement fees and collateral requests) and households. We also lost sight of the damage that can be done by monetary instability.

If we add a money growth target to the inflation target, then we have two key features of the economy being ensured by the central bank: a) the long run inflation environment, and b) the stability of the monetary environment. In the process, output growth should also be stabilised, since output growth will be reflected in money supply growth. A natural pairing of instruments with targets would be for interest rates to react to inflation while the monetary base reacts to the money supply, which it directly affects.

Where does this leave ‘macro-prudential’ policy? Regulations have the effect of raising the cost of credit – and so the ‘credit frictions’ in the economy. This is damaging to economic welfare – the only rationale for enhanced regulation is that it reduces the chances of a future banking crisis. However, if monetary policy were reset as above, this need would be met in that way, at no cost to the economy: one can think of monetary stability as ensuring that the cost of credit is kept at the socially optimal level, allowing for the desired underlying credit friction. Thus, in booms it would stop the credit cost falling unnaturally low; and vice versa in slumps. In these circumstances all that regulation should do is set a ‘basic’ level of regulative constraint on grounds of social ‘bank safety’ factors – this in turn would supply the underlying desired credit friction. There is no need for regulation to vary ‘macro-prudentially’; and this basic level of regulation would be the minimal one required to offset the moral hazard created by deposit insurance. It should not discriminate against ‘risky’ lending to small businesses. Rather it should be set in relation to the whole bank portfolio’s diversified risk level; a minimum capital ratio should be set that would prevail for a band of risk around some normal level on the whole portfolio. In this way, we should get away from the cost of funds for loans to SMEs attracting a much higher cost because their individually higher risk causes extra capital to be raised.

As through a glass darkly, the coalition and their civil servants in Whitehall and Threadneedle Street have begun to realise that their regulatory actions have blocked the credit channel; so more recently we have had Funding for Lending (FLS) schemes 1 and 2, followed by the Mortgage subsidy for first time buyers. These do appear at last to be having an effect on the housing market and on lending conditions for small businesses – the ice blocking the credit channel appears to be cracking slightly. The economy appears to be picking up towards moderate growth. This has been helped by less grasping policies towards North Sea oil and gas producers, so that now we are seeing North Sea oil output bottoming out in line with banking and construction, the latter two aided by this credit channel thaw.

It is messy to have regulation combined with policies deliberately offsetting the regulation. Nevertheless, systems cannot turn on a dime and so we must be grateful for the easing we have in the regulative backlash. The implications of this regulative ‘U-turn’ for monetary policy are that we now need to worry about the return to more normal banking behaviour.

First, we have a massive overhang of bank reserves: the UK monetary base, as measured by Bank liabilities, has expanded to about eight times its level of 2007. This implies that banks have massive liquidity available for lending should they choose to use it. QE simply must be unwound as soon as practicable, although this should be done in a way that does not upset markets unduly. Thus as regulation is eased, the QE that was injected in a failed attempt to offset it needs to be unwound.

Second, what of official interest rates at the zero bound? Ronald Mackinnon in persuasive recent work has shown that if central banks swamp the banks with bank reserves at next to zero interest rates, then banks will not use the interbank market for very short term financing; rather they have all they need held with the Bank. QE at super-low rates has thus crowded out the interbank market, which indeed has fallen into relative disuse. The result has been that the banks’ ‘cost of funds’ has borne no relation to Bank Rate; banks have borrowed on deposit, including longer term deposits from other financial intermediaries, to finance their lending – besides the effect of regulation in forcing expensive extra capital into the funding mix, now being offset by the new FLS and Mortgage subsidy schemes.

Thus, as QE is unwound, Bank Rate should be raised to restore the interbank market and reinsert it into the funding mix. This will not tighten monetary conditions as measured by the cost of funds; it will substitute interbank borrowing for bankers’ balances at the Bank. It will restore a normal banking market and drain off bank liquidity that is now dangerously excessive.

These are transitional measures needed to bring monetary policy back on track as the effects of regulation on the credit channel are eased off. In the longer term, we need to get credit and money growth back on track; once that is achieved interest rates will be back at normal and QE unwound so that the monetary base too is back at a normal level of bank reserves. We must hope too that regulation has been cut back to a much less intrusive level. To conclude, the action needed today is to unwind QE and to move Bank Rate up in small steps, initially by ½%.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up and fully privatise state-dependent banking groups; raise Bank Rate to 2½%, and maintain QE on standby.

Britain’s small open and trade-dependent economy means that it generally behaves like a small boat bobbing around on the turbulent seas of international economic developments. This can be easily verified from charts comparing British growth, inflation and real interest rates with their equivalents in the Organisation of Economic Co-operation and Development (OECD) area as a whole over the past five decades. This makes it impossible for the domestic authorities to fine tune the course of the UK economy, as politicians like to pretend and media commentary tends to assume. The government can improve Britain’s long-term growth performance relative to the rest of the world if it maintains fiscal discipline – which probably means a share of total government expenditure in national output of no more than 35% to 40% – and refrains from ill-considered interventions in the markets for labour, products and finance. However, the global business cycle still tends to pre-dominate in the short term and apparently has been doing so for far longer than is recognised generally.

Likewise, the Bank of England can improve Britain’s relative inflation performance by pursuing policies that pull up the exchange rate and vice versa. However, international inflation is the main influence on the domestic rate of price increase in the short run, not the domestic output gap. In its rate setting, also, the Bank has tended to import the foreign real rate of interest much of the time. If it does not, then sterling tends to adjust to a possibly uncomfortable extent, especially as foreign exchange markets are notoriously prone to speculative overshooting in the short term.

No one who has looked at UK fiscal and regulatory policies since 2000 in the light of the literature on international growth performance can be happy with the massive increase in economic socialisation and regulatory overkill that marked the tenure of the previous government. The present Coalition’s attempt to maintain so much of Gordon Brown’s gigantic state power grab – because it has lacked the moral fibre to do otherwise – means that we are back on the treadmill of relative economic decline that marked the pre-Thatcher years, even when compared to an OECD area whose growth has slowed dramatically. There has been considerable debate as to why ultra-low interest rates and £375bn of QE have not yet had more of a stimulatory effect on UK economic activity. One reason has been the weak international background. Another has been misguided and excessive financial regulation which has been applied at exactly the wrong point in the business cycle and has led to an unduly sluggish growth in real broad money balances and total bank credit. This issue remains of supreme importance but is well covered elsewhere in this document.

However, there is a third, structural, reason that has had less attention than it deserves. In theory, a lax monetary policy can only stimulate activity in the private sector of the economy, which accounted for 51.5% of UK GDP last year, according to the June 2013 OECD Economic Outlook Annexe Tables. This is because the government can always create money at will. However, the size of the private sector in regional GDP in fiscal 2009-10 varied from only around one quarter in Northern Ireland to over two thirds in London, using data for the twelve ‘NUTS1’ regions into which the UK is officially divided. If all twelve NUTS1 regions were separate political entities, London’s general government spending ratio of 31.7% would be the second lowest in the entire OECD after South Korea (30.2% in 2012), while the South East of England’s government spending ratio of 37.9% would then be the fifth lowest OECD figure after Switzerland (34.1%) and Australia (36.1%). In contrast, the North East (66.5%), Wales (71.4%) and Northern Ireland (74.8%) all have noticeably higher spending ratios than Denmark (59.5%), which tops the OECD socialisation scales. The degree of state-dependence in these UK regions approximates to that in the former Eastern European satellites of Soviet Russia and means that such areas are probably incapable of reacting to monetary stimuli as a result.

Certainly, the pattern of regional response to the Bank of England’s aggressive monetary ease have been pretty much what one would expect from the relative degree of economic freedom. London is already showing nascent signs of economic overheating, especially in its property market. However, the heavily socialised former industrial heartlands have shown a far weaker response, except where the more competitive exchange rate and foreign-management initiated structural reforms within specific trades, such as the motor industry and steel, have been unusually helpful. The conclusion is that monetary policy will not work equally across the national domain until the former East German style structural rigidities of the more heavily socialised regions are tackled through aggressive liberal-market reforms.

Incidentally, this is also one of the key issues facing the Eurozone. Germany has by-and-large maintained its general government expenditure ratio at its 2000 level but a number of peripheral economies went on Gordon Brown style spending binges after they had squeezed themselves into the fiscal corset demanded by the Maastricht convergence criteria – apart from Greece, which simply lied about meeting the criteria. The result is that a lax monetary policy at the level of the Eurozone as a whole may well prove an inflationary threat to Germany without providing a stimulus to the more highly socialised fringe members of the Eurozone. This has been pointed out by several German members of the European Central Bank, who have left the institution because they feel that it is no longer acting in the best traditions of the old Bundesbank.

The problem now is that restoring the lower government spending burdens that allowed countries such as Spain to qualify for Eurozone membership in the first place would require such a large fiscal retrenchment – which would of necessity be in the form of spending cuts because they have overshot the limits of taxable capacity – that it could cause a massive political upheaval. When discussing rate setting the tendency is to concentrate on the finer points of the latest monthly economic indicators. However, these are virtually irrelevant sometimes and the important issues are almost geo-political in nature.

As it is, the latest figures for the M4ex definition of the UK broad money stock showed a rise of 4.8% in the year to April, while broad money in the aggregate OECD area was up by 5.5% in the year to March. Current monetary growth rates might be regarded as being appropriate on a medium-term perspective to achieve low and stable inflation given the rather subdued outlook for the growth of potential supply. However, there is an interesting difference between the 7.1% growth in US broad money in the year to April reported by the OECD and the increases of 2.6% and 2.7% reported for the Eurozone and Japan, respectively, over the same period. The main concern is that governments are hogging the money creation process and lending to the productive private sector is being crowded out, largely because of the financial repression caused by excessively onerous regulations. The international financial markets strong negative response to Mr Bernanke’s suggestion that US QE will be approaching its end in the foreseeable future suggests that the UK boat could be hit by another wave of turbulence from monetary policy decisions overseas. This risk, together with the continuing uncertainties in the Eurozone, suggests that it may be hard for the UK monetary authorities to maintain a steady course under their new captain Mr Carney.

The rise in the annual CPI inflation rate from to 2.4% in April to 2.7% in May suggests that the more favourable April figure was an aberration and takes the year-on-year inflation rate back to the 2.7% to 2.8% range that has prevailed since October 2012. Core producer price inflation accelerated from 0.7% to 0.8% between the same two months, but remains well down on the CPI rate where much of the inflation appears concentrated in the service sector. Annual house price inflation on the ONS measure eased slightly from 2.7% to 2.6% between March and April. However, there are substantial differences between the various UK regions with house prices in London up 6% on the year but down 1.3% in the North East. The most recent labour market statistics have shown some signs of weakness in the very short-term comparisons. However, the employment rate was 0.7 percentage points up on the year in February-April; the labour force survey (LFS) measure of joblessness declined from 8.1% to 7.8% over the same period, and the claimant count measure of unemployment eased by 8,600 in May to a level 87,600 down on a year earlier. The reduction in the top rate of income tax at the start of the new fiscal year appears to have induced a surge in bonus payments in April. Nevertheless, overall wage pressures remain weak and economy-wide earnings in February/April were only 1.3% up on the corresponding three months of 2012. Overall, a Bank Rate increase of ½% seems appropriate at the July MPC meeting with no further increase in QE for the foreseeable future. British interest rates will have to be normalised at some point. It is less disruptive to start the process early, and in small steps, rather than leave it too late and then have to slam on the brakes.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To raise Bank Rate.

The economy of the advanced countries is still weak, five years into the Great Recession. Nonetheless, there are signs of recovery. In particular, the US is expanding at around 2% per annum at the moment, and the second quarter growth rate in the Eurozone is expected to be better than the weak first quarter. The British economy is also showing some limited signs of recovery. UK economic growth is still weak, at only 0.3% in the first quarter, which is just enough to avoid falling back into recession again. However, service industries have been growing relatively strongly. In addition, house prices are picking up, which is usually a good predictor that consumption will strengthen. Overall, the British economy remains weak but it is showing some positive signs. However, the annual increase in national output is still far away from the 2% to 2.5% annual growth, which is considered a healthy long-run average.

Monetary policy has run its course. It could do only so much towards lifting the economy. Low interest rates and QE were needed during the worst part of the financial crisis, in order to calm markets and stabilise the financial sector. The loose monetary stance also helped to avoid an even larger decline in output in the first phase of the recession. However, low policy rates do not help the economy return to a healthy 2% to 2.5% growth rate. In particular, low interest rates can buy time for adjustment during a financial crisis, but they can also create perverse incentives if kept low for too long. Firms that borrowed prior to the crises have adjusted more slowly than desirable because of the low interest rates. At the same time, banks are reluctant to lend to new firms until their existing loan portfolio improves. As a consequence, the recovery is slow. To escape from this trap, the central bank needs to raise cautiously its policy rate.
Inflation seems to be under control and inflation expectations are well anchored in the US, the Euro area and in Britain. Expectations can change fast if the recovery speeds up. In particular, CPI inflation has been above the 2% target since November 2009. Although it fell from its 5.2% peak in September 2011 to below 3% by mid-2012, it has been hovering above 2% ever since. It is important to note that the large drop in inflation was primarily due to a drop in the rate of goods price increase, while service inflation has been fluctuating around 3.5% since mid-2010. Overall, there are signs that inflationary pressure is slowly building up in the service industries, which make up the bulk of the British economy. The need to signal the readiness of the authorities to control inflation when necessary, also calls for a rise in interest rates.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

In an unusual turn of events, the chairman of the US Federal Reserve Ben Bernanke’s clumsy interventions have amplified nervousness in the US bond market with adverse implications for the UK rate curve. The upward shift in ten-year gilt yields of 50 basis points in the past month has also dragged up short rates and brought forward the implied date of the first rate increase to mid-2015 from late-2016. The significance of this market move is twofold. First, it casts even more doubt on the desirability and efficacy of QE programmes. Second, it has reinstated scope for a UK policy of calendar-based forward guidance on interest rates, specifically Bank Rate. These issues have pertinence in the context of Mark Carney’s imminent assumption of the governorship of the Bank of England.

MPC members may also be more inclined to supplement QE (in the form of gilt purchases) after the rout in the gilt market, overturning the six to three votes that marked the final months of Lord King’s tenure. Ironically, the MPC may be ready to grant Carney a majority for more QE, if he wants it. The twist would come if Carney were willing to advocate a broadening of asset purchases to embrace securitised infrastructure, property or small and medium-sized enterprise loans.

Every shade of opinion has been expressed regarding the ability of the new governor to change course. An ex-MPC member recently confided that he thought the MPC was ‘stuck in 2009’. Mark Carney has been recruited surely with a view to dragging the MPC out of its rut and the question remains what impact he will seek to have on arrival. Market events suggest that he will push for the adoption of Fed-style forward guidance from the start.

Meanwhile, the UK economy has perked up since the end of the cold and wet spring with the possibility of a strong reading for 2013 Q2 on 25th July. After a 0.3% quarterly increase in 2013 Q1, the second quarter should see a gain of between 0.6% and 1%. The combination of the FLS and the ‘Help to Buy’ scheme has set a positive tone in the housing market and revived gross mortgage lending (up 17% from a year earlier). Retail sales and consumer confidence are both improving more than widely expected.

There have been other indications of normalisation in the banking sector as the Chancellor has committed to the return of Lloyds Bank plc. to private ownership and a final reckoning seems to have been reached in terms of additional capital requirements for other banks and building societies. The prospect of private sector credit expansion is rather more credible now than even six months ago.
M4 growth, excluding intermediate OFCs, is running close to 5% on a year earlier, although this remains inflated by a large public sector contribution to the money supply. If QE is not extended in any form, then private credit growth would need to strengthen in order to sustain M4ex growth.

However, as previously argued, Mark Carney’s most pressing task as incoming Bank governor is to unblock the credit transmission not to construct an elaborate set of conditions under which Bank Rate may one day be raised. Indeed, if there is a role for ‘forward guidance’, it is to reassure markets of the Bank’s determination to take rates back to the region of 2% to 2½% over the next two years. An immediate move to ¾% is my preference with no early commitment to additional QE.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

At the time of writing, financial markets are currently in the process of pricing for the end of asset purchases under the QE programme in the US. For background, the Federal Reserve buys $85 billion of bonds a month, comprised of $45 billion of treasury bills and $40 billion of mortgage backed securities (MBS). The result has been a rise in the ten-year Treasury yield to 2.60% from a low of 1.63% in early May. UK ten-year gilt yields have responded to this by rising from 1.62% to 2.56% in the same period. This is without anything economically fundamental changing in the UK and, as such, seems overdone. It might not of course be overdone for the US economy, where growth is clearly moving towards its trend rate – albeit not above and maybe not at the rate that the financial markets are expecting. Even there though, it could be argued that the move seems excessive, as the Fed was careful in its recent press conference to point out that any tapering was data dependent and that that the Fed fund short term rate would not be raised for a considerable time after QE ended.

In saying any tapering was data dependent, the Fed suggested that it was not hell bent on raising rates come what may but would only do so if the economy continued on its current trajectory. Moreover, the messages were clear that QEIII would end only when unemployment hit 7% and rates would only rise if it hit 6.5%. On this basis, the data are not 100% clear about the timing of the tapering move (or the amount), unemployment edged up 0.1% to 7.6% in May, and inflation fell back, with wage pressure and core inflation very low. On top of that, Bernanke might not be around when QE ends next year, if he leaves as Fed Chairman when his current term terminates in February 2014.

As for the MPC view of the UK economy, it remained divided in June but voted to maintain the status quo 6:3. It was the fifth consecutive month the committee was divided on the need for further stimulus, with the departing Governor, Fisher and Miles arguing for a further £25bn of QE, and the fifth month that Lord King was outvoted (and at his last meeting). The tone of the minutes was broadly unchanged to slightly more upbeat than last month's. While the committee acknowledged the economic data had shown a ‘moderate’ improvement, the recovery was evolving broadly in line with the projections outlined in the May Inflation Report. As such, there was no pressing need for members to change their positions.

MPC concern remained fixated on the debate about the case for further stimulus and continued to centre on the potential damage that weak demand could inflict on the supply base of the economy versus the potential risk to inflation of keeping policy too loose for too long. For the majority of members, the persistent overshoot of inflation, ‘moderate’ signs of economic recovery, and the effect of the previous rounds of QE and the FLS argued for no change. By contrast, the dissenters maintained that the high degree of spare capacity, the importance of rebalancing growth and the substantial risks still posed by the Euro area justified further stimulus.

Positions on further QE are now firmly entrenched, for some the recent correction in asset prices had highlighted the role further QE could play in helping to address financial market volatility and to help shape future policy expectations. Given the extent to which market expectations of UK interest rates have increased over the past month, this suggests some members could vote in favour of QE as a means of managing down bond yields and interest rate expectations if required. However, there must be a big question mark over whether that would work now, given the rise in global yields triggered by the words from the Fed. That said, it is likely that the MPC will adopt some form of conditional forward guidance, possibly after the report into its efficacy for the UK in August.

With regards to recent data releases, the PMIs continue to suggest that growth in the second quarter will be close to ½%. However, the pace in the second half of 2013 will depend on Europe, the US and the rest of the world. On that score, the pace of growth in the rest of the world seems to have slowed, the US economy has exhibited some easing in its progress towards trend growth and Europe seems to be stabilising and no longer declining as quickly (though not yet in recovery mode).

On inflation, annual UK CPI inflation rose to 2.7% in May, unwinding some of the previous month’s decline. May’s price increases saw acceleration in both goods and services inflation. Goods inflation accelerated to 2.0% at an annual rate from 1.7% to reach the top end of the range seen over the last year. Service sector inflation also accelerated to 3.6% year on year in May. Although this rate remains more subdued than recorded over the last six months, service sector inflation is showing few signs of responding to the large amounts of spare capacity in the UK economy and is likely being kept elevated by relatively high unit labour costs. A further rise in June when the inflation numbers are released seems inevitable.

All in all, these figures and the volatility we are seeing argue for leaving rates where they are and QE on hold. However, if the economy firms further in the second half of the year, talk of QE will be all but banished and attention will turn to what would trigger a tighter policy stance from the Bank of England, with Mark Carney possibly using the approach adopted by the Fed.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

In its most recent e-mail poll, which was finalised on 29th May, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 6th June. Four SMPC members wanted an immediate increase of ½%, while one advocated a rise of ¼%. Such a split vote for a rate hike would imply a rise of ¼% on normal Bank of England voting procedures. However, a substantial minority of four SMPC members believed that economic activity in Britain – and also in some of its main trading partners – remained so weak that Bank Rate should be held at its present ½% for the time being. Almost irrespective of their precise views on rates, most members of the shadow committee saw no immediate justification for adding to the existing stock of Quantitative Easing (QE). However, one wanted to start on the process of reversing it.

One reason why a narrow majority of the SMPC wanted to raise Bank Rate in June was the belief that lending costs would have to be normalised at some point. It was less disruptive to make the necessary rate hikes early and in ‘baby steps’ than to leave it too late and then have to make an abrupt upwards move; perhaps, because the financial markets had lost faith in the resolve of the British authorities. There remained widespread concern that excessive financial regulation was impeding credit creation to the private sector. Nevertheless, UK broad money growth had now recovered sufficiently to sustain a non-inflationary recovery, given the slow growth of productive potential. The economic situation was unusually opaque at present because a major re-working of the UK national accounts would be published on 27th June. This could lead to substantial revisions to current growth figures.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Hold Bank Rate for next three months and use rate setting and QE to achieve growth in broad money of 3% to 5%.

The regulatory blight on banking systems continues in all of the world’s so-called ‘advanced’ economies, which means for these purposes all nations that belong to the Bank for International Settlements (BIS). The growth of commercial banks’ risk assets is constrained by official demands for more capital relative to assets, for more liquid and low-risk assets in asset totals, and for less reliance on supposedly unstable funding (i.e., wholesale/inter-bank funding). If nothing else were happening, the contraction of asset totals and the rise in the proportion of capital to total liabilities would result in falls in the quantity of money, broadly-defined, which would in turn imply falls in the equilibrium levels of national income and wealth. In some of the Eurozone’s Club Med countries, and even to some degree in France and Italy, these processes of money contraction are still very much at work, and macroeconomic outcomes are weak and disappointing. Indeed, for the Eurozone as a whole output is flat and unemployment is rising.

In virtually all the advanced economies the ratio of safe assets (i.e., cash and government securities) to banks’ total assets is rising. The importance of new credit extension to banks’ business activities has declined, despite constant laments in the media about the absence of new bank lending to such allegedly deserving causes as small business and first-time home buyers. Senior policy-makers seem not to understand the connection between the regulatory zeal ‘to tidy up bank balance sheets’ and the marked reluctance of banks to grow their businesses. In the UK, this has led to obvious, indeed ludicrous policy inconsistencies. It was the same Chancellor of the Exchequer (George Osborne) who endorsed the regulatory excesses of the Vickers Report in 2011 that announced the Help-to-Buy initiative to boost mortgage lending in the 2013 Budget. The Chancellor’s “left hand taketh away and the right hand giveth back”. Both the taking-away and the giving-back occurred at the same time and were blessed by the same government.

The situation is redeemed to some extent by the widespread adoption of so-called QE, which can be regarded as the deliberate creation of money by the state. (A multiplicity of definitions is possible, because the subject is intellectually a total mess.) Because the banks’ safe assets are growing as a result of QE, the quantity of money is in fact rising slightly – typically at annual rates in the low single digits – in most of the leading countries, including the UK. In association with virtually zero interest rates, low but positive money growth has been accompanied over the last year by asset price buoyancy, with rising stock markets, very low bond yields, and steady markets in residential and commercial property. While the global upturn is being led by the USA, macroeconomic conditions in the UK have been satisfactory. Better growth is also being seen in Japan where an aggressive monetary stimulus is currently intended by the new Abe government. It is only in the Eurozone, where QE operations are hampered by the multi-government, hydra-headed monster that is the single currency area, where monetary conditions remain persistently hostile to growth.

In the UK the M4ex measure of money increased by 4.5% in the year to March, while the stock of M4ex lending (i.e., bank lending to the non-bank private sector, excluding that to intermediate other financial corporations) fell by 0.1% while the stock of M4 lending as a whole was down by 1.9%. In other words, money growth has been positive only because other forces have offset the contractive effect of reduction in bank claims on the private sector. QE has undoubtedly been the dominant such force.

Although recovery is certainly under way in the UK, it is wholly inappropriate for commentators to start worrying about overheating in labour and product markets. In fact, the latest figures for consumer price index (CPI) inflation were better than expected and almost back down to the 2% official target. The news from the labour market varies from month to month, but the most recent numbers – which may be erratic – have indicated rising unemployment. I am in favour of no change in sterling interest rates and the continuation of QE at a sufficiently high level to ensure that broad money growth (on the M4ex measures) runs at an annual rate of between 3% and 5%. My bias – at least for the next three months – is for ‘no change’. It is plausible that I will be advocating higher interest rates in 2014. However, much depends on a realisation in official quarters that overregulation of the banks is, almost everywhere in the advanced world, the dominant explanation for the sluggishness of money supply growth and, hence, the key factor holding back a stronger recovery.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ½%.
Bias: Hold QE.

May 2013 saw a slight fall in the rate of consumer price inflation (from 2.8% to 2.4%) and, whilst it is true that the twelve-month rate for CPI has been reasonably stable, it is consistently high. In an inflation targeting regime, this needs to be confronted because the longer inflation remains above target the more fanciful are claims that it is temporary. The introduction of forward guidance institutionalises the Monetary Policy Committee’s (MPC’s) leeway but at the cost of instilling even greater discretion. The fact that monetary policy since 2007 has been characterised by greater discretion, rather than better rules, is a large part of why it is failing.

Current events exemplify one of the main failures of inflation targeting – the inability to distinguish between price changes caused by changes in the demand to hold money, and price changes due to changes in productive efficiency. For some time, the inflation target has served as a counterproductive anchor that has prevented monetary easing from occurring when needed. However, just because monetary easing would have produced a stronger recovery if employed sooner, does not mean that more monetary easing now can compensate. It seems increasingly clear that with real growth below trend and CPI above target that a large part of the UK’s difficulties fall on the supply side. The fact that there was a demand problem in the past does not mean that there still is one today.

The 2013 Q1 growth rate of Nominal GDP (NGDP) was 3.4% higher than the same quarter of 2012, which is more than double what it was for 2012 Q4. For most of 2012 it seemed that NGDP had fallen to a sub 2% annual growth rate but the fact that it is increasing implies monetary policy is loose. For those who treat 5% NGDP growth as the norm this remains too low, especially if the goal is to catch up to the previous trend. For those who think the previous trend was inflationary, even looser policy would be a concern.

Ad hoc schemes that intend to compensate for blockages in the credit channel bring with them real dangers. The Funding for Lending scheme (FLS) has the potential to encourage banks to lend more but it should be highly concerning when the central bank simultaneously sets wholesale funding costs, and directs the flow of credit. There is no basis to believe that officials possess the knowledge required to manage this policy in a socially desirable way. There is already a concern that zero lower bound policy has generated new bubbles, and the Bank of England should be wary of stoking new ones (or indeed perpetuating existing ones). Emphasis should be on regulatory reforms that allow banks to serve as financial intermediaries. Credit needs to flow to entrepreneurs because they are in the best place to invest in value-generating projects, not because increases in credit are good per se. Lower taxes, fewer regulations, less uncertainty etc. play a bigger role than ‘lack of credit’. If anything, the misallocated credit from the preceding boom has yet to be properly reallocated. This is a prerequisite for a healthy and sustainable economic recovery.

The annual growth of M4ex continues to run at a stable rate and the MPC should carefully balance the risks of loose monetary policy on the one hand, and tightening too quickly on the other. A modest increase in interest rates would restore some credibility to the MPC, but ideally it would be accompanied by clear guidelines on the expected path of both inflation and real output growth. The fact that NGDP growth has jumped up, together with looser policy globally (for example, in Japan) means a ½% rise could be warranted. To be clear, raising interest rates does not necessarily mean a desire for ‘tight’ money. Rather, a 1% Bank Rate would be ‘less loose’ and help us infer what level it should be in order to be neutral.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate; maintain asset purchases at £375bn.
Bias: Employ rate changes and QE to keep M4ex growth at 4% to 6%.

The slow recovery of the British economy continued in 2013 Q1, and the available data suggests this pattern extended into the second quarter. The economy is likely to remain in this gradual, but fragile, improvement mode for the remainder of the year. Progress on the domestic side is being counterbalanced by difficulties on the external side. This is well illustrated by the 1.3% growth of real domestic demand over the year to 2013 Q1, which contrasts with the growth of 0.6% in real GDP over the same period. The difference was due to net trade – mainly the weakness of UK exports to the Eurozone – where the recession shows no sign of abating.

Viewed from the production side, the steady recovery of the service sector is being offset by declines in the manufacturing and construction sectors. Since the recovery started in mid-2009, services have grown fairly consistently at 0.9% p.a. while manufacturing and construction both surged initially in 2009 and 2010, but both have been declining since 2011, reflecting mainly international factors. However, new construction orders improved in the second half of 2012, suggesting a slightly better outlook for this sector in 2013.

In order to see significant progress towards a sustainable recovery at close to historical growth rates, the economy will need to overcome three main headwinds: the continuing weakness of balance sheets in the banking and household sectors; the tendency over the past year or two for inflation to exceed personal income growth, thus eroding purchasing power in the crucial consumer sector; and the weakness of economic activity abroad, particularly in the Eurozone, our largest trading partner.
In the area of balance sheet repair, Britain is making much slower progress than the US, mainly due to the more comprehensive or systemic measures taken by the US authorities to recapitalise American banks and detoxify their loan books in the early stages of the recession. As a result, US bank lending has been growing at about 4% per annum since March 2011 while UK bank lending has yet to start growing again. Household balance sheet repair is progressing roughly at the same pace in both economies, and seems likely to require two or three more years before completion. The reason is that, unlike companies, households cannot either raise capital or easily dispose of assets in order to repay existing debt. Confirming this, survey data quoted in the Bank of England’s Inflation Report shows that the most indebted households have raised their savings rate (and cut consumption) the most.

On the inflation front, the news has recently been better, with the April CPI slowing to 2.4% year-on-year. However, with administered price increases still to feed through to the CPI and energy prices subject to further hikes, progress in bringing down inflation may be slow for the remainder of 2013. Over a longer term horizon, a combination of subdued M4ex growth and weak domestic demand imply it is likely that the inflation target will be undershot in 2014. This should create space for higher employment and steady wage growth to generate stronger growth in real spending, as well as encourage firms to increase output.

On the external side, despite the easing in financial symptoms of the Eurozone crisis, the economic performance of the Euro-area has weakened with recessions in both the periphery and the core. When added to the sub-par growth of the US economy, and the slowdowns in China, India and Brazil, it is no surprise that demand for British exports remains weak. This in turn implies a longer period will be needed to rebalance the UK economy away from consumption and housing towards exports and business investment.

In this environment, the Bank should hold rates stable at ½%, but be prepared to undertake additional asset purchases if monetary growth plunges again, or the Eurozone crisis flares up once more. Rate increases at this stage would damage the prospects for economic recovery, and should be delayed until the recovery is substantially more secure.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Over recent years, the UK economy has experienced an ‘L’ shaped economic recovery. The weak recovery has arisen because of four main headwinds. The first has been the need for deleveraging in both the public and private sectors. The second has been the damage done to the banking system as a result of the financial crisis and the impaired monetary transmission mechanism. Third has been the squeeze on household incomes from inflation running well ahead of earnings growth. Finally, there has been the impact on precautionary behaviour, by both companies and consumers, from the ever present Euro crisis. To a varying extent, and at different times, these headwinds have combined to hold back recovery.

However, in late 2012 and early 2013 the economy also acquired a strengthening following wind, with the pick-up in the rate of M4ex broad money supply growth to around 4% to 5% on a year on year basis in recent months. Whilst such rates of growth still imply a recovery which is more ‘L’ than ‘V’ shaped, they do nonetheless suggest that GDP growth in 2013 could be around 1.5%. The underlying rate of growth in potential output in the UK has probably slipped to under 2%, because of the growth in the total intervention index – i.e., the combined burden of public spending, taxation and red tape. Supply-side weakness suggests that any improvement in nominal GDP growth – arising from the acceleration in broad money – will be split unfavourably towards inflation as opposed to real GDP growth. Consequently, inflation may struggle to fall back towards target in 2014 despite a continued output gap.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To Raise Bank Rate.

Much is made in the media of the debate amongst economists between the majority favouring spending and deficit cuts or believing them necessary if undesirable, and a vocal minority that favour increasing the deficit at least in the short-term. What has gone largely unremarked is the important debate between the majority view that interest rates must continue at around zero – perhaps, accompanied by even more QE - and the minority view that rates should be raised. In my own case, the belief that rates should be increased rests on the propositions that follow.

First, the fundamental challenge confronting the UK economy is not just a few quarters of below-trend growth. The fundamental challenge is that the underlying sustainable growth rate of the economy has dropped from the norm of 2.5% or higher of the 1980s and 1990s to perhaps as low as 1% today. If that underlying growth rate cannot be raised, then UK households and businesses that took on high debts during the 2000s will default on those debts unless there is high inflation, bankrupting our banks. The recent problems of the Co-op bank confirm that the UK banking sector’s problems are by no means over. If the UK’s nationalised and quasi-nationalised banks become distressed again, then the UK government that stands behind them will face the choice of either allowing them to default or bailing them out. Either option will impact on the UK government’s perceived credit-worthiness. If markets lost confidence in UK government debt, bond yields might rise, reducing the value of the Bank of England’s QE-acquired bonds. This capital loss would impose large further costs on the Treasury, and also reduce the value of the UK government bonds held by UK banks, placing them into further distress. That vicious cycle can only be broken by either raising the sustainable growth rate of the economy or by a period of high inflation.

Second, the central lesson of macroeconomics of the past forty years is that loose fiscal and monetary policy cannot raise the medium-term sustainable growth rate of the economy, but can reduce it if done to excess. It is, therefore, both futile to imagine that keeping interest rates at zero and printing money can address our core sustainable growth problem, unless the intention is to deliver high inflation, and dangerous to attempt to do so – since such an attempt could reduce the sustainable growth rate further, making things worse not better. Given that the sustainable growth rate is so low, any short-term boost to output that is achieved by such loose policy can only come at the expense of inflation and fall-back into recession. We saw in 2008 and 2011 that inflation rises to 5% and upwards when the UK economy is not actually contracting.

Third, more than four years into zero interest rates and QE, monetary policy has had its go. Monetary policy can be a powerful tool for boosting growth in the short term. However, the period over which it is efficacious is from around nine months to three years. Beyond that, very loose policy will tend to damage growth and also be morally questionable, as very low rates punish the prudent in order to protect the imprudent from the consequences of their errors. We cannot indefinitely accept that those that chose not to over-extend themselves in the 2000s should suffer, just so as to spare those that did over-extend themselves from the fruits of their folly.

Fourth, very low rates and extra QE at this stage provide a negative signal – they tell the financial markets and economic agents in general that policymakers believe that the situation is dire and recovery is still far off. We are well past the point at which they were signalling that the problem was temporary and policy could and would be used to turn things around quickly (the more normal signal provided by policy loosening). Raising rates would be a sign that there is a future of normality awaiting us, and with baby steps we can get there. The first of those baby steps should be a modest rise in rates. I would start with ½%.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

Mark Carney arrives as the new Governor of the Bank at a time when policy is in disarray but at the same time all the levers of policy are in the Bank’s hands. He has a good chance to improve matters. What is the problem? The Bank is pursuing a monetary policy that is at its loosest for all time. Via QE the monetary base has expanded to nearly eight times its 2007 value. Virtually all that expansion is sitting in bank reserves, as the extra money printed was deposited and not lent; so the banking system has created no additional money, and the total (‘broad’) money supply has barely grown. Meanwhile, interest rates on government three month bonds are held down close to the Bank Rate of ½%, an all-time low that has prevailed for four years; on longer maturities the government can borrow at rates below inflation. Yet, rates on credit to small businesses remain, as far as we can measure them, stratospheric; and lending to Small and Medium-sized Enterprises (SMEs) continues to contract sharply. The economy is growing weakly at best. Equity prices have soared as investors have chased yield elsewhere than in government bonds; yet large businesses refuse to invest, preferring to wait for recovery. As for inflation, it is now sagging back towards 2%, after a long period of being driven up by soaring commodity prices, now mercifully falling back; the lack of credit and money growth has held domestic inflation down so the Bank’s credibility has not been tested.

In a nutshell, this highly and indeed dangerously expansionary monetary policy has had little or no effect on credit, real activity, the broad money supply or inflation but has driven down yields on government bonds and other assets, damaging savers at the expense of government and large borrowers. Why?

What we have been discovering the hard way is that money does not course equally vigorously through all channels, especially when regulators insert large barriers between them via their controls. Small businesses always find it hard to get credit and face a rate much higher than Bank Rate, which varies with general business conditions in a way that we do not observe very well; arrangement and other fees come and go, as do eligibility criteria and collateral requirements. Now, in addition to the usual hurdles they would face because of poor business conditions and the banks’ internal difficulties, these businesses face a new and massive regulatory obstruction: as they are ‘high risk’ they push up a bank’s risk-weighted assets and so force the bank to get expensive extra capital to satisfy the new capital ratios. The banks have reacted by refusing to expand their balance sheets by lending to these expensive firms. Instead they have clung onto their ‘low risk’ large customers and official paper, most especially reserves with the Bank. The credit channel to the dynamic part of the economy, the 50% represented by SMEs, has been blocked by regulation. So all the money printed has gone into the other channels, causing a lake of liquidity to form around governments and large corporations. The economy has flat-lined as these monopolistic elements bask in the luxury of doing nothing much except ‘cuts’.

Mr Carney should change this. As the chief regulator he should cut back these capital requirements, or at least postpone them sine die. As the banks come back to life, he can then junk the clumsy bureaucracy of the FLS and the mortgage subsidy for first time buyers. He will then need to tighten monetary policy as bank credit expands and the recovery strengthens. All those bank reserves created by QE are like dry firewood waiting for a spark; not merely must it be stopped as agreed by majority in the latest MPC minutes but it must also be removed fast. Interest rates must rise to keep credit and money growth under control. There will be difficulties in removing the existing stock of QE, as the Bank’s bond holdings will fall sharply in value with rising interest rates; also politicians will want to stop the Bank ’spoiling the recovery’. However, the Treasury will have to absorb the loss on the Bank’s assets (after all the Bank’s loss is its gain) and the politicians must be ignored.

For the longer term, people will worry that weakening bank regulation will lead to a future crisis. But regulation works against the grain of the free market economy; it would be better to control excess credit expansion by monetary policy in future. The inflation target should stay at 2% because as a society we decided to eliminate the deadly virus of unchecked and uncertain inflation. However, the monetary control mechanism could supplement the target with a money supply target which would proxy the otherwise unobservable cost of credit to SMEs. The setting of Bank Rate and the printing of money could be jointly orientated towards the control of monetary conditions. If Mr Carney can sort these things out, he will have more than earned his unprecedented Gubernatorial package.

What should be done this month? QE should start to be reversed and bank regulation eased back sharply. One interim solution would be to make any capital requirement smaller and also absolute – that is, related not to risky assets but merely to the overall size of the bank balance sheet. Then ‘excess risk’ when it eventually becomes a threat in some years’ time would be handled by making monetary conditions respond to the money supply. Meanwhile, the marginal cost penalty on bank lending to SMEs would be removed. Pending all these changes we need the FLS and the mortgage subsidy scheme to be expanded as necessary to offset the damaging effects of regulation- much as the government is now being forced to do; these actions will continue to bear down on the costs of credit to smaller borrowers. Interest rates on government paper should rise now by 0.5%, to begin the normalisation of the official paper market. Besides beginning to remove the distortion in the savings market, it would also revive the interbank market, whose operations are suppressed by the lake of QE reserves and the low rate on borrowing from the Bank. It will also take the froth off the equity market. Most importantly it will start to reduce the dangers of inflation as the economy re-enters growth.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up and fully privatise state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

Sir Mervyn King has been such a predominant influence on the Bank of England’s economic approach since he became its Chief Economist in 1991, Deputy Governor in 1997, and Governor in 2003 that the Bank’s economists must be feeling a similar sense of disorientation to that felt by the state officials of Eastern Europe after the fall of the Berlin wall. This is not intended as a suggestion that Sir Mervyn was running a totalitarian system. Indeed, the openness and transparency of UK monetary policy making – as demonstrated at the question and answer session at Sir Mervyn King’s final Inflation Report press conference, for example – is probably at the leading edge of central banking practice. However, the removal of such a powerful intellectual presence from any institution after more than two decades must inevitably give rise to a period of reflection and re-consideration. One over-arching concern about Sir Mervyn’s period in office has been the apparent closeness of the Bank’s approach to that of the US Federal Reserve, as against the traditional sound money commitment and long-term policy orientation of the pre-European Monetary Union (EMU) Bundesbank. There is a risk that, as a Canadian, the incoming Governor, Dr Mark Carney, will also adhere too closely to the excessively activist US approach to monetary policy, which led to serious over-steering and was a main cause of the Global Financial Crash. An interesting thought experiment is to ponder what would have happened to the credibility (and also the techniques) of UK monetary policy if an experienced ex-Bundesbank official (several of whom have chosen to leave the ECB in recent years) had been appointed as the new Governor by Mr Osborne.

In keeping with its commitment to transparency, the Bank of England publically released details of its new forecasting ‘platform’ on 24th May. This system has been used since the end of 2011 to generate the Inflation Report forecasts, although resource constraints at the Bank have meant that the documentation has only just been placed in the public domain. The term ‘platform’ has been used deliberately by Bank officials because there are four separate elements involved: COMPASS, which is the new central core model; MAPS, a macroeconomic modelling and projection toolkit; EASE, which is a user inter-face, and a suite of sub-models that are used to supplement and extend the projections generated in COMPASS. The new platform is consciously designed round the institutional forecasting procedures of the MPC; in particular, the important role of pure judgement on the part of MPC members. As such, it guarantees forecasting consistency in a balance sheet sense but it may be too open a system to fully incorporate the feedbacks that once would have been considered desirable in a macroeconomic forecasting model. The documentation provided by the Bank falls not far short of two hundred pages, often containing some dense mathematics, and there has not been time to digest so much material properly.

On the basis of a quick read through, a number of specific concerns are as follows. First, there is only a rudimentary representation of the government sector in COMPASS, despite the fact that general government expenditure accounted for 50.3% of UK non-oil basic price GDP last year. This means that the important feedbacks between monetary policy and the private-sector tax base, together with the independent effects of changes to individual spending items and tax rates on the targets of monetary policy, are not represented. Second, Britain is correctly modelled as an open economy. However, the UK model is not nested inside a global model, so it is difficult to represent consistently the indirect effects of, say, an oil price shock operating through international variables. Third, a relatively short data estimation period of 1992 to 2007 has been employed – the Bank explains the reasons for this choice – but it is easy to over-fit models using such short data runs, making them unreliable forecasters. A fourth concern is that the main monetary policy instrument incorporated in COMPASS is Bank Rate. Sub-models can be run in conjunction with COMPASS that allow credit shocks to be simulated, generally by increasing the wedge between borrowing costs and Bank Rate. However, it is not clear that this is enough to represent the effects of official balance sheet constraints and credit rationing on the economy, a subject that has been of major concern to the SMPC. It is also noteworthy that there is no necessity in COMPASS for the supply of money and the demand for money to be in equilibrium before the model settles down because the money supply itself does not seem to be included. This is consistent with the theoretical approach adopted by central banks in recent decades. However, central bankers have made an unholy mess of the world economy during this period – in large part, because they ignored what the ECB used to call the ‘second monetary pillar’.

The latest figures for the M4ex definition of the UK broad money stock show a rise of 4.5% in the year to March, while broad money in the aggregate Organisation for Economic Co-operation and Development (OECD) area was 5.5% up on the year in the first quarter of 2013. The post-2008 crisis period of very weak monetary growth seems to have come to an end during the course of last year. Current monetary growth rates might be regarded as being appropriate on a medium-term perspective to achieve low and stable inflation given the rather subdued outlook for the growth of potential supply both internationally and in the UK. The main concern is that governments are hogging the money creation process and that both total bank credit creation and, within it, lending to the productive private sector are being crowded out, largely because of the financial repression caused by excessively onerous regulations. The only cure is for the financial supervisors to regulate more intelligently and less aggressively and for governments to improve fiscal discipline by means of better spending control.

The drop in the annual CPI inflation rate from 2.8% in March to 2.4% in April was a pleasant surprise, which was reinforced by a drop in core producer price inflation from 1.3% to 0.8% between the same two months. However, annual house price inflation on the ONS measure picked up from 1.9% to 2.7% between February and March, possibly as a reflection of the recently higher rate of M4ex increase as well as Mr Osborne’s misguided schemes to ramp up the housing market. The ONS will be rebasing and redefining the UK national accounts on 27th June. Previous annual re-workings of the official GDP figures have sometimes introduced such radical back revisions that they have altered the tone of the entire economic debate. This means that there is probably little point in worrying too much about the finer details of the unrevised 0.3% increase in real GDP in the first quarter reported on 23rd May, which represented a 0.6% rise on 2012 Q1. The most recent labour market statistics have shown some signs of weakness, especially in annual earnings growth which was only 0.4% in the year to 2013 Q1 and zero in the private sector, and need to be watched carefully. Overall, however, a Bank Rate increase of ½% seems appropriate at the June MPC meeting – incidentally, this will be Sir Mervyn King’s last rate decision before Dr Carney takes over – with no further increase in QE for the foreseeable future. British interest rates will have to be normalised at some point. A stability orientated monetary policy maker would recognise that it is less disruptive to start the process early, and in small steps, rather than leave it too late and then have to slam on the brakes.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; no extension of QE.
Bias: To raise Bank Rate.

It is testament to the strength of regulatory pressures on the banks that the annual pace of M4 lending, excluding intermediate other financial corporations, has fallen back from 1.7% in December 2011 to -0.1% in March 2013. Blockages in private sector credit transmission remain a formidable obstacle to UK economic recovery. The M4 money stock, with the same exclusions, has picked up some momentum over the same period to register annual growth approaching 5% on average over the three months to March. Plainly, it is the underfunding of public sector borrowing that separates the outcomes.

The failure to stimulate additional lending, notwithstanding four years of ½% Bank Rate, £375bn of asset purchases and the FLS, illustrates the policy dilemma. The gold-plating of international bank regulation by the UK authorities has deprived the economy of valuable lending capacity at a time when public expenditure was in retreat, for very good reasons, and the Eurozone economies were in spasm.
Nevertheless, there are tentative signs that large companies have begun to increase their capital market borrowings. Private non-financial corporations borrowed £8.5bn in the first quarter of 2013 in the strongest showing since 2008. The pace of bank loan repayment slackened; bond issuance strengthened; net equity issuance turned positive, and even commercial paper made a modest contribution. As for SMEs, there is no evidence of volume gains, but a much larger percentage of small businesses have access to interest rates of 4% or less relative to last year. Lending spreads are very tempting for the banks, suggesting that competition will continue to weaken the cost of borrowing.

The weight of criticism of the government’s Help to Buy programme, not least by the outgoing Bank governor, can be taken as a positive sign: to attract such opprobrium suggests that few doubt its potential to have a definite impact on housing transactions and house building volumes. Much of the criticism surrounds the danger of reigniting house prices, yet a firm housing market is a necessary inducement to persuade vendors to offer their properties for sale.

Against a backcloth of a lacklustre potential GDP trend, even a modest improvement in the outlook must be regarded as an invitation to begin the painful task of normalising the short-term interest rate. The era of ½% Bank Rate should have ended in 2010; instead it lingers on. The first steps towards rate normalisation – which might only be as far as 3% – should not be delayed. My vote is to raise Bank Rate by ¼% and to keep going.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

Is the UK economy at a lower business-cycle turning point? On the surface, it appears that it is. Economic growth was confirmed at 0.3% in the first quarter. Looking at the Purchasing Managers Indices (PMIs) for services, which is further above the breakeven level of 50; manufacturing, which is edging up towards 50, and construction, which is also pushing up towards 50, growth in the second quarter could be as much as ½%. Taking the first and second quarters together (assuming the latter is that just suggested) would give 0.8% growth in the first half of 2013.

Such an increase can be compared with the forecast of 0.6% for full year growth in 2013 made by the Office of Budget Responsibility (OBR) in March, and the Consensus Forecast of 0.9%. Moreover, inflation has fallen to 2.4% in April, with producer prices slipping and suggesting that pipeline inflation pressure is easing. The world backdrop is more stable than a few months ago, with financial markets in particular on the up, indicated by equity markets hitting new multi-year highs recently (though off those in the last few days). Employment gains are still holding up well in the UK and consumer and business optimism is trending higher than they have been at any point since the second half of last year. That means UK economic growth could end 2013 above 1% for the first time in three years. What better time to start to withdraw the extraordinary stimulus of the last few years?

The problem is that the recovery narrative does not hold up that well under scrutiny. First quarter growth was down to a sharp rise in inventories; without which real GDP would have contracted slightly. Also, there is no guarantee that national output will not fall back in the second quarter for the same reason – i.e., inventories but this time as the first quarter surge unwinds. The low paid jobs created in the last few years still leave consumer spending under pressure. Lower inflation helps household real income increases to be less negative, but nominal earnings growth continues to slide. Government spending is starting to be a drag on growth – if the first quarter figures are right – as fiscal retrenchment starts to bite. Our key export markets in Europe continue to struggle, with recession likely for eight consecutive quarters. Euro-zone GDP in 2013 as a whole is likely to be down by ¾%, a quarter of one percentage point worse than last year’s decline.

However, the issue is that it is difficult to see that the real drivers for sustained recovery are yet in place. Productivity continues to fall. Labour supply growth is positive but the jobs are low paid overall, and, together with the lack of investment in plant and machinery that is required to kick start productivity gains, the recovery in the first half of 2013 looks likely to fall back to just about flat in the second half. So, all in all, it is too soon to withdraw the stimulus. I would therefore leave rates on hold and keep QE at the current level, awaiting UK developments in the second half of the year. Let us see what the new Governor of the central bank thinks of all this when he takes over at the end of June. He will find that, in May, six members wanted policy to stay on hold and three (including the outgoing Governor) wanted to ease via QE.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 16th April, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 9th May. Five SMPC members wanting an increase of ½%, another voted for a ¼% increase, and three voted to hold Bank Rate.

This vote distribution implies a ½% increase on normal Bank of England voting procedures. The recommendation of a rate rise in May represented the fourth consecutive month that a majority of the SMPC had voted in favour of higher interest rates. However, it was the first time for several years that a majority of the shadow committee had recommended an increase of ½% rather than ¼%.

While the SMPC has recommended a more hawkish stance than the official rate setters recently, there has always been a SMPC minority who wished to freeze rates until there were clear signs of recovery. The SMPC was also more hawkish than the official rate setters during the credit bubble that preceded the 2007 and 2008 financial crash. It is hard to argue, with hindsight, that the Bank of England was justified in ignoring the signs that the Heath-Barber and Lawson credit booms were being repeated in the earlier 2000s.

There appear to be three main intellectual differences between the majority view on the SMPC and the official one. These are: 1) the extent to which weak growth is a supply-side phenomenon, rather than a demand-side one; 2) how far misguided financial regulation has led to a damaging restriction in the supplies of money and credit, and 3) whether Quantitative Easing (QE) has been exhausted as a stimulus or, alternatively, should be re-directed towards private sector debt.

Minutes of the meeting of 16th April 2013

Attendance: Phillip Booth (IEA Observer), Roger Bootle, Kent Matthews (Secretary), Patrick Minford, David B Smith (Chairman), David H Smith (Sunday Times Observer), Peter Warburton, Trevor Williams.
Apologies: Tim Congdon, Jamie Dannhauser, Anthony J Evans, John Greenwood, Graeme Leach, Andrew Lilico, Akos Valentinyi, Mike Wickens.
Chairman’s introductory comments

The Chairman began the meeting by stating that he had been overseas at the time of the March Budget. However, he was not surprised that the official borrowing projections had been revised up yet again or that the official growth projections had had to be revised down. This is exactly what one would expect from the extensive international literature on fiscal consolidation. The Chancellor had consistently pursued what were known as ‘timid’ Type 2 fiscal consolidation policies – in which taxes were raised and the volume of government consumption increased, albeit through poor control rather than overt intent – and the result had been exactly what one would expect from the fiscal stabilisation literature; i.e., persistent deficit overshoots and growth way below official expectations. The interesting questions were: who on earth the Chancellor was looking to for advice, and why the Conservatives had spent their thirteen years in opposition without ever getting to grips with the intellectual issues involved? The Chairman then invited Trevor Williams to give his assessment of the global and domestic monetary situation.

Economic situation

Trevor Williams began his presentation by stating that he would start with an examination of the global monetary statistics and then work down to the Euro area and finally to the UK. He started with money supply growth in the leading three (G3) international economies and the emerging economies, which showed continued stagnation in the former and a slowing in the latter. Within the developed economies, the USA had seen some acceleration but was still below recent highs, whereas monetary growth in the UK had picked up but was still running at a very low rate. Monetary growth in Japan and the Eurozone remained flat. In Asia, monetary growth was dominated by China but here there was a slowing. Monetary growth was robust in Latin America but this looked to be an excessive growth rate if continued for too long. Brazil was, perhaps, an example of where there has been too much focus on excessive credit creation rather than supply-side reforms.

Credit growth in the developed economies was also slow and flat, with the UK still in negative territory. Surveys of bank lending conditions in the emerging markets revealed a tightening of credit standards. Furthermore, the price of credit had been rising in the USA, UK and Eurozone with adverse consequences for economic recovery. Policy rates remained low in the advanced economies and had remained stable in the emerging economies.

Global inflation had remained under control and it was also contained and falling in the developed economies. Global GDP was still heading up. However, the gap between the growth of the emerging economies and the sluggishness of the mature economies remained as large as ever. Elsewhere in the real sector, manufacturing output in Asia had risen sharply but had fallen back in the mature economies. The bottom line was that there was insufficient strength in the world economy for an inflationary danger to emerge. Inflation was not a major problem. A plot of output gap and core inflation for the major economies revealed no discernible pattern and little in the way of inflation risk. This meant that policy rates could remain low.

Trevor Williams went on to examine the statistics for the Euro area starting with ten year government bond yields. Euro area risks had reduced on the surface, owing to policy action, but underlying problems remained. While the European Central Bank (ECB) balance sheet was set to stabilise along with that of the US Federal Reserve, the Bank of Japan balance sheet was set to take-off. Despite the increase in ECB liquidity to the markets, corporate lending rates in Italy and Spain had widened against Germany and France. Euro area divergence continued with differences in manufacturing growth between Germany and the rest. In Germany, house prices had been rising gently, while those in Spain and Ireland had been declining.

In the UK, inflation was likely to remain above target but wage inflation would be weak and the economy was likely to slow in March after a good start to the year. The indicators were signalling a worsening of output, following some signs of growth at the end of 2012. The British economy had seen some improvement in money and credit conditions. However, these were insufficient to spark a strong revival in growth. Nevertheless, the latest figures for 2013 Q1 (Editorial Note: this refers to the figures released on 25th April) showed that the economy expanded by 0.3%, based on the 44% of output data available in that quarter.

This offsets the fall of 0.3% in 2012 Q4, if left unrevised. The good news was that world inflation trends remained benign. With commodity prices off lower in recent months, as the world economy slowed, inflation was set to stay low, recently in line with the weakening of global growth. The Bank of Japan had joined the QE party, and seemed prepared to go for higher inflation to revive their economy, with attendant risk for government debt.

Discussion

The Chairman then thanked Trevor Williams for his excellent presentation. He said that, in keeping with tradition, he would ask the IEA Observer, Philip Booth, to make a vote as the meeting had been inquorate. He then kicked off the discussion by expressing some unease about the manner in which the Retail Price Index (RPI) had recently become an ‘un-statistic’ as far as the Office for National Statistics (ONS) was concerned. The figures were still being published under the banner “NOT NATIONAL STATISTICS”. However, the ONS could not have it both ways. If the RPI was not a useful variable, why had the ONS persisted with its publication every month since the late 1940s? If it was worthwhile then, why had it now ceased to be useful, given that it was widely employed in private-sector contracts as well as for Index-Linked Gilts?

David B Smith’s fundamental concern was that, having failed to achieve a meaningful fiscal consolidation, the Chancellor was now planning to go even further in unleashing the inflation tax – perhaps, with the hoped-for acquiescence of Mr Carney and the Bank’s proposed more flexible inflation mandate – and was trying to disguise that decision by downgrading the RPI and its constituents. David B Smith added that some of the new measures of the price level (such as CPIH, which added housing costs to the established Consumer Price Index or CPI) were potentially useful. Unfortunately, only a relatively short back run from February 1998 onwards was available for the new measures. This was too limited a period to permit of any serious econometric modelling, something that represented a serious impediment to a forward-looking inflation targeting framework. David B Smith then added that it was not clear that the new RPI ‘Jevons’ (RPIJ) – which was named after a Victorian economist – was superior to the old RPI from a conceptual viewpoint.

That depended on the assumption that there was no loss of consumer utility when one switched from, say, apples to pears because the price of apples had gone up, even if one disliked pears. All that one could say was that retail-price inflation fell somewhere between the 2.7% shown by RPIJ and the 3.3% shown by the RPI, and not that any one measure was superior. There followed a short discussion about the proposed statistics.

The Chairman then asked Patrick Minford and Roger Bootle to make their respective comments immediately, as he knew that they both had to leave before the adjournment of the meeting. In addition, he said that he would need to call for two further votes in absentia in order to complete the magic nine. These votes were subsequently supplied by Jamie Dannhauser and Andrew Lilico. Having taken the votes of Roger Bootle and Patrick Minford, the Chairman stated that it was time to go round the table and record everybody else’s views. He said that, on this occasion, he would allow the discussion to continue into the voting round and that other people’s comments on the votes would be recorded for once. This reflected the relatively small size of the group remaining and the fact that there was still a reasonable amount of time left. The votes concerned are listed in alphabetical order below, including the two votes cast in absentia.

Comment by Phillip Booth
(Institute of Economic Affairs and Cass Business School)
Vote: Raise Bank Rate by ½%.
Bias: Hold QE.

Philip Booth said that he was nervous about the mortgage guarantee scheme. He said that there was an inconsistency between the government encouraging the banks to build up capital, so that they would not fail and be a burden on the taxpayer, and at the same time for the government to guarantee loans directly. The logical policy was for the government to create a legal framework to allow banks to fail and to deal with the ‘too big to fail’ problem. In response, Kent Matthews said that he did not see an inconsistency in the government having a too-big-to-fail policy and the government absorbing the risk of bad assets of the banks through an asset guarantee scheme. It was a logical extension of a too-big-to-fail policy.

Philip Booth said that the underlying problems were on the supply-side. He said that the productivity problem could not be solved by monetary policy and that Bank Rate should be raised by ½%, given the forecast for inflation, and that there should be no further QE.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold Bank Rate.
Bias: To cut to 0.1%.

Roger Bootle said that for once he agreed with Patrick Minford (see below) in his assessment but not in his conclusion. He said that the banking system was broken. In the 1930s, the banking system had supported the recovery, as it had also done by-and-large in former recessions. He agreed that there had been regulatory overkill. Roger Bootle added that it was not clear why there was a need to tighten regulation now rather than later. He said that the popular culture of putting bankers in the stocks did not help the recovery process. This was because active bankers were needed to get the economy out of its current mess.

Roger Bootle added that the Treasury attitude of fattening up the publicly owned banks for sale was not the right structure for recovery and that the government was not addressing the problem of the banks. The economy was flat but there remained potential for improvement. The fall in commodity prices had been significant. Oil at around $100 a barrel (Brent crude) was an important milestone. He said that inflation would probably come in better than expected. If inflation fell by the end of the year, the portents for recovery were good. He said that he was only a lukewarm supporter of QE. Sterling had depreciated sufficiently already, so there was no need for further QE. He added that there should be no change to interest rates immediately. However, it may be necessary to cut rates further to 0.1%, and have negative rates imposed on bank reserves held at the Bank of England, if the economy remained moribund.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: Additional QE and a rebalancing towards non-gilt assets.

In his vote in absentia, Jamie Dannhauser stated that CPI inflation remained stubbornly above the 2% target. It could go to 3% in the months ahead, in his view. However, around 1 percentage point of this could be explained by higher administered prices, suggesting a more subdued rate of underlying inflation. Absent the effect of higher university tuition fees, ‘core’ UK inflation had been below 2% since November. Indicators of price pressures in the more recent past, for instance the three-month annualised change in ‘core’ inflation, painted a picture of benign inflation. Other series, such as average wage growth or the annual change in the gross value added deflator, support the contention that the current inflation overshoot was not generalised.

Output growth continued to disappoint. The first quarter data might well show a small expansion in real GDP, but there was little momentum in the economy. External risks to growth remained sizeable given the fragility of the underlying economic position of the Euro area, even if complacent financial markets suggested otherwise. Monetary growth had picked up somewhat. There were signs that the Funding for Lending Scheme (FLS) had led to an easing of credit conditions, especially in the mortgage market. The increased availability of higher-risk loans to first-time buyers in particular could have a marked impact on house prices in the short-term and UK households’ propensity to save. Prospects for consumption had improved since the autumn.

Following news that the FLS was to be extended, there was no need to alter policy this month; it seemed advisable to wait-and-see what additional support to credit supply and broad money growth might be forthcoming. Nevertheless, with slack in the economy, particularly in the labour market, and good reasons to fear that persistently sluggish demand growth would feed through into damage to Britain’s supply capacity, monetary policy should be biased towards additional ease until such a time that there was a clear, self-sustaining momentum in broad money growth. The demands from regulators for UK banks to increase their capital buffers – by between £25bn and £50bn – by year end would be an important headwind to monetary creation in the short-run that monetary policy could attempt to offset.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate; no more QE.

In his vote in absentia submitted following the SMPC gathering, Andrew Lilico expressed the view that, with GDP growth somewhere between slightly negative and slightly positive for two years, it was understandable that policymakers were scrabbling around for some new magic bullet to boost the economy once more. Such initiatives included the FLS, the ‘help to buy’ scheme and flexible inflation targeting. What policy makers did not want to accept was that there are no painless fixes here. This was not a crossword puzzle to solve with a moment's inspiration.

On the other side, were a few defeatists who said that we must learn to live in a growth-free world. Andrew Lilico claimed that we should not accept that either. The government could do some positive things to boost medium-term growth. For example, it could: cut the size of the state; raise public sector productivity; raise the workforce size through higher retirement ages, and privatise or liquidate the nationalised banks.

Macroeconomic policy, per se, could not boost medium-term growth – as Mark Carney had acknowledged recently. Done to excess, though, macroeconomic looseness could damage growth, and had arguably been doing so for some time. Those that argued for yet more stimuli should ask themselves this question: "What would persuade me the path of stimulus was not working, if not the past three years' experience?" If the answer is: "Nothing", what you have in place is a habit, not an economic policy.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate; additional QE to be used only if the Euro crisis re-emerged.

Kent Matthews said that nothing had changed in the economy since the last physical meeting of the SMPC, held on 15th January, to make him change his mind on policy. Monetary policy had run its course and there was no sign that the economy was going to respond the low interest rates or the past policy of QE. He agreed with Phillip Booth that the problem of the economy was a supply-side one. QE and low interest rate policy had distorted the capital markets making inefficient the natural process of financial intermediation. Low interest rates were keeping enterprises that should have died in a state of ‘un-death’. This was starving new enterprises of much needed funds. Bank policy was hampering the efficient working of the capital market. While there was a need to regulate banks, he agreed that this was something for the future. Even announcing tighter regulation in the near future would influence commercial banks’ expectations and create perverse effects. Tighter regulation should be suspended until it was clear that the economy was on the road to recovery. He voted to raise Bank Rate by ½% and to hold QE which could be deployed if the Euro crisis were to flare up as it would inevitably.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate.

Patrick Minford said that the credit channel was blocked. America had managed to unblock its own credit supply through the US Federal Reserve buying sub-standard assets. However, the Bank of England had refused to buy anything other than gilts. The conservative attitude of the British Central Bank towards policy and towards the regulation of the commercial banks had blocked the credit channel. QE had distorted the capital market, which had made it cheap for the government to borrow but not companies. Distortionary monetary policy had resulted in firms being kept artificially alive while starving credit elsewhere. Funding for lending was an attempt to unblock the credit channel but with little success. He said that the capital regulations for the banks should be suspended in order to unblock the credit channel. QE should be stopped and interest rates should be pushed up. The problem was that the Treasury was focussed on fattening up the Royal Bank of Scotland group and Lloyds for sale so that the taxpayer did not incur a loss. It meant that the banks were more engaged in building up capital than in lending and reviving the economy. He said that interest rates should be raised to 1%.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up and privatise state-dependent banking groups; raise Bank Rate further, and hold QE.

David B Smith said that the economy had experienced a major – and predictable – supply withdrawal. There was a mass of empirical evidence that a rising government share in national income reduced capacity in the long term, even though there might be a short run boost from fiscal policy. His own statistical research suggested that roughly one-third of the output shortfall in the OECD area as a whole since 2008 had occurred because of the increased socialisation of the international economy since 2000, although the rest does seem to have been associated with the financial crash. In the UK, there were three things going on simultaneously. First, the increased socialisation of the economy had contributed to slightly over one half of the output shortfall since 2008, although the rest was statistically associated with the crash, if these were assumed to be independent events. Second, monetary policy had provided some transitory stimulus. However, monetary ease could not stimulate output in the long run – when the supply side was the crucial influence – and it had probably exhausted its effectiveness by now. Third, incentives and regulation had had perverse effects, especially in the case of the commercial banks.

With macro-policy exhausted, there was an overwhelming need to implement bold micro reform of the economy generally and financial institutions, specifically. For competitive reasons, as well as the too-big-to-fail issue, we needed to go back to smaller banks with regional head offices in some cases. This could be quickly brought about by breaking up the big state-owned banking groups into their historic constituents and flogging off the bits at the best price that could be achieved. He accepted that this might leave the government with a rump ‘bad bank’. However, competition and manageability should be the goals, not trying to get the taxpayers’ money back. Policy needed to address three issues. These were: first, deregulation; second, government spending, and third, the structure of the banking market. He voted to raise Bank Rate by ½% to restore monetary discipline to refocus on inflation. There was nothing further to be gained from additional QE.

Philip Booth cautioned the committee not to advocate a top-down bank restructuring because markets were not being allowed to come to a natural solution. In response, David B Smith said that he accepted Philip Booth’s argument as a general rule, when the starting point was a competitive system. However, that was not the case with the British banks, which were heavily cartelised, often as a result of officially encouraged mergers, such as those of the early 1920s and the late 1960s, which had reduced the number of clearing banks from eleven to five.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; no extension of QE.
Bias: To raise Bank Rate further.

Peter Warburton agreed with the diagnosis that blockages in private sector credit transmission were the greatest impediment to UK economic recovery. Policy innovations, such as the extended FLS and the help-to-buy initiatives were designed to “fly under the radar” of an overbearing financial regulatory regime. FLS has demonstrated beyond all reasonable doubt that it is market interest rates that matter to economic behaviour rather than the largely irrelevant Bank Rate. Paradoxically, to regain relevance, Bank Rate needs to increase in order to reconnect with the market structure of rates. With the Budget announcement of a new Bank of England remit and the invitation to further policy experimentation, it is imperative that Bank Rate is not committed to remain at ½% for an extended period. Were this to be done, its irrelevance would be ever more apparent.

However, with the addition of the massive dose of Japanese quantitative and qualitative easing, the force of global reflationary policy has increased materially. Japan has an urgent agenda for economic expansion and for policies to affirm the credibility of the 2% inflation target. It would be a surprise if the global economy did not strengthen, and also display more of an inflationary bias, in the remainder of 2013. UK’s distinctive susceptibility to imported inflation, aggravated by early-year Sterling weakness, reinforces the argument for beginning the process of Bank Rate normalisation.

There are compelling reasons to diversify some of the £375bn of existing QE into a portfolio of other assets, including securitised property, infrastructure and possibly even SME (small and medium-sized enterprises) assets as a means of lowering the regulatory burden of the banks that relates to these loans. The fact that the ‘Bad Bank’ debate has revived in recent weeks is a reminder of how little structural progress has been made to restore health to the UK banking system.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold; no further QE.
Bias: Neutral.

Trevor Williams said that Bank Rate should be held and that QE should also be on hold. In the UK, household savings had risen and government savings were not as negative as they once were. However, significant further adjustment was required before they were stable. Corporate balance sheets were robust but adjusting lower as household savings rose. In other words, corporate profit growth seemed to have slowed sharply. The wider current account balance of payments deficit last year, at 3.7% of GDP, was a sign that the savings/investment balance in the UK was still misaligned. A troubling economic environment in Europe was making it very difficult for the UK to grow through exports, although the situation was not helped by the domestic fall in productivity and the subsequent rise in unit labour costs. Nevertheless, raising interest rates was not the answer, despite the legitimate worries about the negative effects of keeping them too low for too long. Keeping rates on hold did not preclude the need for supply-side reforms to help kick start confidence and recovery. Indeed, it bought time for this to happen. An immediate increase in rates would most likely lead to higher default rates and hit already fragile consumer and business confidence, further delaying recovery rather than speeding it up. He voted to hold Bank Rates and hold QE. However, the Bank should buy non-gilts if further QE was to be exercised.

Policy response

1. On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in May. The other three members wished to hold.
2. There was only modest disagreement amongst the rate hikers as to the precise extent to which rates should rise. Six voted for an immediate rise of ½% but one member wanted a more modest rate rise of ¼%.
3. All those who voted to raise rates expressed a bias to raise rates further. There was also a common view that QE would be more effective if it was directed towards the purchase of private-sector liabilities, rather than government bonds.

Date of next meeting
Tuesday 9th July 2013.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

In its most recent e-mail poll, which was finalised on 27th March, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 4th April. Two SMPC members wanted an immediate increase of ½%, while three wanted a rise of ¼%, implying a rise of ¼% on normal Bank of England (BoE) voting procedures.

This represented the third consecutive month that a majority of shadow committee members had decided that a rate increase was justified on economic grounds, and the second month in a row that it was five to four in favour. Of the four that voted against a rise, none voted for more QE though it was held in reserve by one.

The verdict on the Budget was that it was neutral and so will do little to stimulate the economy. More broadly, some believed it was a missed opportunity: to go further in stimulating the economy via capital projects to kick start growth and more on the BoE’s remit. On the latter, the worry was generally that the changes announced and Mark Carney’s arrival suggests a period where monetary policy would be loose and could be seen to endorse inflation.

Fears about the public sector's debt position were felt by some to have been vindicated in the Budget. With more debt, for longer in the future, with not enough effort in the view of some to rein it in, prospects for recovery were damaged.

For one, lack of control of fiscal policy is as responsible for the lack of recovery as the supply side issue that the UK faces. For another, that the rating agencies were too slow to recognise the UK’s debt problem, not too fast. One worried that the focus on both fiscal and monetary policy is wrong and self defeating, their failure actively contributing to the weakness of the economy. Structural reform is key to recovery.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: To achieve low and stable growth of the quantity of money (broadly-defined).

Disappointment about the UK economy’s performance is widespread today. The government is under pressure ‘to do something’. However, its macroeconomic options are limited. Some Keynesian critics say that the government should boost its own spending, in order to stimulate aggregate demand as a whole. But the large budget deficit and associated increases in public debt prohibit such so-called ‘fiscal reflation’, while experience over many decades shows that fiscal policy does not work in the manner discussed in the textbooks. The Budget documents therefore endorse ‘monetary activism’, with the Bank of England (BoE) reported to have been given new powers to influence the economy in a positive way.

I would say that the central problem in monetary policy at present, as over all of the last five years, is that banks cannot readily grow their balance sheets while they are struggling to meet officialdom’s demands for more capital and liquidity relative to risk assets. Since equilibrium national income is a function of the quantity of money broadly-defined (i.e., of the total of bank deposits, more or less), officialdom’s demands remain a powerful deflationary force. Monetary activism in the form of ‘quantitative easing’ (QE) (i.e., the creation of new bank deposits [money] by the state) has been tried and has been vital in mitigating the officially-imposed deflation. However, various initiatives ‘to ease credit conditions’ – such as the Funding for Lending Scheme (FLS) and the granting of powers to the BoE to purchase corporate bonds (i.e., to engage in the ‘credit easing’ advocated by Ben Bernanke) – are of little importance relative to the clamp on money growth implied by the official pressure for safer bank balance sheets.

The Budget announced that public sector net borrowing is expected to be about £120 billion in the coming 2013/14 fiscal year, much as it was in 2012/13. The Office for Budget Responsibility (OBR) has correctly said that Mr Osborne’s campaign to reduce the budget deficit has ‘stalled’. As a result, public debt will rise faster than national income this year and next. Even more worrying are the medium- and long-term prospects for the UK’s public finances. In documents published with the Budget the OBR sets out a plan with assurances that, on present policies, the debt/GDP will peak in 2017. However, it had previously given assurances that the debt/GDP would peak two or three years earlier, and it was wrong. The remainder of this note discusses why the government has failed to bring the budget deficit down to lower and more sustainable levels.

The economy’s weaker-than-expected growth performance is often mentioned as the main cause of the disappointing fiscal arithmetic. Since the start of the Conservative-LibDem coalition government in 2010, growth of national output has been lower than envisaged. As tax revenues are a proportion of national output, they also have been lower than forecast. On this basis the blame for the above-target deficit outturns lies with the ‘supply side’ of the economy, which is understood as having less dynamism than in the 1980s and 1990s for all sorts of reasons that cannot be immediately remedied. Osborne has not yet been criticised because of unsatisfactory control of public expenditure. Indeed, the standard badmouthing he receives from ‘the left’ in British politics is that he has been too austere (or even ‘too austerian’, to quote Paul Krugman’s neologism in his 2011 book, End this Depression Now!). The left seems to think that Osborne has been dogmatic and uncaring in his commitment to lowering public expenditure. My argument here is that some important evidence does not support this view. On the contrary, Osborne has not reduced general government consumption at all.

As is well-known, Gordon Brown reacted to the Great Recession by so-called ‘Keynesian fiscal reflation’, so that government consumption continued to grow even as private spending and the government’s tax revenues fell. That led to the sharp widening in the budget deficit recorded between 2007 and 2010. After the change of government in 2010, the first few quarters of data appeared to suggest a move to austerity. The annual change in general government consumption was negative in each of the four quarters to the second quarter of 2011. Meanwhile, the rebound in the economy in 2010 and early 2011 boosted tax revenues, causing the budget deficit to drop significantly from 11% of GDP in 2009/10 to 8% of GDP in 2011/12. Osborne’s Plan A seemed to be in place and the UK retained its triple-A credit rating.

In the last few quarters for which data are available (i.e., up to the third quarter of 2012), general government consumption was rising faster than total expenditure in the economy. On this basis the claims of tight expenditure control under the coalition governments, and the polemics about an unjustified move to austerity, are invalid. Total expenditure in the economy is predominantly expenditure by the private sector. Whereas it has been barely growing since 2011, general government consumption has been increasing at about 2% - 3% a year.

It is therefore not true that the setbacks on the budget deficit are entirely to be attributed to weak tax revenues and the inability of the economy to expand because of supply-side constraints. The setbacks on the budget deficit are also to be explained by rising public expenditure. Osborne and his team have a more definite responsibility to control government consumption than the government’s transfer payments, the levels of which are set partly by statute and the economy’s performance (as with welfare benefits) and partly by conditions in the government debt market (as with debt interest). But an obvious link holds between control of government consumption expenditure and the budget deficit, and then between the budget deficit and the burden of debt interest. Further, the higher is the budget deficit, the greater is the increase in the national debt and – for any given average interest rate on the debt – in the debt interest that has to be paid on the debt.

The analysis in this suggests that so far Osborne’s record in curbing the budget deficit has been at best mediocre. In the last few quarters he has allowed government consumption to increase noticeably in real terms. That is one reason why the budget deficit will remain well above 5% of GDP when the present Conservative-LibDem coalition government comes to an end.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%. No change to QE.
Bias: Neutral but liquidity support available if Eurozone situation deteriorates.

Several important things came out of the March 20th budget. One is the continued implausibility of the OBR’s growth forecasts. Although the 0.6% growth forecast for 2013 is disappointing, the subsequent rates of 1.8% (for 2014), 2.3% (for 2015) and 2.7% (for 2016) are hard to believe. The OBR appear oblivious to the fact that there has been a negative supply shock, and even if potential GDP remains >2% there is little rationale for believing that the output gap will be closed. As I argued in a policy report for the Mercatus Center, the forecast reduction in government spending as a proportion of GDP can in large part be attributed to over optimistic growth forecasts. Attempting to stimulate aggregate demand in a world where potential GDP has fallen will lead to frustratingly sluggish growth and rising inflation expectations (having almost fallen to 3% in 2012, they are now approaching 4%) – exactly what we see today.

The Chancellor’s attempts to reignite a UK boom in subprime lending appear to be a muddled attempt to kick life into the housing market. It is not clear whether it will help the intended target of those priced out of the housing market, as opposed to existing homeowners using public money to cash in on another housing bubble. However, the combination of low interest rates and reduced lending standards generates adverse selection (in terms of enticing people to take on debt that they cannot afford to service) and moral hazard (incentivising mortgage holders to take on more risk). Lending standards provide an important market test and “Help to Buy” backfires if it’s help to buy an asset that you cannot ultimately afford. In a 2012 report the Financial Services Authority (FSA) pointed out that although sales of fixed-rate mortgages were increasing relative to variable rate ones, there has been a sizable shift of people already on mortgages from the former to the latter – 55% of new mortgages were fixed rate, but less than 30% of outstanding mortgages were fixed. Although it is incredibly difficult to use monetary policy to deflate specific asset bubbles, the BoE should not facilitate government efforts to maintain them. The release of data regarding the FLS should generate scepticism about the Chancellor’s efforts to widen the scope. There’s no doubt that such schemes can help at the margin but it is unlikely that they will drive banks’ decisions to extend credit.

In terms of the monetary policy remit, the announcements were underwhelming. Moving towards forward guidance ties the hands a little of those who attempt to simulate the MPC’s decisions, and inevitably turns attention away from speculating about policy decisions and towards the remit itself. Delaying the date in which the letter to the Chancellor is due constitutes an acknowledgement that inflation will continue to remain above target, without changing that target. Adding the objectives of “growth and employment” constitutes a slightly more flexible target, but is merely making a vague de facto remit, a vague de jure one. It formalises the discretion with which the MPC have already been utilising, but fails to offer a clear replacement. It is this leeway that is stymieing recovery, because it generates uncertainty. It would have been preferable to combine a nominal growth target with unambiguous expectations about its future path. Nominal GDP grew by 6.6% in Q3 2012 (relative to the previous quarter), but only 0.4% in Q4. Most would agree that going forward the optimal rate is somewhere between the two, but the stability of expectations are more important than the actual rate. In a similar way, it is the permanence of QE that determines its impact, and uncertainty about how the stock of QE will be maintained over time has limited its potential impact. Forward guidance is a fairly meek way to manage expectations relative to the types of commitment central bankers should be making.

Over the past few months, I have argued that the overriding goal of the MPC should be to get back to a neutral monetary policy, and I would still argue that rates are artificially low. Even though there is a danger of raising them too soon, the events in Cyprus also remind us that there’s a limited window of opportunity. With such disappointing growth figures it would be dangerous to raise interest rates without also have a clear communication strategy to explain why, but for the purposes of debate I vote for a moderate rate rise even without this. If events in the Eurozone begin to pose a serious risk to the UK banking system, it would be unwise to wait until an MPC meeting to act. Therefore the BoE should be prepared to offer liquidity provisions as and when needed.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Monetary growth, the housing market and survey evidence point towards a muted recovery in 2013. The Budget was fiscally neutral and won't change the short-term economic outlook. Nor should it. Fiscal policy should concentrate on deficit reduction and long-term growth, by improving the incentives to work, save and invest. The underlying budget deficit is stuck. Over the 2011-12, 2012-13 and 2013-14 period the underlying deficit is flat at close to £120 billion. Yes, it is projected to fall thereafter, but these are forecasts and the error factors are huge ¬¬- around 1 percentage point of GDP per annum for every year ahead i.e. £15 billion 1 year ahead, £30 billion 2 years, £45 billion 3 years etc. It wouldn't take much for the budget deficit to get stuck at £100 billion for as far as the eye can see.

I differ with the consensus about the short (stronger) and long term (weaker) economic outlook. Basically, I think the short-term outlook, driven by the recent pick-up in broad money growth, could be a little stronger than expected. With regard to the long-term outlook, the potential growth rate of the UK economy is probably below 2 per cent. If so, and in the absence of radical supply-side reform, fiscal policy will be under pressure throughout the current decade and as a result monetary policy could remain loose for the entire period.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise rates ½% and no more QE.
Bias: To raise Bank Rate.

Rationale: British policymaking is stuck in a rut. The Fixed Term Parliaments Act has condemned us to no General Election until 2015, when in a healthy political system we might have had two General Elections by now, since 2010. Policymakers are therefore trapped by foolish promises they made in 2008 and 2009, or even earlier, regarding their approach to fiscal and monetary control. That has meant that any concerted effort to raise the UK’s sustainable growth rate by cutting government consumption spending early or seriously increasing the efficiency of government consumption spending has been impossible. The government, having in 2011 abandoned its target of eliminating the structural deficit over a Parliament, has in the latest Budget abandoned any attempt to cut the deficit at all, being content to allow the deficit to sit at £120bn in 2011/12, 2012/13 and 2013/14. With no deficit reduction scheduled in the deficit for three years, the government’s economic policy can no longer even pretend to be a “deficit reduction programme”.

Having abandoned efforts to cut the deficit or raise the sustainable growth rate, and with events in Cyprus reminding us – if the experiences of Iceland, Ireland and Spain were not already lesson enough – that countries with as large banking sectors relative to GDP as the UK’s cannot save their major banks without bankrupting the state, the government is now clearly switching to a policy of “financial repression” to make its obligations manageable. Public service spending, benefits, tax allowances, and the deficit are all to be held in nominal terms, then inflation encouraged to accelerate fiscal drag, devalue benefits, and ease the burden of debts, whilst easing the balance sheets of bust banks by eroding the real value of their liabilities to depositors. Understandable though such a policy is, the choice of such a route constitutes surrender to events.

In the Budget a change to the monetary policy remit was announced, with George Osborne effectively informing the BoE that from now on it was fine for inflation to be as far above target as the Bank likes, for as long as it likes. That such a change in the remit was greeted with a shrug and remarks along the lines of “But that’s what policy has been for years anyway” just indicates how totally the BoE’s credibility has been eviscerated in recent years.

The new BoE framework can best be described as “not avoiding inflation”. Policymakers around the world, through the long and sad history of the monetary system of exchange, have found not avoiding inflation a tempting route. It often seems as if letting inflation go just a little higher would make everything just that little bit easier. But once inflation goes much above 5% it becomes volatile as well as difficult to keep down. The consequence will be that employers and workers will be forced to anticipate inflation in wage-setting. However, they will find it difficult always to predict inflation accurately. A number of consequences spring from this: some years employers may pay far too much, and either go bankrupt or cannot hire workers; in other years employees may be paid far too little, and therefore find themselves unable to service their own debts. High and volatile inflation thus causes unemployment and personal and corporate insolvency. Policymakers appear so set on attempting (but failing) not to repeat what they regard as the failures of the 1930s that they have forgotten the key lessons of the 1970s and 1980s and set aside the core insights of the macroeconomic theory of the past forty years.

This is the most fundamental lesson of the past few decades of macroeconomic theory and practice: neither fiscal nor monetary policy can raise the medium-term growth rate of economies, but can lower it if pursued to excess. Debates about “fiscal stimulus” and “flexible inflation targeting” thus miss the point. We do not have a short-term problem susceptible to short-term solutions. We have a deep-seated structural problem that only structural solutions can address. Monetary and fiscal stimulus measures have had their go, and achieved what they could. They have now passed the point at which they do good and reached the point at which they do harm, and the longer they are kept in place the more harm they will do.

Comment by Kent Matthews
(Cardiff Business School)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: To raise rates further.

In case anyone thought that the euro crisis looked to be coasting towards some sort of resolution based on the politician’s hope that something ‘good’ will happen if we could just hold on, the whole thing flares up again. Indeed this crisis will run and run with periodic lulls until something ‘good’ really happens as the politicians hope or the whole experiment be declared a failure with the breakup of the single currency. Whatever happens in the future, the Bank needs to have enough ammunition in its arsenal to use against the fallout from a likely breakup and the inevitable contagion of the ensuing bank crisis. QE worked to arrest a fall in the financial markets from developing into a disastrous collapse. It can be used again if the euro crisis threatens to turn into a survival phase with all the negative implications for the UK.

With this backdrop it has certainly not been a good time for Cameron’s fourth budget. Earlier, Moody had downgraded UK debt from its AAA rating and now Fitch has placed it on negative watch. The budget itself was unadventurous with only weak signals of a future supply side policy that might have positively influenced growth expectations and provided a boost to domestic investment spending. What is left of policy is a dependence on the continuation of a supposed loose monetary policy that has demonstrably failed to stimulate a moribund economy. More of the same does not sound like a good policy.

There are three reasons why the Bank should start the process of raising interest rates – two good ones, and one weak one. If the euro crisis reaches a terminal phase with the knock on effects for the UK economy, at near zero interest rates, monetary policy has no traction. A phased rise can be reversed sharply if needed to provide comfort to financial markets. The second good reason is that the current policy has led to the survival of zombie corporates (bank credit insiders) while companies that need to grow (bank credit outsiders) are faced with a credit famine and relatively high borrowing rates and tough conditions. The result is that the current policy of QE and low official bank rate has denied the economy of a Schumpeterian process of ‘creative destruction’. The third reason is that the Bank, even belatedly can try and restore some credibility to its inflation target policy. It is a weak reason because the credibility of its anti-inflation policy may well have been irreparably damaged and any rise in interest rates may fail to influence inflation expectations. However, it is worth a try!

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

While there has been criticism of the Chancellor’s decision to subsidise mortgages, for me this is a most significant step for monetary policy. As I have argued in previous SMPC submissions, excessively harsh regulation of the banks – and especially the heavy new capital requirements which are expensive to meet now when banks are unattractive to investors – have raised the costs of credit to SMEs and personal borrowers, the two sets of clients who have no effective alternative to banking. So the credit channel is blocked by regulation.

By subsidising mortgages which are widely used by both these client sets, the Treasury is directly offsetting this distortion. It remains to be seen how effective the subsidy is in practice; as so often with these bureaucratic interventions one cannot know until the detail is laid out of how it is all accessed, what side-conditions and so on. However, what is becoming clear is that the Treasury and the Bank may at last be taking action to relieve the effects of their other, regulative, actions on monetary conditions; the FLS is another one of this type that may be having a modest effect. QE, as I have argued and shown in the data, is not doing the job; it is merely reducing returns to savers; cheapening the cost of credit to government, and possibly preserving ‘zombie’ clients.

It would be better to reverse the regulations and allow the market to work freely. But with the great and the good determined to regulate, as seen in the Parliamentary Committee and the Vickers Report, the only avenue left is this sort of offset.

My view therefore is that this latest mortgage offset, together with the FLS, should be consolidated and strengthened as necessary to eradicate the distortion and get the cost of credit down to these two sets of clients. QE should be stopped and steadily reversed. Interest rates should be raised towards normal levels, starting with 0.5% this month, with a bias to continue upwards. The object should be to return general rates to normal, while eradicating the abnormal premium on SME/personal lending.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

As expected, the Treasury has revised the remit for the BoE’s MPC to allow even greater flexibility in the interpretation of the inflation objective. Although the inflation target remains unchanged at 2% “at all times”, there are three concessions to flexibility that are potentially significant in combination.

First, the MPC has been given permission “to deploy forward guidance including intermediate thresholds in order to influence expectations and thereby meet its objectives more effectively. The Government considers any use of intermediate thresholds to be a matter subject to the Committee’s operational independence in setting policy, to be considered in exceptional circumstances. The Committee is requested to provide an assessment of such approaches to setting policy alongside its August 2013 Inflation Report.”

Second, in forming and communicating its judgments the Committee should promote understanding of “the trade-offs inherent in setting monetary policy to meet a forward-looking inflation target. It should set out in its communication … the horizon over which the Committee judges it is appropriate to return inflation to the target.”

Third, when actual inflation departs from the target, in conjunction with the publication of the MPC minutes, the Committee should “communicate its strategy towards returning inflation to the target after consideration of the trade-offs.”

The disturbing aspect of these remit changes is the acquiescence of the Treasury to the Bank’s judgment and economic model. The terms of the remit allow for two distinct circumstances in which departures of inflation from target will be tolerated. The first takes for granted that there is a clearly identified short-run, and perhaps medium-run, trade-off between inflation and real economic activity. The second concerns situations where “attempts to keep inflation at the inflation target could exacerbate the development of imbalances that the Financial Policy Committee may judge to represent a potential risk to financial stability.”

Hence, the MPC is given the flexibility to “look through” inflation deviations when to tighten monetary policy would be judged to create additional output volatility and/or to jeopardise financial stability. In essence, the Bank has been given carte blanche to disregard the inflation target over an indefinite horizon.

There is an underlying premise in the Treasury document “Review of the monetary policy framework” that the sources of above-target inflation are temporary and irrelevant to the operation of monetary policy. However, since QE plays a well-documented role in driving up primary product prices, then energy and commodity price impulses cannot be considered exogenous or temporary. Similarly, the side-effects of fiscal tightening such as higher excise duties, VAT or air passenger duty, reflect the reality of ongoing fiscal normalisation. These are not exogenous or temporary, either.

The remit is crafted as if the inflation rate were drawn, as if by a gravitational force, back to 2% per annum. It does not consider the alternative: that the UK inflation rate may be in transition to a new and higher equilibrium. Our decomposition of the Retail Price Index into semi-exogenous factors (e.g., administered prices, excise duties, oil and commodity prices) and prices mainly determined in the domestic private sector is revealing. The series for private sector inflation has a clear upward drift in its inflation rate that has been in place since 2005. The Treasury makes no attempt to explain the persistence of this trend, nor its implications for the task of anchoring inflation expectations. This upward drift in private sector inflation, mirrored in consumers’ inflation expectations, is unlikely to be arrested by the adoption of a more flexible inflation mandate.

Finally, the revised remit rules out the replacement of inflation targeting with nominal GDP targeting, but holds open the door for the level of nominal GDP to play a role as an intermediate threshold, should Mark Carney wish to exercise this freedom. For further illumination on this issue we must wait until August.

However, neither the scope for larger and longer inflation departures from target nor the freedom to adopt US-style forward guidance on the level of Bank Rate addresses the fundamental blockage in the credit system. Until the Bank of England relaxes the overbearing capital and liquidity requirements on UK banks and considers the purchase of private sector assets within its asset purchase programme, then the effective growth-inflation trade-offs will remain hostile. Mark Carney’s most pressing task as incoming Bank governor is to unblock the credit transmission not to construct an elaborate set of conditions under which Bank Rate may one day be raised. Indeed, if there is a role for ‘forward guidance’, it is to reassure markets of the Bank’s determination to take rates back to the region of 2% to 2½% over the next two years. An immediate move to ¾% is my preference.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold interest rate and no increase in QE.
Bias: Hold interest rate for now.

After a broadly neutral budget that allows the debt-GDP ratio to rise to levels not seen for fifty years, the weakening of the inflation remit of the BoE, the appointment of Mark Carney and the negative-watch warning from the credit rating agency Fitch, the question that is being asked increasingly is whether the UK is positioning itself to partly inflate away its debt. Although this would be officially denied, it is becoming increasingly likely and may even shortly come to be seen by many as the only politically acceptable solution. I think that this would be the wrong way out of our debt and growth problems.

There is no convincing evidence to show that increasing government expenditure would raise private consumption expenditures, even in the short term, as assumed in Keynesian economics. If it did so in the long run, this would imply, most implausibly, that the larger the government sector, the better off would people be. Increased government investment expenditures, if well targeted, would lead to an increase in GDP and consumption. It was probably a mistake by the government to cut these, but increasing them now would only bring longer term benefits to growth. I would have preferred a budget that put more money into the hands of those most likely to spend it immediately and paid for this by cutting further wasteful government expenditures.

The changes to the BoE’s remit are still vague but strongly suggest allowing more inflation in order to increase growth, especially over the cycle. This makes sense if higher inflation is due to a negative supply shock, but not if it is due to a positive demand shock. In fact, the BoE has already adopted this policy but, perhaps due to its remit, has not formally admitted it. It is clear, however, that such a change in its responsibilities are unlikely to have made much difference to the conduct of monetary policy in the current recession, or to have increased the ability of monetary policy via interest rates to affect the real economy. The zero lower bound to interest rates has caused this. Only outright money financing of the deficit might raise GDP in the short term. Even QE and bailing out the banks is fiscal policy. In short, whatever the , monetary policy is much less effective in dealing with a recession caused by a negative supply shock as now.

In my own recent research on the UK’s credit rating (CEPR Discussion Paper 9378, March 2013) I found that the UK’s credit rating should rather have been downgraded in the second quarter of 2008. From 2010, when the government came to power, the UK’s credit rating would have started to rise, and at the present time it is even healthier. In other words, the credit rating agencies appear to have got their timing of the UK’s credit rating completely wrong. The news in Moody’s and Fitch’s down-ratings is that they are too late.

In my view the Chancellor is correct to say that one of the main reasons why the UK economy has not performed better is its export performance to the Eurozone. I would add to this the rise in the UK’s saving rate as households and banks tried to rebuild their balance sheets. Although higher inflation would probably lead to a further depreciation of sterling – as well as reduce the real value of debt – I do not recommend this as the right solution for the UK because UK imports are not that price sensitive and exports to non-euro markets are already competitive, are growing and are higher than those to the euro area. The main problem with higher inflation that lasts too long or is too high, even temporarily, is that it risks raising longer-term inflation expectations. In short, I think that we just need to stick to plan A, be patient and not adopt policies for the short term that worsen things later. It was short-termism that got us into this mess in the first place.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and hold QE in reserve.
Bias: Neutral.

As the UK Chancellor said in the opening of his Budget speech, 'this is a fiscally neutral Budget'. So it proved, with spending increases offset by spending cuts and tax increases in future years. However, as the starting point in 2013/14 was worse than forecast in the Autumn Statement in December - a PSNB of £86.5bn rather than the £80bn expected then, some £6bn higher. The cumulative effect of higher deficits in coming years means that net debt peaks at 85.6% of GDP in 2016/17 rather than the earlier 79.9% in 2015/16. That represents an increase of roughly £100bn more at the end of the five-year projection period. Gross debt peaks at 100% of GDP.

It would have been worse but for an under-spend by government departments in this financial year that has been carried forward and used to increase spending in some areas. In addition, economic growth has been revised lower by the OBR for 2013, to 0.6% from 1.2%, and next year to 1.8% from 2.0% previously. Unemployment is expected to peak at 8% by the OBR and stay there for at least two years, and CPI inflation has been raised modestly higher for this year and next. The result of these revisions is lower tax revenues relative to the previous projection in the December 2012 Autumn Statement. But these figures did not surprise financial markets and so have had little impact. Gilt yields have actually fallen back somewhat and the currency has barely moved (though likely partly down to events in Cyprus). Essentially, fiscal austerity has been maintained in the medium term with little increased borrowing in the short term.

As for the monetary policy stance, once again there was actually little change in practice. The remit has been maintained, and a study of the UK's monetary policy framework published by the Treasury concluded that the mandate should continue to focus on the primacy of price stability and the inflation target. But the BoE has been asked to look at how it could refine its operational activities - by perhaps providing conditional forward guidance and by explaining in more detail the trade offs between greater inflation flexibility and the impact on growth. Although clearly influenced by the Federal Reserve’s current practise, the changes announced were close to the bare minimum that markets expected.

The main announcements from a corporate perspective were to boost infrastructure investment, to cut the main rate of corporation tax to 20% by 2015/16, and to boost housing market activity through various measures. All in all, this was a business-like Budget that enshrined the government's tight fiscal policy stance and the loose monetary stance of that has been in place over the last few years.

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

In its most recent e-mail poll, which was finalised on 26th February, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 7th March. Three SMPC members wanted an immediate increase of ½%, while two advocated a rise of ¼%, implying a rise of ¼% on normal Bank of England voting procedures.

This represented the second consecutive month that a majority of shadow committee members had decided that a rate increase was justified on economic grounds. However, no one expected to see an actual rate change this close to Mr Osborne’s 20th March Budget. In addition, four SMPC members believed the British economy was so weak that Bank Rate should be held, while one believed that additional Quantitative Easing (QE) would be required before the economy could recover.

The majority view was that the stock of QE should be held at its present £375bn, however. Both the SMPC’s ‘hawks’ and ‘doves’ included people who believed that QE would be more effective if the Bank bought more private-sector assets and relied less on government debt purchases. There was also disquiet about the extent of the structural fiscal weakness that might be revealed in the 20th March Budget.

This might exacerbate the downwards pressure on Sterling that was initially triggered by Sir Mervyn King’s comments at the 13th February Inflation Report launch and subsequently exacerbated by the removal of Britain’s AAA rating by Moody’s on 22nd February. The rapidly diminishing credibility of other aspects of UK policymaking made it difficult for the Bank of England to carry conviction, especially given its history of inflation overshoots, in the view of several SMPC members.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Additional QE and a rebalancing towards non-gilt assets.

Over the last month, the trade-weighted value of the pound has fallen by another 3½%. Its total decline so far in 2013 has been roughly twice as large. The implied fall in Britain’s real effective exchange rate (REER) represents an important stimulus to growth, given the economy’s need to rebalance away from domestic spending towards net exports. The extent to which this nominal depreciation translates into a sustained real depreciation is unclear; there is a possibility that it could be dissipated in a higher price level. However, given recent experience and the considerable slack in the labour market, upward pressure on unit labour costs should remain limited and a lower REER is likely to persist.

This removes some of the urgency for additional Bank of England asset purchases. Nevertheless, the case for continuing monetary aggression remains strong. Indeed, a major driver of recent sterling weakness has been the Monetary Policy Committee (MPC) itself. Its recent pronouncements suggest a greater willingness to look through above-target inflation, an expectation of additional gilt purchases – three MPC members voted for another £25bn at February’s meeting – and a desire to expand the authorities’ monetary arsenal. The minutes of the latest meeting point to a wide-ranging discussion of other tools to boost activity in the UK. While the Bank remains reluctant to undertake these unilaterally, there does appear to be some support for co-ordinated action. Importantly, there seems to be greater consensus on the MPC of the dangers for long-term supply capacity of allowing demand growth to be persistently weak. In technical jargon, the MPC’s ‘reaction function’ may include not just the output gap and the deviation of inflation from its target, but also the growth rate of output.

This is sensible monetary policy-making in today’s highly unusual environment. Even though Consumer Price Index (CPI) inflation is set to be above 2% into next year, the risks to inflation over the medium-term are limited. Powerful deflationary forces persist, including the on-going Euro crisis, the persistent failure to resolve global imbalances and widespread fiscal consolidation in the advanced world. A central bank concerned about wider financial stability and hysteresis effects on long-run supply capacity has a strong incentive to err on the side of doing too much. At the current juncture, this gives the green light for continuing monetary aggression.

However, there is also an argument for more targeted interventions. A general expansion of the stock of broad money via gilt purchases remains a powerful tool, and should continue to be used where necessary to maintain adequate bank deposit growth; but there are good reasons to consider other types of action, including co-ordinated steps with the government, that would involve the purchase of non-gilt assets. The obvious parts of the economy that could be helped via such a mechanism are: the commercial property sector, the home building industry and the energy and transport infrastructure sector.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%.
Bias: Raise Bank Rate further.

Two things suggest that the present situation of Bank Rate at ½% and a £375bn stock of QE may be about to end. On the one hand, growth remains sluggish at best, and three members of the MPC wanted to increase QE last month. On the other hand, CPI inflation continues to remain above target, and the Bank of England seems increasingly likely to publicly admit that they are happy for it to remain so. Both sides of the debate are finding compelling evidence to support their positions. One might think that the so-called ‘doves’ are the pessimists, because they’re still haunted by the (thus far, absent) threat of deflation. And the inflationary fears of the ‘hawks’ mark them as optimists, in the sense that they anticipate that past monetary easing will finally start kicking in. However, another way to view this is that by wanting to keep interest rates low indefinitely, the doves are implicitly assuming that once the present storm has passed it will be plain sailing. In other words, once the waters are calm again we can start to worry about exit policy. By contrast, the hawks may reject the idea that we are in the process of leaving the storm. Indeed, if one anticipates that there may be a deterioration in the health of the economy – whether it’s through another US fiscal cliff, a Euro-zone crisis, double digit inflation, etc. – then we might view the present as an opportunity to repair our defence mechanisms before the real storm actually arrives. In this sense, we need to fully consider the opportunity costs of keeping interest rates unchanged, and the trade-off between prompting a crisis as against having the monetary policy tools in place to respond to a future one.

As we prepare for the arrival of a new Governor, there seems to be greater attention being given to finding ways to loosen monetary policy. One of the problems with QE though is that the more successful it is the more it prevents markets from adjusting. The supposed positive impact of the Funding for Lending (FLS) scheme comes at the cost of propping up a housing market that is artificially high. In addition, interest rate guidance can backfire if the market interprets it as the central bank accepting that the recovery will be long and slow. Furthermore, it impedes the Bank of England’s desire to have a clear communication policy about their target.

Given that Nominal GDP is growing at a moderate rate, and growth in M4ex continues to rise – in December it hit 5.2% which is higher than it’s been for more than two years – the economy is in reasonable shape. One can always find reasons to wait but there’s even been good news on the fiscal front with a higher than anticipated surplus in January. The change in Governor also presents a window of opportunity to act. A moderate action would be to begin the process of raising interest rates back to their natural rate. This would make growth quicker and more sustainable, and also provide ammunition should external events cause a future deterioration. There is no reason to believe that raising rates would send a positive signal about the economy and boost confidence, but there’s also no reason not to believe that. A more ambitious action would be to get serious about replacing the regime of inflation targeting.

A Nominal GDP level target would help the Bank of England deliver monetary stability, and avoid the present challenges of trying to boost growth when inflation is above target. Most importantly, it would make future crises (caused by the central bank) less likely, because Nominal GDP is a better indicator of the monetary stance than CPI. Nominal GDP targets do not rely on timely and accurate estimates of GDP, because you can target market expectations instead. Mark Carney has indicated that a debate about monetary policy would be a good thing. One has to agree.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Maintain asset purchases at £375bn; only increase the total to offset declines in M4ex.

Why has economic growth been so much weaker in Britain than in the United States? This is not something that can be explained by a superficial comparison of the components of GDP. Keynesian economists tend to focus on the role of fiscal stimulus, yet this does not provide a satisfactory explanation of the different performance of the two economies. There has been much blame heaped on the coalition government for its strategy of austerity. However, the UK’s fiscal strategy has been less restrictive than that of the US when measured by the rate of narrowing of the budget deficit. In short, the US budget deficit has narrowed more, yet real GDP growth has been clearly superior to that in the UK. The explanation must lie elsewhere.

The evidence suggests several more fundamental factors that differentiate US and UK performance – namely the vastly greater leveraging up of Britain’s banks during the bubble, the relative failure of the British government’s measures to restore the health of the banks, and the more adverse consequences for the economy of British bank deleveraging. Ironically, the British government led the way in recapitalising the banks in the wake of the Lehman crisis, only to lose its lead to the US after the US Treasury’s Troubled Assets Relief Programme (TARP) was adjusted to focus primarily on repairing the balance sheets of the banks.

In the United States, the total debt of all domestic sectors (household, non-financial corporations, financial corporations and government) has declined from 311% of GDP in 2009 Q1 to 255% in 2012 Q3, a decline of 56 percentage points. In Britain, by contrast, total debt of all corresponding sectors has declined only about half as much. From a higher absolute peak of 561% of GDP in 2010 Q1, UK total debt has declined to 529% of GDP in 2012 Q3, a decline of 31 percentage points. Basically, this means British households and institutions are having more difficulty repairing balance sheets than their American counterparts. Is it possible to pin-point the differences?

Drilling down into the debt ratios for individual sectors shows that both the household and the non-financial corporate sectors in Britain are lagging in their balance sheet repair. However, the major problem is in the UK financial sector. This is partly on account of its larger size relative to GDP, partly on account of British banks’ high dependence on non-deposit financing (such as inter-bank borrowing and debt issues) during the credit bubble of 2003 to 2008, but also due to the adverse impact of financial sector deleveraging on the economy. Given the amount of balance sheet contraction that has been required of the banks, partly from regulatory pressure, and partly stemming from their own shareholders, creditors and customers, it was inevitable that banks should pass on the effects of deleveraging in the form of reduced lending and the imposition of tighter credit conditions to households and businesses.

Just as there was a positive feedback loop in the financial sector during the bubble which meant that rising asset prices created more collateral for banks to lend against, so in the current de-leveraging phase a negative feedback loop has operated whereby lower asset prices and tighter credit standards have reduced the amount that banks are willing to lend. Above and beyond all of this, the British government’s early measures to restore the health of the banking system were far less effective than the measures taken by the US authorities.

The process of US bank rehabilitation consisted essentially of four main elements. First there was greater attention to restoring capital levels: the US Treasury and the Federal Deposit Insurance Corporation (FDIC) required immediate recapitalisation by all banks, much of it directly from the government in the form of preference shares, but some of it from market sources. Second, this was quickly followed by a series of demanding stress tests and further rounds of capital-raising where necessary. Third, the FDIC required the banks to take substantial write-downs against toxic loans, and to take back ‘on balance sheet’ at least $400 billion of securitised loans, cleaning up their balance sheets by late 2010. Finally, the US Federal Reserve provided large amounts of additional liquidity by means of its QE operations, pushing banks’ excess reserves to $1.2 trillion by February 2010. In short, capital levels were greatly increased, loans were reduced, balance sheets were cleaned up, and liquidity enhanced. The net result was that US banks were able to embark on new lending by March 2011. Indeed, US bank lending has been growing at roughly 4% per annum since then – in marked contrast to the UK or the Eurozone where bank lending is still declining.

An additional factor that operated in the US but was not present in the UK was that the US banks were able to rely on the guarantees of the two giant nationalised housing agencies, Fannie Mae and Freddie Mac, which have served as an additional shock absorber for the mortgage portfolios of the US banking system.

In Britain, the successive shock failures of Northern Rock, then RBS and HBOS seemed to paralyse the government and the Financial Services Authority (FSA). Instead of forcefully taking them over in their entirety or insisting on some minimum level of systemic recapitalisation for all the banks, things were handled on a non-systemic, case-by-case basis. A systemic approach seemed beyond reach, either because the government had already shot its bolt with its very large current spending at the onset of the crisis, or because the amounts of capital required would have threatened the government’s AAA credit rating. In any event some banks, such as Barclays, were permitted to seek external sources of capital, while others like HSBC did not have to raise capital at all. The stress tests conducted by the European Banking Authority (EBA) in Europe and the UK were widely regarded as noticeably more lenient than those conducted in the US, and the extent of loan losses imposed was much less damaging to banks’ balance sheets. Consequently UK banks remained more leveraged and with less robust balance sheets than their US counterparts.

As an example of the consequences of this different treatment of the banks in the UK, consider the results of their reliance on non-deposit funding. At the peak of the bubble in early 2009, banks were funding an astonishing £760 billion or 55% of GDP from non-deposit sources. The subsequent withdrawal of these non-deposit sources by wholesale, domestic or foreign, lenders is inevitably forcing banks to deleverage – either by reducing their lending, or by selling their subsidiaries, whether core or non-core businesses. Based on the latest data, bank lending that is funded from non-deposit sources was still £184 billion in December, or 10.8% of GDP in 2012 Q3. This means that the British economy and the British banks, in particular, still have further to deleverage before they can start to expand again without relying on leverage.

In view of this challenging backdrop, it is appropriate for the Bank of England to keep Bank Rate at ½% and for it to continue to provide additional liquidity as necessary in the form of QE operations if, and when, money and credit threaten to become too tight in quantitative terms.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and QE.
Bias: Neutral.

Monetary growth, the housing market and survey evidence point towards a muted recovery in 2013. Consequently, there is probably no need currently to adjust QE or interest rates. Any tightening in interest rates risks a further weakness in Britain’s broad money supply at present. The argument for a tightening based on the misallocation of resources under QE is a tempting one. However, an immediate rate rise could prove counterproductive. This is because a higher Bank Rate could reduce the broad money supply, which would hasten the need for an offsetting, and economically distorting, expansion in QE in turn.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To Raise Bank Rate.

The British economy has, as expected, been downgraded from AAA status – first by Moody’s. Moody’s key driver for this decision – the poor medium-term growth outlook for the UK – is entirely correct. Most discussion of growth policy in the UK is highly confused. Monetary and fiscal policy can move growth around in time, so as to achieve the country-wide equivalent of household consumption smoothing, limiting recessions in exchange for lesser booms.

However, we need to recall the old truth that it is only supply-side and structural reforms that can increase medium-term growth rates, not government borrowing or loose monetary policy. That is the central lesson of macroeconomics of the past forty years, and yet people forget it so easily: if we have a medium-term growth problem we cannot solve it with fiscal or monetary stimulus, since neither fiscal nor monetary policy can increase medium-term growth; they can only reduce it if they are done to excess.

Monetary policy has passed that point of excess. Remarkably, at the last MPC meeting three members voted to increase QE even though the Bank itself forecast inflation to be far above target for years – illustrating how little the inflation target constrains policy any more. MPC members have stopped even pretending that their decisions to print extra money are driven by the need to avoid inflation falling below target several years hence in some model that systematically under-predicts actual inflation. Now they are content to vote for even more inflationary measures when they themselves say inflation will be above target.

Monetary policy is a powerful short-term tool. It can limit damage during the first eighteen months of a severe recession. It can limit the peaks and troughs of more normal and gentle cycles. It can prevent inflation running away. What it cannot do is to create medium-term growth.

Interest rates were cut to near-zero in late 2008 and early 2009. Good. We started printing money from early 2009. Excellent! But at some point any serious economist should accept that monetary looseness has had its go and must make way for longer-term policies. Six years into the financial crisis, and four years into zero rates and quantitative easing, it is surely reasonable to ask whether the short term has now turned into the medium term.

To put the point the other way around: almost everyone is agreed that current policy is not working, and many say it’s time to try something else. We have tried the path of ‘über’-looseness and it did not work. Might we not, whilst there is yet time to try something else, try the path of merely extreme-looseness, tightening a little to see if it helps?

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks; unwind QE.

It should be reasonably clear by now that the UK has slow growth for ‘fundamental’ or ‘supply-side’ reasons. First, the huge rise in raw material prices has impoverished us. Since the Bank of England has done little to stop this raw material inflation passing through into consumer prices, a rough measure of how much living standards have been driven down as a result is provided by the cumulated excess of inflation over the 2% target since 2006. This will be 7% up to the end of this year on the assumption that inflation averages 2.8% in 2013. The hike in raw material costs is probably the biggest element in causing the drop in real income; an adverse movement of this size in the terms of trade is just like a fall in productivity. Essentially, it means that, for the economy not to spend permanently more than its income, spending must drop by this amount. Notice that this cannot be offset by higher demand from government, say, because it is permanent; any attempt to do so would lead to excess international borrowing and hence solvency problems.

Along with this, there is a consequent fall in output, as permanently lower demand deprives various home-focused industries of their market: housing is the most obvious but other industries particularly affected by high material costs are also hit, notably transportation and travel. Hence we notice that certain sectors, such as volume cars and house building, have great excess capacity. However, since demand cannot be stimulated in a general way, this excess is ‘structural’ and has to be disposed of by accelerated depreciation. This is no doubt why measures of relevant ‘excess capacity’ (i.e., in sectors where there has not been the same structural collapse) are small.

Then, we come to the collapse of the UK’s two most productive sectors, North Sea oil and banking. This collapse appears to account for the bulk of the fall in labour productivity since the crisis. Both collapses were partly due to circumstances – with the North Sea, it was the exhaustion of extractable reserves and with banking, the crisis itself – and were partly due to government actions. With the North Sea our governments have been ‘time-inconsistent’, constantly changing the rules to squeeze extra income out of the industry; the extractive oil and gas industry no longer has much confidence that any further exploration/extraction efforts will not be milked by HM Treasury. With banking, the Coalition government has, as I have argued repeatedly, over-reacted in its new regulative agenda while also failing to restore bank competition; hence the industry is contracting sharply. This was an avoidable disaster.

Finally, we come to the main side-effect of the banking collapse – the fatal blocking of the credit channel. This is another ‘structural’ element in our economic situation which is turning out to be non-remediable by monetary means; no amount of QE and bureaucratic schemes like FLS has loosened this constraint because the regulations create massive incentives for bank contraction.

So, like it or not, our situation is one of weak growth forced on us by fundamental constraints. Only supply-side action can change this situation. Apologists for ‘demand stimulus’ argue that the government could spend more on infrastructure, which is true as borrowing against good long-term projects is not difficult and does not undermine solvency. However infrastructure projects are held up by planning and political hurdles, not particularly by lack of funds. Other apologists point to the effect of the Second World War in stimulating output. Of course, a war changes an economy’s structure towards the production of armaments and military consumption, and a one-industry state can commandeer the means of production and force them to operate at high capacity; but in peacetime the economy is diverse and structural/supply-side issues have to be solved by peacetime policies to get the resources into the right places and permit growth based on market forces.

Where does this leave monetary policy? The answer is in a difficult place. QE and ultra-low interest rates are doing nothing to change growth, as one would expect. They are in fact massively distorting the market for savings by creating a privileged borrower, HM Treasury, at the expense of those committed to lending to it (e.g., for pension reasons). They are also subsidising bank profits on their existing balance sheet by giving banks a large arbitrage profit on the bank reserves produced by QE. Through this subsidy the present policy is distorting credit supply in favour of large existing firms, which seem like ‘zombies’ to be on bank life-support. It is time to put an end to these distortions and return to a realistic monetary policy that understands its limited capability.

If the government wants to stimulate money and credit, then it should look to the serious loosening of the new regulative framework and also a renewed push for bank competition, perhaps by break-ups of the large Treasury bank holdings into several smaller banks. In my view, the ring-fencing debate is an irrelevancy and an intrusion into industrial structure – the banks have argued persuasively that they need to be able to fulfil multiple functions. What matters is the number of banks and the competition they engender, which has been curbed sharply by the new cartelised set-up. Of course if the government did succeed in this loosening up, the huge overhang of QE would be an inflationary threat as existing bank reserves would be rapidly converted into credit expansion. Far better therefore to unwind this programme while there is still no threat, because the banks are immobilised by regulation. In summary, I recommend a rise in interest rates by ½%, no further QE, and a programme to unwind QE, while raising rates to normal levels, over the next two years.

Comment by David B Smith
(Beacon Economic Forecasting and University of Derby)
Vote: Raise Bank Rate by ½%; hold QE.
Bias: Avoid regulatory shocks; break up and fully privatise state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

With the UK Budget scheduled for 20th March and something of an inter-regnum in place at the Bank of England until Mark Carney takes over on 1st July, it is most unlikely that Bank Rate will be altered when the MPC meets on 7th March. In addition, it is improbable – albeit, possible – that any substantial new QE initiative will be announced, either. This does not mean that a rate rise might not be desirable on economic grounds simply that it is unlikely to happen. An interesting aspect of the MPC minutes, published on 20th February, was the sign that officials were already anticipating the more activist monetary stance believed to be preferred by the incoming Governor. This clearly helps to smooth the transition. It is possible that Sir Mervyn King’s unexpected vote for an extra £25bn of QE in February reflected the discussions that he had been having with his successor. Given that a well-run monetary policy should minimise the shocks it delivers to the real economy, this would all be very reasonable and civilised if that is what actually transpired.

Such civilised niceties should not be allowed to disguise the fact that UK fiscal policy is now massively – and, humiliatingly for Mr Osborne – off course and that British policy makers are losing their credibility in the financial markets, as can be seen from the decision by the Moody’s rating agency to withdraw Britain’s AAA rating. One result is that a 1976 style stabilisation crisis can no longer be ruled out, particularly as we draw closer to the 2015 general election date and the prospect of a Labour government or a Labour/Lib-Dem Coalition. For anyone who remembers that period, there are aspects of the current UK economic conjuncture that are reminiscent of the policy errors of the mid 1960s and early 1970s that culminated in the December 1976 International Monetary Fund (IMF) bail out of the British economy. First, the groundwork for the mid 1970s crisis was laid because the supply performance of the economy was severely damaged by the more than 10 percentage point increase in the share of government expenditure in GDP under the 1964 to 1970 Labour government, just as it has been by the broadly similar rise between 2000 and 2010. Second, in both cases, the growth of potential real GDP collapsed to some 1% to 1½% per annum because of the ‘crowding out’ – particularly, of private investment – that resulted. However, the authorities failed to adjust their policies accordingly, ran an unduly lax monetary policy and created stagflation, not growth. Third, between 1970 and early 1974 an ineffectual Conservative administration then tried to use a Keynesian demand stimulus to boost the economy, in which they were aided and abetted by a central bank which was politically subservient and intellectually soft on inflation. Finally, and following the humiliating collapse of the Conservative Heath administration in February 1974, the new Labour government let public spending rip, ignored rising inflation and the deteriorating trade deficit, aggressively raised taxes, and piled populist intervention upon intervention, until the markets finally lost patience.

One important difference with this earlier period is that the recent growth of broad money and credit has tended to be too low because of a misguided and pro-cyclical regulatory tightening, whereas the mid-1970s still suffered from the monetary overhang build up in the earlier Heath-Barber credit boom. However, accelerating inflation can result from a collapse in the exchange rate in a small, open and trade-dependent economy such as Britain’s. Furthermore, higher inflation does not have to be validated by a faster monetary expansion if the real exchange rate falls. The real exchange rate can tumble out of bed because the perceived post-tax rate return on human, physical and financial capital is reduced – perhaps as a result of higher taxes or populist anti-business rhetoric – or if the markets lose faith in the competence with which the economy is managed. The present Governor seems to believe that a weaker pound is necessary to re-balance the economy and to stimulate private demand. However, it is by no means certain that a weaker pound is indeed stimulatory. Whether or not currency depreciation boosts activity is essentially a quantitative question that depends on the deeper structure of the economy and the precise values of certain key parameters. A lower exchange rate will increases activity if: 1) the price elasticities of demand for exports and imports are high; 2) the pass through from the exchange rate to domestic prices is partial and slow; 3) higher inflation does not provoke adverse feedbacks, such as a rise in the savings ratio, and 4) there is ample spare capacity in the sector of the economy that engages in international trade. The Bank has published remarkably little research as to whether these conditions are currently satisfied. Instead, official rhetoric sometimes appears to be re-cycling a warmed up version of 1960s Cambridge Keynesianism, which implicitly assumed that these conditions held.

Unfortunately, it is no longer possible to examine the properties of a wide range of UK macroeconomic forecasting models to see how far these conditions are satisfied, as one could have done twenty or thirty years ago. Indeed, we are still waiting for details of the Bank’s new forecasting model COMPASS to be published, although that is promised to happen in the next few months. For what they are worth, the properties of the current version of the Beacon Economic Forecasting (BEF) macroeconomic model suggest that: 1) competiveness elasticities have fallen sharply and consistently in recent decades and may now be zero in the case of imports; 2) the pass through from the exchange rate to domestic prices is eventually 100%, and 3) higher inflation reduces activity through a range of mechanisms. That high and variable inflation reduces growth has also been found in international panel data studies, which try to explain the long run growth performance of a set of countries, and also in much of the empirical work published in the 1970s and early 1980s. The Bank’s apparent belief that higher inflation is positively associated with stronger activity appears to have forgotten this earlier research, which generally indicated the opposite. Finally, one must have reservations as to whether an economy with some 5½ million government employees and some 2½ million working in manufacturing – which is the current British situation – has the same capacity to increase output in response to a lower exchange rate as one with 3¾ million government employees and 7¾ million in manufacturing, which was the UK situation in the mid-1960s, for example.

As far as the forthcoming 20th March Budget is concerned, “sufficient unto the day is the evil thereof” applies. However, it needs emphasising that, in terms of the fiscal stabilisation literature, all that Mr Osborne has attempted has been a ‘timorous Type 2’ fiscal consolidation programme, in which tax increases have been front-end loaded, public investment has been cut, and current government expenditure and welfare costs allowed to rise. There exist countless international studies showing that Type 2 packages lead to unexpected output weakness and a worsened fiscal position. One can only despair at either the quality of the advice that the Chancellor has been receiving, or his willingness to listen to it. In contrast, a ‘bold Type 1’ package of tax cuts, public consumption reductions, tight control of welfare bills and no public investment cuts – which the Conservatives should have prepared while in opposition and then implemented immediately – is normally associated with positive output surprises, reduced joblessness and an improved fiscal position.

However, before giving up in despair it is worth noting four chinks of light penetrating the gloom. The first is the recent strength of world equity markets, which might be regarded as a longer-leading indicator of the economy. Some central bankers have expressed concern that this development represents a return to bubble conditions. However, the normal monetary transmission mechanism is for financial markets to respond first to monetary stimulus, and then commodity prices, before activity picks up and eventually inflation at the end of the process. The second has been the consistent acceleration in the growth of the M4ex broad money measure from 1.5% in December 2011 to 5.2% in December 2012. This development could be derailed easily by ill-considered regulatory interventions. However, if the acceleration continued much further, there could be concern about its longer-term inflationary consequences. Third, there has been the parallel and linked turn round in the housing market, with the Office for National Statistics (ONS) house price index declining by 0.4% in the year to December 2011 but rising by 3.3% in the year to December 2012. Finally, there has been the continued decline in both official measures of joblessness. This development may encourage consumer confidence, even if it is hard to reconcile with the ONS growth figures.

As far as the March Bank Rate decision is concerned, the breakdown of fiscal discipline, the recent weakness of sterling, the faltering market confidence in UK policy making, and the likelihood that higher inflation reduces activity, suggest that it is time to introduce a ½% hike in Bank Rate. This is not because of any economic effects that it might have, which would be small, but in order to demonstrate that the Bank of England has not just become a supine underwriter of fiscal profligacy. A second reason to raise Bank Rate is to head off the possibility of a major run on the pound developing because speculators would no longer face a one-way bet after a rate rise if they short sold sterling. The stock of QE should be left where it is for the time being and only added to if broad monetary growth threatened to nosedive, perhaps as a result of renewed problems in the Euro-zone. Because recent UK inflation overshoots have probably reduced economic activity, it is now time to say enough is enough. The Bank of England should act with the same counter-inflationary resolve as the pre-EMU Bundesbank would have done under current circumstances and not as it did itself in the 1960s and 1970s when Britain was reduced to the ‘sick man of Europe’.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

UK monetary policy has been thrown into even greater disarray, if that were possible, by speculation over impending changes in HM Treasury’s remit to the Bank of England, hints that incoming governor Mark Carney will alter the substance and style of policy and the news that the present Governor voted with a minority to raise the amount of QE to £400bn. The side effects of these developments, especially their impact on overseas holders of Sterling, are unequivocally bad for inflation outcomes. The latest Bank of England Inflation Report contains a notably downbeat inflation assessment and Martin Weale’s balance of payments speech spells out the risks of external inflation.

While there may be some glimmers of hope regarding UK output and export volumes for the year ahead, these remain vulnerable to the resumption of debt hostilities in the Euro area and the potential for disappointment regarding the FLS. Nevertheless, with a more stable demand outlook than seemed possible a few months ago, the time to begin the normalisation of Bank Rate is now. It would serve the added purpose of rebutting the charge that the Bank of England has forsaken its responsibility to preserve sound money. There remain four months before Mark Carney arrives. This is far too long an interval to allow the weak Sterling trend to go unanswered.

The Bank of England must not lose sight of its goal of normalising short-term interest rates. Running policy on the basis of a permanent emergency is sending a depressing message to the entrepreneurial sector. If there is a role for ‘forward guidance’, it is to reassure of the Bank’s determination to take rates back to the region of 2% to 2½% over the next two years, beginning with a move to ¾% immediately.

The suggestion that the Bank should consider the purchase of other assets besides gilts is worth pursuing. The Bank of England could learn from the experience of the Bank of Japan, that relatively small purchases of private sector assets – for example commercial property, exchange-traded equity funds and commercial paper – could have potentially more powerful effects on the real economy and business confidence than further huge purchases of government debt. At the same time, the gradual withdrawal of Bank funding of the budget deficit would help to discipline fiscal policy.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and keep QE at £375bn.
Bias: Neutral.

So far this year, the economic data in the UK have continued to be broadly flat: some indicators have pointed to faster growth others to slower. There is as yet no decisive trend suggesting a sustained recovery is underway. That said the economy will probably grow this year compared with last but only a lacklustre recovery, with growth close to 1%, seems on the cards at present. It is not a recovery that leaves the MPC comfortable that enough has been done, if the minutes of the February meeting are anything to go by. Clearly, it has also left the rating service Moody’s uncomfortable as it cited weaker growth than expected at this stage of the recovery as the principal reason for the decision to downgrade the UK’s credit rating from AAA to AA1. That having been said, the downgrade was not a huge surprise and probably means very little for the UK’s cost of borrowing. After all, official borrowing costs have remained low in the US and France – which is, probably, the better example for the UK – even after they were downgraded.

However, the MPC still appears comfortable with the prospect of inflation remaining above the 2% target until 2015. We know this because they said so. The voting at the February meeting showed that Governor King and Paul Fisher joined with David Miles in wanting more QE but these three were outvoted by the six other members of the Committee. This suggests that the biggest concern for the three is economic growth (is there more bad news in the forthcoming data that they are aware of?) and that even above target inflation would be accepted. Actually, the minutes showed that the whole MPC accepted above-target inflation, but the three dissenters wanted further easing now, implying a greater willingness to risk inflation for growth. Of course, their view is that inflation will eventually fall below target, if no action is taken now to boost the economy. In other words, that there can ultimately be no long lasting inflation threat if growth stays weak. For now, the financial markets have accepted this, although inflation expectations are creeping up.

To some extent this is borne out by the latest labour market data, which showed wage inflation of just 1.4% in the year to December. With consumer price inflation running at 2.7% this implies a drop in real pay of 1.3%. If there is sustained consumer price inflation, it certainly seems unlikely that it will be of the cost-push variety. However, producer price inflation did come in higher than expected, with the usual suspects of higher food prices and utility charges to blame. Meanwhile, manufacturing shows only a modest recovery and retail sales continue to struggle, though UK automobile sales remain remarkably resilient.

Claimant count unemployment fell by 12,500 in January (with December’s fall revised to 15,800 from 12,100). The Labour Force Survey (LFS) measure of employment surged again, and was up by 154 thousand in the fourth quarter of last year. With GDP contracting again in 2012 Q4 this suggests that the UK productivity puzzle – i.e., why it has remained so sluggish – continues. The softening in annual earnings growth to 1.4% on a headline basis in the three months ending in December is consistent with weak productivity gains. The problem is that weak productivity is consistent with weak growth, so how to break the link? Perhaps the Budget on 20th March may have something to say on that score.

My vote is for keeping interest rate at ½% and QE at £375bn for now, but with a bias to ease via more QE but with more variety in the assets being purchased. If economic activity weakens further - or shows no signs of recovering - economic growth in the first quarter of this year looks like it will be around plus ¼% or so, based on data from the latest Lloyds Bank Commercial banking's business survey. If this growth projection still holds as more data for 2013 Q1 are released, it may not be enough for the MPC. After the action from Moody’s, they may be even more willing to try to boost the economy than before. 

What is the SMPC?

The Shadow Monetary Policy Committee (SMPC) is a group of independent economists drawn from academia, the City and elsewhere, which meets physically for two hours once a quarter at the Institute for Economic Affairs (IEA) in Westminster, to discuss the state of the international and British economies, monitor the Bank of England’s interest rate decisions, and to make rate recommendations of its own. The inaugural meeting of the SMPC was held in July 1997, and the Committee has met regularly since then. The present note summarises the results of the latest monthly poll, conducted by the SMPC in conjunction with the Sunday Times newspaper.

Current SMPC membership

The Secretary of the SMPC is Kent Matthews of Cardiff Business School, Cardiff University, and its Chairman is David B Smith (Beacon Economic Forecasting and University of Derby). Other members of the Committee include: Roger Bootle (Capital Economics Ltd), Tim Congdon (International Monetary Research Ltd.), Jamie Dannhauser (Lombard Street Research), Anthony J Evans (ESCP Europe Business School), John Greenwood (Invesco Asset Management), Graeme Leach (Institute of Directors), Andrew Lilico (Europe Economics), Patrick Minford (Cardiff Business School, Cardiff University), Akos Valentinyi (Cardiff Business School, Cardiff University), Peter Warburton (Economic Perspectives Ltd), Mike Wickens (University of York and Cardiff Business School) and Trevor Williams (Lloyds Bank Commercial Banking). Philip Booth (Cass Business School and IEA) is technically a non-voting IEA observer but is awarded a vote on occasion to ensure that exactly nine votes are always cast.

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 15th January, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 7th February.

Four SMPC members wanting an increase of ¼%, while two advocated a rise of ½%, implying a rise of ¼% on normal Bank of England voting procedures. The recommendation of a rate rise in February was the first time since September 2011 that a majority of the SMPC had voted in favour of higher interest rates.

One reason was that fiscal policy seemed even further off course than was previously believed, and risked damaging the credibility of all UK policy making. Another was that the lull in the storms engulfing the Euro-zone provided an opportunity to raise Bank Rate while the markets were still reasonably calm.

However, there were also some noticeable intellectual differences between the SMPC majority, who wanted a rate rise, and the approach more commonly favoured by UK policy makers and the financial media. In particular, it was believed that the almost unprecedented degree of government intervention in the UK economy in recent years was leading to major problems with aggregate supply and preventing the re-allocation of resources from Zombie sectors to those with genuine growth potential. It was also feared that sustained artificially low interest rates were leading to a growth-destroying misallocation of capital.

However, three SMPC members believed that there was a genuine demand shortfall, which would be alleviated by additional monetary stimulus. Most SMPC members thought that there should be no additional Quantitative Easing (QE) for the time being, however.

Minutes of the meeting of 15th January 2013Attendance: Phillip Booth (IEA Observer), Roger Bootle, Jamie Dannhauser, Anthony J Evans, Graeme Leach, Andrew Lilico, Kent Matthews (Secretary), Patrick Minford, David B Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.
Apologies: Tim Congdon, John Greenwood, David H Smith (Sunday Times Observer), Mike Wickens.
Chairman’s introductory comments

The Chairman commenced the gathering by recording the thanks of the Committee for the contribution made by the retiring SMPC member, Ruth Lea, over many years. He then welcomed the newest recruit Graeme Leach, Chief Economist of the Institute of Directors, to his first physical meeting of the Committee. As there were eleven members in attendance, the Chairman announced that the comments of members that arrived after the first nine turned up would be recorded but not counted for the final rate recommendation. This followed the precedent of the rare previous meetings when the gathering had been super-quorate. The ’extra’ pair of comments and votes have not been ‘lost’, however, but are recorded in full in the Appendix to the main vote. The Chairman then invited Andrew Lilico to give his assessment of the global and domestic monetary situation.

Economic Situation

Andrew Lilico started his presentation by listing the risks faced by the different economic blocks that made up the world economy, beginning with the USA. The risk facing the USA was that the present activist stimulus policy could generate only a temporary expansionary effect, followed by inflation. The risks confronting the British economy included a small likelihood of a gilts crisis and the loss of its AAA rating. The Euro-zone crisis remained in the wings. Looking further afield, the risks of higher inflation in China, a