In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by six votes to three to leave Bank Rate unchanged at its present ½% on Thursday 4th March. The three dissenters, in contrast, all voted to raise Bank Rate to 1%.

This reflected their concern that the adverse fiscal background had damaged the economy’s supply side so extensively that it left the monetary authority facing a helplessly malign output/inflation trade off. Both SMPC hawks and doves agreed that the recent UK output data had been disappointingly weak and that there was a serious risk of a renewed downturn in activity. The disagreement was whether this was primarily a demand-side problem, perhaps associated with the slow growth of M4X broad money, or a supply-side malaise caused by the 16.8 percentage point rise in the government spending ratio since 2000 and the mass of new regulations that has been introduced.

There was also debate among the shadow committee as to whether Quantitative Easing (QE) should be resumed, now that the initially intended £200bn schedule had been completed in February. Here, views were mixed. Some ‘holds’ were happy to maintain the QE pause for the foreseeable future, while others thought that the authorities should be prepared to re-introduce QE at any moment, particularly if the growth of M4X remained sluggish.

One advocate of a 1% Bank Rate also wanted to re-instate QE of £25bn per quarter, while another hawk was prepared to wait and see, and a third wanted some rolling back of the £200bn already committed. There was a general agreement that the uncertainties about the future course of the economy were such that strongly entrenched views were inappropriate. The fact that this was a pre-election period also rendered fiscal and monetary policy making problematic. This was because the time horizon of senior politicians was now less than the lag between cause and effect when policy settings were altered.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold.
Bias: Hold for the time being. Use funding policy to sustain money growth.

The current flare-up in inflation is temporary and reflects the large rise in energy prices in the last six to nine months - as Saudi Arabia has re-asserted its control of the oil price in an improving international environment – together with the continued follow-through effects from the pound’s devaluation in late 2008. Money growth remains disappointingly weak, although Quantitative Easing (QE) added probably about 10% to the January 2010 level of M4. Until money creation by means of banks credit to the private sector shows definite signs of reviving (and it does not at present), policy-makers must err on the side of ease in their interest rate decisions. Keep base rate at ½% for the time being.

I have two main policy recommendations on the structure of policy-making. The aim must be to ensure that the quantity of money continues to grow despite the pressures from regulators, asset price weakness and so on. First, suppose that the contraction in banks’ risk assets has a few years still to run. Then the state – either the government or the central bank (or both working together) – must conduct its own financial transactions so that increases in its borrowings from the banking system sustain banks’ balance sheet totals and replace their reduced claims on the private sector. The UK’s QE experiment is an example of what can be done. However, the deliberate monetisation of public debt by the government (i.e. with the initiative being taken in the Treasury) should also be considered. The 1985 full funding rule is apparently still causing trouble.

Secondly, decisions about financial regulation and the management of the public debt have monetary effects. Financial regulation and debt management therefore need to be integrated with monetary policy decision-making. Because of the necessary interdependence of these aspects of public policy, the notion of ‘central-bank independence’ can be over-interpreted. Central banks must work with finance ministries and regulatory agencies on public debt management and banking regulation, just as finance ministries and regulatory agencies must work with central banks on the monetary consequences of public debt management and banking regulation.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Prepare to resume QE to offset private sector de-leveraging.

The risk markets – including equities, commodities, and high yield/commodity linked currencies – have all suffered a significant sell-off since the start of 2010. The apparent triggers for the sell-off have included: (1) the measures threatened by the Obama administration against the banks; (2) the tightening measures in China that threaten to curtail credit growth in the one region where money and credit has been buoyant, and (3) the rising sovereign risk problems of the peripheral Euro-zone economies. All of these are plausible reasons for the sell-off, but are no more than superficial explanations.

There are deeper reasons for the current malaise. In particular, just as the start of the credit crisis in August 2007 was triggered by a prior period of six months of near zero growth in money and credit, so the current sell-off comes after an extended period of pronounced weakness in both money and credit both within and outside the banking system. The mini-inflation surge evident in Consumer Price Index (CPI) movements around the world is highly misleading in this context. The underlying prices trend is very weak once the commodity-related and tax factors are removed.

In the US, M2 broad money growth has slowed abruptly since September 2009, falling from an annual 10.5% in January 2009 to 6% in November and just 1.9% by mid-January 2010. At the same time, bank credit has declined continuously since October 2008 and on a year-on-year basis since September 2009. It would be unprecedented if such low rates of money and credit growth could co-exist with rising rates of inflation for any sustained length of time. It is more likely that the current inflation episode - which is based on a statistical echo of the weakness of commodities and other items in late 2008 and early 2009 - will fade away within three to six months, to be replaced by substantially lower inflation rates, or even some risk of deflation.

In the Euro-zone, money and credit growth has also been exceptionally weak, with M3 declining by 0.6% in December, while loans to households and non-financial corporations fell by 0.2%. These negative growth rates are without precedent in the Euro-zone or its predecessor economies. They imply severe weakness in spending and the risk of widespread deflation if continued. Japanese broad money (defined as M2 plus Certificates of Deposit) increased by a yearly 3.1% in December, while bank lending declined by 1.2%. The clearest evidence of risk aversion is the banks’ vigorous purchases of securities, such as Japanese Government Bonds. In September, these increased by 32.1% year-on-year and in December they were still increasing at 19.3%. While Japan has occasionally experienced more risk-averse behaviour by the banks in the past decade, these numbers clearly show another shift towards caution.

Finally, money and bank credit in the UK continue to show only very weak growth. The latest data for M4 show a sharp slowdown to a 5.3% increase year-on-year, while money held by households and non-financial companies (M4X) continues to drift along at 1% to 2% p.a. As in Japan, de-leveraging by the private sector is more than counter-balancing the attempts by the authorities to expand money and credit via QE. Again, this is in no way compatible with any sustained acceleration of inflation, irrespective of what happens to sterling. Against this backdrop, the authorities should prepare for a decidedly weak recovery and the risk of deflation in 2011.

Outside the banking system, the shrinkage - or very weak growth - of credit continues. The balance sheets of the main organisations that financed the credit and housing bubble during the last decade - the investment banks and the shadow banks - continue to contract. Based on US data for the third quarter of 2009, the combined balance-sheet total for broker dealers and shadow banks exceeds M2 broad money so these magnitudes are not trivial. In particular, two specific forms of non-bank credit that were aggressively employed during the credit bubble - commercial paper and repurchase agreements - have continued to decline.

Commercial paper has contracted by 51% since it peaked at $2.2 trillion in July 2007, declining to $1.09 trillion at the end of January. This decline has occurred despite the US Federal Reserve’s overt support for the commercial paper market in the wake of the Reserve Primary Fund ‘breaking the buck’ and triggering a run on other money market funds in September 2008. Repurchase agreements were (and are) a key source of funding for investment banks. At their peak, just before the credit bubble burst, outstanding repurchases were running at $5.4 trillion, a figure that has now declined to $2.4 trillion. None of these funding operations shows any sign of resurgence. The conclusion is that the international credit squeeze continues, even if interest rates are very low.

At the end of 2008, commodity prices - including oil, petrol and other elements of the US, UK and Euro-zone CPIs - plunged steeply, and UK VAT was cut from 17.5% to 15%. With the end of the post-Lehman panic, commodity prices bounced back after March 2009, prompting a smaller bounce-back in consumer prices. It is this bounce-back that has been reflected in the recent rise in year-on-year CPI figures around the developed world. However, this rebound will soon terminate as oil and other commodity prices stabilise or decline again, and the more heavily weighted components such as housing and services come to dominate the trend in the CPI. The housing component of the US CPI peaked in July 2008 and has been on a downward trend subsequently. The money and credit trends discussed above suggest that commodity prices are likely to weaken in the months ahead. Consequently, the recent year-on-year jump in the CPI will rapidly evaporate, leaving the trend inflation rate far below the Monetary Policy Committee’s (MPC’s) target.

The legacy of over-indebtedness from the credit and housing bubble will result in a prolonged period of balance sheet repair that is incompatible with any strong bounce-back in real GDP, or consumer or business spending in the leading developed economies. The latest UK and US GDP data for 2009 Q4 confirm this view. In the UK case, GDP growth was just 0.1% in the fourth quarter according to the preliminary figures. In the US, the advance 5.7% annualised rate for 2009 Q4 was mainly due to a reduced inventory rundown, while domestic final sales growth (excluding inventory changes) slowed to 1.7% in the fourth quarter from 2.2% in the third. Without money or credit expansion, the growth of spending or economic activity will depend primarily on income growth which is likely to be weak in 2010. There is no case for a rise in interest rates or an end to QE any time soon.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold.
Bias: To maintain QE pause for now.

The British economy appears to be heading for a double dip recession, mirroring the pattern across much of Europe. I expect this second dip to be a mild and fairly short-lived affair - perhaps a couple of quarters of contractions of less than half a point of GDP. Unemployment is likely to rise considerably, as labour hoarding schemes are surrendered once businesses and workers realise that recovery will not be rapid.

Inflation is above target at the time of writing, which makes policy management difficult, but on a year-to eighteen-month perspective the real threat is deflation. Monetary and lending growth are both weak. Perhaps most dangerously, total employee compensation is down well over 5% from its peak and has been shrinking further during the latter half of 2009 - and this despite unemployment not rising much, reflecting widespread private sector wage freezes and cuts. Households have been struggling through because their other income (e.g. benefits) has risen and their costs (e.g. mortgages) have fallen. These cost reductions cannot be sustained indefinitely, and without nominal wage growth the risk of widespread defaulting on debts driving further financial sector problems will lie continuously just beyond the horizon.

After the election, there will be a ferocious fiscal tightening, unprecedented for nearly a century. Such fiscal consolidations are least damaging to growth if they can be combined with monetary loosening. There will be a need for further QE to commence perhaps later on this year and perhaps to be sustained through 2011 (at least). This will eventually drive a significant spike in inflation. That is not desirable, but the deflationary alternative - falling nominal wages; failing banks; sovereign default - is much worse. Policy should aim to deliver mainly upside inflation risk and very low deflation risk. So, QE will return, but not yet.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold.
Bias: Neutral for Bank rate; stand ready to resume QE.

With the MPC deciding to pause, the initial program of QE has ended. A second program will most probably be needed. What are the lessons from the first valid for the second? I was one of the early advocates of QE. I was alarmed by the collapse in monetary growth, more precisely in M4X (M4 less intermediate OFCs) and, in particular, by the actual fall in the deposits of non-financial corporations in 2008. The primary aim of QE was to boost these monetary aggregates. The principle mechanism was to inject money directly into the economy, by-passing the banking system, as described by Mervyn King in his BBC interview of 5th March 2009. Some argued that the aim was to boost bank reserves, in the expectation that this would lead to banks increasing lending. I argued that reliance should not be placed on this for two reasons. First, it was unlikely to be successful; whilst a horse can be lead to a trough, it cannot be made to drink. Second, the focus should be on monetary growth and not on bank lending. One of the reasons for this is that money is normally quite like the hot potato of the children’s game. Whereas one person can pass it to another the group as a whole cannot get rid of it. Money normally stays in the system and has a continuing effect whereas bank lending has a one-off effect.

In the event, much of the money injected by QE was got rid of. When the Bank of England bought gilt-edged stock, the sellers of the stock received £200bn. A substantial amount of this was spent on new issues by banks, which destroyed the money. Some was spent subscribing to new issues of corporate bonds, the money being destroyed when the corporations issuing the bonds repaid bank loans. Other money may have gone abroad or have been switched into foreign currencies. None of these was the main aim of QE but all were desirable. As far as the first two are concerned, banks and non-financial corporations needed to strengthen their balance sheets. The third may have been one of the reasons why sterling fell, which was desirable because it will in due course stimulate the economy by boosting exports and import substitution. These are successes of QE and not failures.

The more worrying impact of QE was the way in which the money has been spent on assets rather than on goods and services. Normally, money staying in the system percolates after a while through from the one to the other. Little if any of the percolation has happened. The main impact has so far been on asset prices. Some economists have argued that the rise since March has been ‘almost miraculous’. On the contrary it has been more or less precisely in accordance with the liquidity theory of asset prices. What did these economists expect the people who sold gilts to the Bank to do with the money? Was reinvestment not anticipated? Did they not realise that this would raise asset prices? In the event the bears had to run for cover, which raised prices further. The demand for money as a medium for holding savings then fell as perceived risk of loss on equities, etc., fell as the bear market changed to a bull market.

The main direct beneficiaries of QE are the holders of assets, including banks. Banks profits have rebounded. It is particularly galling to see bankers being paid bonuses resulting not from their own expertise and efforts but because of QE financed by tax payers. This leads to the thought that tax payers would have enjoyed the profits if the Bank had bought equities rather than gilts. As it is, the Bank’s program of £200bn purchases of gilts has driven up gilts prices and there is an obvious danger that the Bank will make a loss when it disposes of the medium and long-dated stock it has bought under QE. Another criticism of QE is that a second round might lead to a bubble in asset prices. This danger is in the future rather than current because UK asset prices are at present probably fully-valued rather than over-valued. Asset prices are likely to fall in the coming months not because they are over-valued but because of a general lack of liquidity resulting from the collapse in monetary growth in both the US and European Union; sluggish growth in the UK, and reduced surplus savings from China as the authorities there tighten policy. A second leg of the UK recession appears likely and the first sign of this is likely to be a fall in asset prices, with financial markets reacting, as usual, more quickly than the real economy. Perceived risk of loss is then likely to rise again. Put another way, the current level of asset prices is not firmly based on an increase in the supply of money but on a fall in the demand for money that could suddenly reverse.

Overall QE has played a vital role in arresting the collapse in asset prices and stopping a serious recession from turning into a depression. The gain vastly exceeds the costs. The authorities should pay close attention to the behaviour of asset prices in the coming months. If there is a substantial fall exceptional circumstances will warrant exceptional measures. The Bank should stand ready to purchase equities, employing several fund managers rather than choosing the investments itself.

Comment by Peter Spencer
(University of York)
Vote: Hold.
Bias: To resume the QE programme.

The economy remains very weak. The fourth-quarter GDP headline figure was disappointing, although this is likely to be revised up in line with more recent output data. With CPI inflation back in letter-writing territory at 3.5% in January, there have been concerns that the UK is in for a period of stagflation. The key theme of the minutes from the January MPC meeting was uncertainty, and in particular the wide spectrum of risks to inflation. However, I believe that the inflation risks are overdone and that with fiscal policy tightening, economic growth should remain the focus of monetary policy. I think that it was probably a mistake to suspend the QE programme and would be inclined to resume asset purchases at an early stage.

I do not share the view that inflation is resurgent. The increase in CPI inflation over the last two months is largely due to VAT and base effects arising from falling petrol prices last year. These upward pressures are short-term in nature. Significantly, RPIY - which excludes indirect taxes like VAT - showed a big decline in January. This suggests that underlying price pressures are weakening. Wage pressures remain very subdued and the weak recovery will leave a large overhang of spare capacity bearing down on inflation. I expect the CPI to fall back below target by the end of the year.

The monetary figures are still extremely depressed and with the QE programme abeyant I expect them to remain so. Banks and their borrowers remain very risk averse. Money and credit growth are unlikely to return to normal until banks rebuild their balance sheets, and with revenues being siphoned off into bonuses as they recover, this could take the best part of the decade. In the meantime, the customer funding gap remains as large as ever, despite the increase in personal savings. Moreover, the banks will have to use increases in private sector deposits to repay the funds raised through the Special Liquidity Scheme (SLS) by 2012 and under the Credit Guarantee Scheme (CGS) by 2014. These obligations amount to about £300bn and are in addition to the large outstanding loans to overseas banks.

Against this bleak fiscal and monetary background I would have continued to buy assets under the Asset Protection Scheme (APS). Fortunately, the MPC has left the door open for further asset purchases. I think the downside risks to the economy make it likely that these will resume later in the year.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate by ½% and maintain QE pause.
Bias: Wait and see; fiscal consolidation necessary to maintain monetary credibility.

The normal practice when writing text books or designing student courses in economics is to put monetary policy, public finance, regulation, and the determinants of aggregate supply into separate and self-contained compartments and not to bother about the feedbacks between the four. However, the economy is a holistic organism. The potential self-reinforcing feedbacks between these policy areas can have more significant consequences than what is happening within each one, especially when mutually inconsistent policies are being pursued by the authorities concerned. The high degree of specialisation in modern economics and the fact that macroeconomic model building has fallen out of favour mean that it is now unusual for economists to take a necessarily rough-and-ready top down view of the system as a whole, rather than concentrating in Pre-Raphaelite fashion on the microscopic details of a small canvas. There is now a serious policy inconsistency between the regulators’ desire to impose restrictions on the banks - restrictions that will inevitably lead to cut backs in the supplies of money and credit - and the simultaneous use of QE to prop up broad money. No threat of new financial regulation until the economy recovers and no QE either would be a more sensible option. At present, it looks as if the Bank of England’s initiatives to stimulate the economy will be nullified by the actions of officials elsewhere.

The same consideration applies to fiscal policy. One reason for attacking Gordon Brown’s post-2000 spending blow out is that the trade-offs facing the central bank deteriorate sharply as the share of government expenditure in national output increases beyond its optimal level of 35%, or so – the sort of numbers seen in Australia, Switzerland and London and South-Eastern England. One reason is that monetary policy can only operate on the private sector and ever coarser proportionate adjustments have to be forced onto it as the private sector takes a diminishing share of GDP. Another is that managing disinflation in the labour market without generating mass unemployment becomes more difficult as welfare benefits and relatively high wages in government employment provide a floor below which nominal private earnings cannot fall, even if this is necessary to equilibrate the labour market. This is a particular issue in some of the cheaper and less productive areas of the country, where central and local government are the dominant employers. A third reason is that the growth of aggregate supply tends to slow down as the share of public spending in national output increases, meaning that more of any given monetary stimulus appears as inflation and less as higher activity. Finally, large budget deficits both lead to funding problems and can undermine the credibility of the monetary authority as well as the fiscal one, including in the foreign exchange markets.

Recent UK economic indicators suggest that a decade’s worth of fiscal incontinence has now led to a permanent structural deterioration in the economy’s supply side and its ability to generate real private sector jobs. The acceleration in annual CPI inflation from 2.9% in December to 3.5% in January has been much commented on. Less attention has been paid to the fact that the double-core Retail Price Index, which excludes both mortgage interest payments and implied house prices and is the most consistently defined historic inflation measure, accelerated from 4.1% to 4.9%. The UK’s trade deficit on goods and services also deteriorated from £8.1bn to £9.5bn between the third and fourth quarters, when the deficit was the largest since the third quarter of 2008. This provides another indicator that the UK has an unhealthy balance between aggregate demand and aggregate supply, even at present low levels of activity. Total GDP is a somewhat misleading measure of economic activity, now that more than one half of national output is in the government sector, particularly as imports and welfare benefits act as important swing factors to offset movements in private sector activity. During the first three quarters of last year, Britain’s real GDP fell by 5.4% but real private domestic expenditure – defined as non-welfare financed consumption, private investment and stock building – plummeted by no less than 11.7%. The unexpected 0.4% drop in M4X in December, took the annual growth rate down to a mere 1.1%, according to the Bank’s calculation, and caused a ¼% reduction in the previous Beacon Economic Forecasting prediction for the average UK growth rate this year, which now stands at 1.1%, followed by 2.7% next year and 2.8% in 2012. With the annual growth of broad money in the OECD area also slowing progressively from 8.2% in the first quarter of last year to 6.9% in the second quarter, 5.7% in the third and 3.6% in the final quarter, global monetary aggregates are clearly not behaving as central bankers desire.

The US$64,000 question is what the Bank of England should do under these circumstances where the costs of any policy error are likely to be far higher than they would be in an economy with a lower government spending burden and a more responsible fiscal stance – Britain has the largest structural Budget deficit in the entire OECD area. The Bank was right to pause with QE, presumably until after the General Election, while leaving open the option of reviving it if activity takes a turn for the worse. The main regret is that Bank Rate was not raised to 1% at the same time. In practice, Bank Rate is now likely to remain on hold until after the election. However, it would enhance the MPC’s reputation for political neutrality if it went up by ½% in March and this is my recommendation. (Editorial note: David B Smith has recently written an empirical paper Money Still Matters – the Implications of M4X for Quantitative Easing, which examines the links between QE and broad money in more detail. This will shortly be downloadable from www.iea.org.uk).

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Raise Bank Rate by ½%.
Bias: Hold/achieve 1% Bank Rate. QE should not be resumed and should start being reversed soon.

The dilemma facing monetary policy is getting worse. The Bank’s original justification for a ½% interest rate was that the economy needed to be stimulated in order that inflation would be high enough to meet its 2% target. This helped increase the demand for private-sector loans but the banks were unwilling to lend. QE was begun in order to provide the banks with the necessary liquidity to provide the additional demand for loans, but instead the banks used this liquidity almost entirely to rebuild their balance sheets. Even the government-‘owned’ banks like the Royal Bank of Scotland group, when faced with two conflicting government instructions – to rebuild their balance sheets and to increase lending – decided on the former. Thus, both conventional and unconventional monetary policy failed. To add to these woes, inflation has now exceeded the permitted upper limit, mainly due to supply factors. Given the Bank’s remit is to control inflation, the case for continuing a loose monetary policy is now threadbare.

The government is concerned about output and employment and so, despite entering the recession with an unsustainably loose fiscal policy, it has allowed the fiscal deficit and national debt to reach unprecedented heights. Given that the government shows no intention to do anything about this, it must continue to hope that the Bank does not tighten monetary policy, especially as it would increase the cost of servicing national debt and worsen the fiscal deficit if the Bank raised interest rates.

So the dilemma for the Bank is whether to keep strictly to its remit by tightening monetary policy (and giving up QE), or to ignore its remit (and the evidence on the lack of success of QE) and support the other objectives of the government.

According to the Bank of England Act of 1997, which gave independence to the Bank, it should only support the other objectives of the government subject to achieving its inflation remit. The implication is clear: the Bank should tighten monetary policy. I would therefore support an interest rate of 1% and a start to winding down QE with a view to restoring nominal interest rates to a more sustainable long-run level. This implies that it becomes even more urgent to get to grips with the fiscal deficit. None of this would be palatable to a government shortly to seek re-election. This is the price for the government not acting much sooner. What is more important: the economy or getting the government re-elected?

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ½%; reinstate QE at £25bn per quarter.
Bias: To raise Bank Rate.

The first release of GDP at current prices for the final quarter of 2009 should confirm that a recovery of nominal spending and income has been underway since the spring of last year. Using timely, but incomplete, data there is every reason to believe this to be true. The value of manufacturing output rose 4.7% between January and December last year, with 5.5% predicted for the annual gain to January 2010. Retail sales value (excluding automotive fuel) rose by 3.7% in the year to January, up from a low of minus 1.9% last May. For non-store retailing, the annual growth was 17.8%. There is an abundance of evidence that the UK’s deflationary panic is over. Extremely slack settings of monetary and fiscal policy, in combination with an accumulation of sterling weakness since mid-2007, are indeed delivering a robust nominal recovery.

If there are grounds for disappointment in the response of the UK economy, these rest with the weak initial estimates of real growth and the contrasting strength of the inflation readings. The reaction of the Bank of England in the latest Inflation Report has been to disregard these inflationary tendencies as temporary and self-correcting, while reiterating their expectation of a phase of rapid real GDP growth. Our analysis suggests that this is a mistaken comprehension of the situation, with the inflation risks skewed heavily to the upside. Abstracting from the rollercoaster effects in the annual inflation data, the compound rate of inflation over the previous two years has risen from 1.5% last April to 1.9% for the headline retail price index; from 2.8% last April to 3.5% for the old inflation target, RPIX; and from 1.4% last January to 3.1% for our composite private sector good and services (ex-fuel and light) measure.

The MPC’s decision to suspend the Asset Purchase Facility in February cannot be rationally construed as a counter-inflation response. Rather, its suspension should be interpreted as a warning to the Treasury that the Bank does not stand ready to finance indefinite laxity in the public finances. However, this is an odd decision to take three months before the likely date of a general election. The chances of forcing additional fiscal tightening during an election campaign must be regarded as slim in the extreme. Consequently, the suspension of QE has been greeted with dismay in the gilt-edged market with UK benchmark yields rising by 25 basis points in the week to 19th February, much more than any in other government bond market, bar Greece. A neutral course of action in February would have been the extension of QE at its prevailing rate of £25bn per quarter. The increase in gilt yields is considered to include an inflation uncertainty premium that relates to the future financing of the UK’s budget deficit.

A much clearer and consistent policy action would have been to raise Bank Rate to 1% from its longstanding ½% rate. This would warn borrowers that the emergency rate settings were no longer appropriate. Even at a 2% Bank Rate, UK real interest rates would be negative this year, on average. If the Bank wishes to defend its inflation target and assert influence over inflation expectations, then a rise in Bank Rate is the only sensible approach. The transmission from different amounts of asset purchase to the inflation objective is far too vague to constitute a coherent policy response. Finally, the renewed weakness of the broad monetary aggregates is a reminder that the rehabilitation of normal banking activity is still some way off. Eagerness and ability to repay bank loans by corporations and financial institutions is likely to weigh upon the aggregate data for a few months to come, but steady M4 growth of 5% to 10% per annum should resume later in the year. Slowing monetary growth should not be viewed as a distress signal in these extraordinary circumstances.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: Ease further via an extra £50bn of QE, taking stock to £250bn.

My arguments for a continued ½% Bank Rate and bias for further monetary easing via further QE are straightforward. The UK economy barely grew at all in 2009 Q4, when it expanded by just 0.1%. This figure compares with the 5.7% annualised growth reported in the US and 1.1% in Japan, which we are led to believe has more serious problems than the UK. Although the UK's fourth-quarter growth rate is similar to that of the Euro-zone in the same period, it ignores the fact that the Euro-zone has already had two quarters of positive economic growth prior to the fourth quarter slowdown to just a 0.1% expansion. Indeed, this slowdown in Euro-zone growth itself is a cause for concern for UK growth prospects, as it implies that net exports will be even less likely to offset the weakness of domestic demand.

In this context, a weak sterling exchange rate might not be enough to boost exports, as the Continent is the destination for over 50% of UK exports. Moreover, UK firms seem to be raising export prices in line with the fall in the value of the pound, perhaps in order to benefit from a lower currency by allowing profit margins to improve at a time when domestic margins are being squeezed by weak domestic demand. The implication in the February Inflation Report is that GDP growth will be revised up to 0.7% for 2009 Q4 in due course, with a projection of 3% growth by the end of 2010 and a similar rate during 2011, the upper end of independent forecasts. However, the likelihood of significant upward revisions to fourth quarter UK GDP at the current time seems unlikely, based on the data that is currently available. Unemployment is starting to rise again, with the January 2010 increase (along with revisions to preceding numbers) alone reversing the falls recorded in the final quarter of last year. The volume of retail sales also fell by 1.8% in January. Money supply growth is dropping. And whilst manufacturing output is no longer falling, the level of output remains very depressed.

This is precisely why price inflation seems unlikely to be a serious concern in the medium term - although it is clear that UK price inflation is higher than in similar developed economies, perhaps due to a weaker exchange rate. Wage inflation is still flat, up 0.8% in the three months to December at an annual rate. There is plentiful spare capacity in the economy, even though some of the lost output may never be brought back on stream. With fiscal tightening yet to take effect, and overseas growth weakening in our biggest export market, the UK economy faces a stiff challenge in the quarters ahead. For all of these reasons, UK economic growth will likely be very modest this year in the context of the fall last year, so in my view justifying further monetary easing. Otherwise, the inflation target will be significantly undershot in the medium term, with higher unemployment and more lost output than necessary.

What is the SMPC?

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

SMPC membership

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

Following its latest quarterly gathering, the Shadow Monetary Policy Committee (SMPC) voted by seven votes to two to leave Bank Rate unchanged at ½% on Thursday 4th February. The two dissenters, in contrast, both voted to raise Bank Rate to 1%.

This reflected their concern that inflationary pressures were building and that a reduction in the real rate of interest was not appropriate given the irresponsible fiscal background. A specific concern was that the credibility of the monetary authority might become tainted by association because of the persistent failure of the fiscal authority to achieve its borrowing forecasts.

A majority of the shadow committee felt that an explicit and detailed fiscal consolidation plan needed to be put in place immediately electoral considerations allowed. Two members advocated a revived Medium-Term Financial Strategy, similar to that of the early 1980s.

There was debate among the shadow committee membership as to whether Quantitative Easing (QE) should be allowed to expire after the current schedule ran out this month. Four members wanted to extend the QE program, with three specifically asking for an additional £50bn; while three SMPC members believed that there should be a pause.

One reason for pausing was to demonstrate that the Bank of England was not under-writing a pre-election giveaway. QE could be revived after the election but a lost reputation for virtue would take longer to restore. The final view, which overlapped with the others to some extent, was that QE should be altered to deliver an appropriate path for the M4X broad money supply. Some SMPC members were concerned that official proposals to force banks to hold more capital and liquidity would reduce the supplies of money and credit and undo the benefits of QE.

Minutes of the Meeting of 19th January 2010 (5pm)
Attendance: Philip Booth (IEA Observer), Ruth Lea, Andrew Lilico, Kent Matthews (Secretary), Patrick Minford, David Brian Smith (Chair), David Henry Smith (Sunday Times observer), Peter Warburton, Trevor Williams, External observers Hiroshi Oka (Minister for Economic Affairs, Embassy of Japan), Hajime Yoshimoto (Senior Economic Analyst, Embassy of Japan), party from North London Collegiate School.

Apologies: Roger Bootle, Tim Congdon, John Greenwood, Gordon Pepper, Peter Spencer, Mike Wickens.

Chairman’s comments
David B Smith welcomed the external observers and explained to the school visitors the way the SMPC worked. He then called upon on Andrew Lilico to provide his analysis of the global and domestic monetary situation.

The Monetary Situation
The International Situation – Signs of fragile recovery
Andrew Lilico referred to his previously prepared slides on the ‘Background to SMPC Decision’ (Editorial note: the slides concerned can be obtained from Andrew.Lilico@policyexchange.org.uk). He began by examining various world economic indicators. These included international stock market prices, the OECD’s composite leading indices and the NIESR indicator of recession in advanced countries – all of which were showing signs of recovery in recent quarters and indications of positive growth in the final quarter of last year. However, fragility remained with global house prices still looking strongly overvalued in some economies, widening spreads in government bond yields over German Bund yields and low broad money growth.

The UK Economy – Halfway through deleveraging process
The contraction in UK national output has been about 6%, according to Andrew Lilico. The December 2009 Pre-Budget Report figures and Bank of England projections suggested growth of around 4% in 2011, but the average of independent forecasters saw only a moderate pick up in 2010 and 2% growth in 2011. As with the world economy, the various British indicators – including the Purchasing Managers Supply Index, new car registrations, business climate surveys and consumer confidence indicators - suggested an emergent recovery. The poor December 2009 inflation figures reflected the unwinding of VAT and oil price effects twelve months earlier and should not have been unexpected, even if they were worse than the City had predicted. The Bank of England expected a drop off by the end of this year. One reason was that underlying monetary pressure remained weak, with a continued low growth in the M4X definition of broad money. The cumulative level of Quantitative Easing (QE) was now close to the currently intended maximum. Gilt yields showed no discernible change.

Turning to the section of his presentation that dealt with ‘Headwinds and Threats’, Andrew Lilico examined the developments in non-financial corporations indebtedness, the savings ratio, and household liabilities as a proportion of nominal disposable income. Using a simple macroeconomic model, he examined the question ‘how much deleveraging is there to go?’ Some heuristic calculations suggest that the economy was half-way through the deleveraging process. Commercial banks had to raise capital faster than losses materialised. Unemployment may not have peaked and only remained low due to pay freezes or cuts in wages. The figures for government expenditure as a share of GDP, falling public sector receipts, widening spreads on bond yields and rising budget deficit all demonstrated the need for robust fiscal consolidation.

Judgement
Andrew Lilico summed up his presentation. He said that the growth outlook was uncertain and the risk of a double-dip recession was high. He said that he expected a large rise in unemployment followed by more defaults. House prices had further to fall. The main domestic risk was deflation, through wage cuts and defaults leading to more banking sector problems. Fiscal consolidation was both necessary and inevitable and should be combined with monetary easing. He said that QE should be paused so that something could be held back for later.

Patrick Minford asked why QE was not showing up in the M0 monetary base. Andrew Lilico said that the Bank did not publish data on M0 anymore but it can be constructed by adding cash reserves and bankers deposits at the Bank of England into cash held by the non-bank public. M0 measured in this way has risen by £100bn. Where the other £100bn had gone he felt would be better explained by others.

Discussion
The chairman thanked Andrew Lilico for his most thorough and thought-provoking presentation. David B Smith added that the experience of the private and public sectors of the British economy had been so divergent that it was important to analyse them separately. For example, while real GDP had fallen by an annual 5.4% in the first three quarters of last year, real private domestic expenditure had plummeted by no less than 11.7%. Likewise, he said that stripping out welfare-benefit financed consumption out of total consumption would show that underlying household consumption fell by 5.6% in the first three quarters of 2009 rather than the 3.4% contraction shown by the aggregate figure.

Regarding unemployment, he said that people were drawing false parallels with the experience of the 1980s and the 1990s. The main difference between then and now was that there was no longer scope for gut-wrenching job losses in manufacturing where redundant workers were highly likely to appear in the unemployment rolls. In contrast, job losses in private services had a much smaller impact on the jobless totals and the effect of changes in government jobs was weaker still. He added that another interesting issue was the extent to which high marginal rates of tax and national insurance and the system of tax credits encouraged firms to hoard workers. This was because the net loss of post-tax and post-credit income from shorter working hours was significantly less than the gross cost. The chairman then asked Patrick Minford to present his comments as he knew Patrick had to leave promptly at 6.00 pm.

Patrick Minford said that there were two uncertainties. First, there was the need for fiscal consolidation. But public sector spending was largely decentralised - for example, example via universities - which made consolidation difficult to deliver in a predictable way; it is quite possible that cuts would come in faster as spending units anticipated hard times. Second, there was the banking system. As fast as the Bank of England loosened monetary policy through QE, the Financial Services Authority (FSA) instructed commercial banks to tighten through higher capital requirements. Hence the sharp fall that could be observed in broad money supply growth. It was vital that QE should be allowed to work and increase the growth of M4X. Money had to be allowed to flow to small companies. Finance had been coming available for large companies through bond and equity issuance and this had been finding its way back to the smaller companies somehow, presumably through trade credit or ad hoc market intermediaries. However, while finance was getting to Small and Medium-sized Enterprises (SMEs) through the backdoor, it was not doing so through an increased money supply. He concluded that QE should continue on a ‘suck-it-and-see’ basis. The parameters of determination should be the recovery and inflation.

Peter Warburton said that the extent of the fiscal deficit was larger than expected. He wanted to pick up on the role of tax credits. He said that because the tax system was progressive there was a gearing down of revenue in a downturn. Tax credits had saved employment from falling too much. There had been a 10% increase in housing benefit claims. The extent of the transfer from the private to the public sector had been enormous. The corporate sector debt burden had been lifted so growth in investment was likely to be strong and inflation much more likely. Kent Matthews asked Peter Warburton to clarify why exacerbated inflation is likely. Peter Warburton raised significant doubts over the measurement of the output gap and its relevance to the credit-induced slump. Usable economic capacity had been reduced by the credit crisis to a greater degree than was widely realised and this had had the effect of increasing costs along the global supply chain. For given monetary conditions, the UK was likely to experience greater inflationary pressures than before.

Philip Booth said that the tax-credit system worked as an employment subsidy. The tax credits had possibly, therefore, stopped unemployment rising further, although this temporary effect does not justify them. David B Smith suggested that tax credits were working like the 1795 Speenhamland system of outdoor relief or the ‘OXO’ system in the 1930s, which had encouraged collusion between employers and workers to gerrymander working practices to qualify for state support. He said that the collapse in global supply chains had induced a collapse in intermediate demand that could be best comprehended in the context of an input-output model. A fall in intermediate demand appears as a destocking in conventional national accounts. One sign that supply chains were cranking up again would be when the current run down of inventories went into reverse. David B Smith added that the negative effect of a rising government spending burden on productive capacity was generally not well appreciated. He expected the growth of British productive capacity to be possibly 1½ percentage points per annum lower as a result of the aggressive re-socialisation of the UK economy over the past dozen years and that trend GDP growth would only average around 1¼% to 1½% in consequence. This meant that there was nothing like as much spare capacity as was measured by the conventional output gap.

Trevor Williams said that he did not buy the argument of rising domestic demand as mentioned by some. He said that the state of household debt, risk of unemployment, and low real wage growth is going to constrain household spending. The personal sector saving rate will rise further as the household sector continues to strengthen its balance sheet. Therefore, domestic demand will remain weak. He said that a second downturn is also possible. He asked why we should expect the saving ratio to fall - a necessary though not sufficient condition for recovery - if, as is currently the case, broad money is slowing.

Ruth Lea said that David B Smith had given a cogent explanation as to why unemployment had not risen as much as expected. She said that she agreed with Trevor Williams that there was a lack of robust expansion. She said that she was pessimistic about the prospects for growth. There were signs of recovery but its strength was uncertain. However, there was a case for a pause in QE and wait for fiscal consolidation. QE could be revisited if the economy was not seen to be growing. She said that she was unworried by inflation, which had been driven by the unravelling of base effects, Value Added Tax (VAT) and oil in the short term. Current inflation only became a worry if it fed into wages but there was little indication that this was happening. She said that she was relaxed about the dangers of inflation.

The chairman then asked the Sunday Times observer, David Henry Smith, for his views on the current state of the economy. David Henry Smith said that the discussion about the effects of the tax credit system was interesting. One of the arguments for the minimum wage was to stop employers from exploiting the tax credit system and get a free ride on wages. It was striking that output had fallen by 6% but employment had fallen by only 2%. It was possible that the fall in output had been over stated. He said that the labour market was a lot healthier now and referred to a recent Department of Work and Pensions discussion paper that had examined flows into and out of unemployment. In the light of the poor December inflation figures, he said there was a case for a pause in QE as the market was beginning to think that the Bank of England no longer cared about inflation. He said that he agreed with recent comments by the former Monetary Policy Committee (MPC) member Wilhelm Buiter that there should be a halt in conventional QE but that the Bank should also announce that they would be willing to purchase quality assets from the private sector. The market would produce these assets if there was a need.

David B Smith said that one of the main roles of QE was the defensive one of neutralising the crowding out effects that would otherwise have arisen from the large budget deficit. Gilt rates would have been higher and M4X consequently even lower without it. Kent Matthews said that there had been no discussion of the effects of QE on expectations. He said that there were strong parallels with the 1930s. For the decision to come off the gold standard, read devaluation of sterling, for countries that remained on gold read EMU. The exchange rate played a pivotal role in the 1930s and we should expect the same now. Part of the sterling devaluation was due to expectations and expectations could reverse if QE was halted. He said that he favoured a new medium term financial strategy, similar to the one implemented in the early 1980s, that announced targets for a declining fiscal deficit as a share of GDP and increasing QE at a specified rate of growth.

Votes
The Chairman then asked each member present to make a vote on the monetary policy response. The votes are listed alphabetically rather than in the order they were cast, since the latter simply reflected the arbitrary seating arrangements at the meeting. The Chairman traditionally voted last as at all SMPC gatherings. However, Tim Congdon’s vote was subsequently cast in absentia, because only eight SMPC members were able to attend the 19th January gathering.

Comment by Philip Booth
(Institute of Economic Affairs)
Vote: Keep rates on hold. QE to be sufficient to deliver M4X growth of 5%. Fiscal consolidation necessary.
Bias: To end QE rapidly if and when M4X growth starts to pick up.

Philip Booth expressed a dislike for the current terms in which QE was discussed and the amounts of QE determined. He believed that amount of QE should be sufficient to prevent M4X from falling. What this would mean in terms of further tranches would be determined on a week-to-week or month-to-month basis. He believed a fiscal consolidation was necessary if the end of QE was not to lead to a funding crisis.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold.
Bias: Neutral; adjust QE to maintain broad money growth at around 5%.

In his e-mailed submission, received on 26th January, Tim Congdon stated that the recovery remained fragile, with much of the rebound in other advanced nations since mid-2009 due to the inventory cycle rather than growing final demand. Business surveys were more or less alright for the UK at present and suggested roughly trend growth in early 2010. However, they appeared to be losing momentum in our European trading partners. The ‘Club Med’ members of the Euro-zone – which accounted for about a third of its GDP – were in serious macroeconomic trouble, with no obvious escape from a deflationary black hole.

UK official policy had to be organised to sustain a positive rate of growth of M4X. Monetary developments needed to be watched month by month and were much more encouraging than in late 2008 or early 2009, but there was no doubt that banks were not in an expansionary mood at present. Bankers continued to be intimidated by new regulatory requirements (notably from the December proposals from the Basle Committee), while unused credit facilities and mortgage approvals had collapsed compared with mid-2007 and were going sideways at best. Tim Congdon was in favour of keeping Bank Rate at ½% and using pragmatic month-by-month variations in QE to keep M4X growing. One qualification was that the government’s debt financing plans for fiscal 2010-11 included provision for some £70bn to £80bn of financing at the short end. This would almost certainly be taken up mostly by the banks and result in money creation.

Tim Congdon’s submission added that he was worried about the possibility that the demand for loans would be reviving; possibly, in early 2011 (but who knew?). The Bank of England would then need to sell its gilts in order to fend off eventual inflationary pressures. These gilts would be likely to be sold at a loss. This was not a problem for the UK as a nation because we were all both taxpayers and bondholders via pension funds etc. But the newspapers might have another field-day of misinterpretation and alarmism. He added by emphasising that he was not in favour of large-scale and irresponsible monetary financing of the budget deficit over the medium term. That would be inflationary and of course he opposed it. But he remained in favour of aggressive monetisation of existing public debt for as long as banks’ claims on the private sector were flat or falling. Over the medium term his prescriptions were still – as they had been for over thirty years – for growth of the broadly-defined, deposit-dominated quantity of money at a rate consistent with price stability and low inflation (i.e., about 5% in the middle, but with a band of, say, 3% to 7%) and strong public finances, focussed on the return of an approximately balanced budget. An explicit consolidation plan – as with the Conservatives’ Medium-Term Financial Strategy in the early 1980s – remained not just desirable, but essential.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold. Pause in QE. Fiscal consolidation necessary.
Bias: Towards further easing.

Ruth Lea said that the recovery looked very uncertain and, even though she was not worried about inflationary pressures picking up, she felt that the Bank of England should pause with QE as any expansion now might give the markets the impression that it was no longer serious about meeting its inflation target. Later in the year, when more should be known about the speed and extent of the fiscal consolidation process, the Bank could offset further fiscal tightening with more QE if it was considered appropriate.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold. Pause with QE. Fiscal consolidation is necessary.
Bias: Hold Bank Rate over next three months, although rates will rise later this year; extend QE again from August 2010.

QE cannot continue indefinitely. The next six months, which will probably see positive GDP growth, are a good moment for a pause, while holding back a further additional large tranche of QE to be used in co-ordination with the large fiscal tightening that there is to come.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold. Increase QE by £50 billion. Implement targeted fiscal consolidation.
Bias: Neutral.

Kent Matthews said that he favoured a targeted approach to fiscal consolidation to accompany a targeted increase in QE that produces a rise in broad money growth of 5% a year.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold.
Bias: Neutral on Bank rate; add another £50bn of QE after February.

Patrick Minford stated that his vote was for interest rates to stay low around current levels and for QE to continue at roughly its present rates of flow, with no bias. This would mean a renewal of the currently available stock of QE by another £50bn in the near future.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate by ½%. Pause QE.
Bias: Wait and see; fiscal consolidation essential to maintain monetary credibility.

David B Smith commented that, just as it had been foolish to separate the Bank’s regulatory and debt management responsibilities from its rate setting role in 1997 – because all three functions fed back on each other – it was equally misguided to believe that monetary policy and fiscal policy operated in self contained boxes. Monetary policy decisions could not be made in a vacuum, irrespective of the wider fiscal background. The decision to increase public spending further in the December Pre-Budget Report was feckless in the extreme and had damaged the credibility of all British policy makers. The likelihood that political pressure ahead of the election will lead to an even worse fiscal deterioration suggested that the Bank now needed to disassociate itself from any suspicion that it was underwriting a pre-election giveaway. Otherwise, it would lose the respect of the foreign exchange and bond markets.

By chance, the December 2009 CPI inflation rate of 2.9% was the same as the figure in March 2009, when Bank Rate was originally set at ½%. However, inflation was then receding but is now clearly accelerating, even before the return of VAT to 17½% has appeared in the figures – which will happen next month. The annual increase in the ‘double-core’ retail price index, which is the most historically consistent UK inflation measure, accelerated from 3% in November to 4.1% in December. Leaving Bank Rate unchanged at ½% in the face of rising inflation would imply an unwarranted cut in the real rate of interest. These were uncertain times and it was important to be flexible. However, an immediate ½% hike in Bank Rate to 1% seemed the right decision. Pausing QE until after the election also seemed appropriate, if the Bank wanted to maintain a reputation for political neutrality. Both decisions could be reversed after the election, if needs be, without doing any permanent harm, whereas a loss of monetary policy credibility would take years of stringency to rectify. He remained of the view that it was lunacy to persist with QE while the regulatory authorities were imposing restrictions that could only lead commercial banks to: 1) contract their balance sheets, and hence M4X; and 2) hold more government debt within the reduced assets book and so extend less credit to the private sector.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Interest rate to rise by ½%. QE to be extended by £25bn. Fiscal consolidation is urgently required.
Bias: To tighten.

As December’s inflation report amply illustrated, the UK economy has a particular vulnerability to inflationary pressures. Disruptions to the global supply chain have penalised countries like the UK, which have suffered significant currency depreciation since the crisis erupted in 2007. UK inflation expectations over the medium term are creeping higher and may have already detached from the MPC’s inflation target. With the headline CPI inflation rate likely to exceed 4% within a few months, implying materially negative real interest rates, there is an urgent need for the MPC to normalise bank rate towards the 2% to 3% range. My vote is for an immediate ½% increase in Bank Rate. Nevertheless, it is appropriate to extend QE by another £25bn to help smooth the adjustment to higher yields in the gilt market.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold: increase QE by £50bn.
Bias: To hold.

Trevor Williams said that he expected the economic recovery to be anaemic and possibly to stall in the first quarter. What was being seen was a minor technical bounce after a sharp downturn, not a sustainable pick-up. There was a serious risk of a relapse in the recovery if QE is withdrawn at this stage. The rise in CPI inflation should be ignored, as it is a change in the price level, not inflation. With flat domestic demand, plenty of spare capacity and no growth in private sector earnings, UK inflation will fall back to below 2% in the next eighteen months. Hence, there is no reason why monetary policy cannot stay loose.

Policy response

1. A seven to two majority of the shadow committee felt that Bank Rate should be held at ½% in February. The two dissenting members wanted an immediate ½% rise in Bank Rate to 1%.

2. A majority of the SMPC felt a policy of fiscal consolidation needed to be put in place and two members advocated a revived Medium-Term Financial Strategy.

3. Three members of the shadow committee said that there should be a pause in QE after the current programme expires this month; four members wished to extend QE beyond February, with three specifically requesting an additional £50bn; and two SMPC members believed that the amount of QE should be determined pragmatically in the light of the behaviour of M4X.

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

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

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one to leave Bank Rate at the ½% originally set in March 2009 when the Bank of England’s rate setters next meet on 7th January.

The dissenter voted to raise Bank Rate to 1%, because the era of very low interest rates and supercharged bank profits had outstayed its welcome in his view. When asked to look further ahead, most SMPC members had no marked bias where Bank Rate was concerned. This was largely because of the uncertainties involved. In contrast, the dissenting SMPC member thought that the official discount rate would need to be raised again.

Another member thought that Bank Rate should probably be raised to 1% in February, when a new set of Inflation Report forecasts would be available to the monetary authorities.

The previous SMPC vote had been released before the 9th December Pre-Budget Report. Several members of the shadow committee used their January submissions to express disquiet about the fiscal backdrop to monetary policy. One member pointed out that the government’s intention to spend 53.2% of factor-cost GDP in 2009-10 and 53.6% in 2010-11 pushed the general government spending ratio to well above the 46½% recorded in the 1916-18 period, when World War I was at its peak.

It was hardly surprising that spending on this scale gave rise to unprecedented peacetime budget deficits and the economic and financial strains that traditionally epitomized wartime finance. Some SMPC members were concerned that current official proposals to force banks to hold more capital and liquidity would perversely reduce the supplies of money and credit. There was little to be gained from employing such a controversial technique as Quantitative Easing (QE) if the benefits were going to be nullified by negative regulatory shocks to the supply of broad money.

The SMPC is a group of independent economists who have met quarterly at the Institute of Economic Affairs (IEA) since July 1997. That it is the longest established such body in Britain and meets physically to discuss the issues involved distinguishes the SMPC from the similar exercises carried out by several publications. The current SMPC poll was ‘frozen’ on Wednesday 30th December 2009, although most submissions were received some days earlier, in part because of the Christmas holiday period.

The first SMPC gathering of 2010 will take place on Tuesday 19th January and its minutes will be published on Sunday 31st January 2010. The next two e-mail polls will appear on the Sundays of 28th February and 4th April.

Comment by Tim Congdon
(Founder Lombard Street Research)
Vote: Hold
Bias: Hold; QE should be varied to maintain positive broad money growth

The discussion of UK monetary policy is bedevilled by a verbal confusion. According to standard theory, the equilibrium level of national income is a function of the quantity of money, where the quantity of money consists of the currency circulation, plus bank deposits held by the domestic private sector. In practice money is dominated by bank deposits, and the phrases ‘the quantity of money’ and the quantity of bank deposits’ can be used interchangeably. It follows that an increase in bank deposits of, say, 10% implies an increase in equilibrium national income also of 10% (plus or minus a variety of factors, most of them minor). The evidence in support of this proposition is clear-cut in all economies at all times.

Since 1964, the ratio of non-financial-sector money to UK GDP has risen on average by about 1½% a year. The ratio of such money to national income has therefore doubled over the forty-five years. However, the increase in nominal national income was a compound 9% a year, meaning that money went up by ninety times and national income forty-five times. To repeat, the dominant effect of changes in the quantity of money is on the equilibrium levels of national income and expenditure. This effect is qualified by changes in the ratio of money to income, but over the medium and long the qualification is of limited significance.

The key proposition above – that national income depends on the quantity of money – says nothing about ‘bank lending to the private sector’. The relationship between money and national income holds regardless of whether bank lending is falling, contracting or going sideways. Indeed, bank assets could consist entirely of cash and government securities, and the relationship between money and national income would be maintained. Unfortunately, there is a complication. This is that – when banks make new loans to the private sector – they add extra deposits to their liabilities and so create new money. A large number of people – including, apparently, the chairman of the US Federal Reserve – go from here to believing that, when banks make new loans, ‘they increase spending in the economy’ and that ‘spending’ depends on ‘lending’.

This second claim – that spending depends on bank lending to the private sector - is the fallacy of ‘creditism’. It has nevertheless been given academic respectability by Bernanke and Blinder (1988), Benjamin Friedman’s articles in the late 1980s and early 1990s, and hundreds of subsequent papers about a so-called ‘credit channel’. It has also been parroted so often in the media that most financial journalists believe that the purpose of quantitative easing is ‘to increase the supply of money and hence boost bank lending to the private sector’. This is how the verbal confusion over ‘money’ and ‘credit’ has come to bedevil the current debate on monetary policy.

Why is the claim that ‘spending depends on lending’ a fallacy? It is in fact so wrong that it could be shot down from several analytical vantage points, as the following will show. Payments by means of money – which nowadays means almost exclusively payments across bank deposits – are a vast multiple of both national income and new bank lending to the private sector. Roughly speaking, in the UK today the value of payments is: (I). about fifty times the size of national income; and (II). a variable multiple of the increase in the stock of bank lending to the private sector, assuming that this stock is increasing. For example, in 2004 such lending was under £100bn and so was 1/600th of the value of payments, whereas in 2009 it was perhaps £30bn and was 3/8000th of that value.

A clear implication of (I) is that virtually all of the payments in an economy could be made if no new bank lending whatsoever took place. If this seems odd to creditists, they might ask themselves when they last took out a bank loan? Were they spending nothing in the months and years before that event? Did their spending suddenly surge by the amount of the loan afterwards? Let them just think for a minute or two about their own behaviour.

A further clear implication is that bank lending to the private sector can contract but people and companies will continue to spend, and national expenditure and income chug along without difficulty. If the UK banks had not lent £30bn in 2009, but instead seen their loan portfolios shrink by £30bn, the transactions directly affected would have been under 0.04% of all payments. (The effect of a drop in the stock of bank loans on the quantity of money is, however, a very important matter, because money is turned over many times and agents have a stable demand to hold it, but I anticipate.) Creditists might come back, and assert that bank lending should be compared with national income and expenditure (i.e. the totals of £1,500bn or so which are UK GDP), not with the total of payments. Well, they should again check facts. The overwhelming majority of payments from the deposits newly created by bank loans are to acquire existing assets, and have no direct and immediate impact on the Keynesian income-expenditure flow.

Bank loans to households are mostly to buy existing houses, not newly-built houses; bank loans to companies are largely for expansion by acquisition and hardly any lending to the financial sector is to finance goods and services. Furthermore, most agents do not have bank loans, if companies are excluded. Does that mean they don’t spend? Or that their spending doesn’t change unless they take out a bank loan? It is a simple exercise to show that – even in the corporate sector – there is no relationship between new bank lending and corporate spending, where Britain is concerned.

In short, the notion that spending depends on lending (i.e. creditism) is utter tosh. The correct theory is that the equilibrium level of national income depends on the quantity of money. If we could be confident that the quantity of money would grow in 2010, the macro outlook would be fine. The trouble is that various commentators and authorities, including key people in officialdom, have not understood basic monetary economics and think that ‘lending by itself’ is what matters. Given the prevailing intellectual muddles, it seems to me difficult to make a meaningful macro forecast for 2010. Bank lending to the private sector does not matter much by itself, but it matters enormously as an influence on the quantity of money. If the state’s financial transactions (i.e., those of the government and central bank) are assumed to have no effect on the quantity of money in 2010, my surmise is that bank lending to the private sector would contract by 5% to 10% and the quantity of money would fall by a similar percentage.

I would therefore expect a return of intense recession. However, there is a large budget deficit, which will be financed partly from the banks. In addition, the Bank of England has announced a programme of QE and given a semi-plausible account of how it believes QE to work. So QE remains in the policy-makers’ toolkit and the state’s financial transactions may add 5% to 10% to the quantity of money in 2010. With interest rates at virtually zero, balance sheets, asset prices and demand ought not to be disastrous. Even so, I am inclined to expect beneath-trend growth rather than above-trend growth in early 2010. Money trends in the USA, the Euro-zone and Japan are disturbingly weak, but the so-called ‘advanced world’ will probably pull in real money balances from Asia in the next few quarters. Asian banks etc. are mostly in fine fettle.

My policy prescription is to keep interest rates at near-zero levels and use the state’s ability to create money to ensure that money growth stays positive. That should go some way to neutralize the catastrophic effect of official regulatory pressures on the banks, which are obliging the banks to shrink their risk assets, their deposit liabilities, the quantity of money and the economy. If commentators believe that the Bank of England’s balance sheet has become unwieldy because of the QE exercise, the government itself should borrow directly from the banks and create money that way. I am of course opposed to excessive monetisation of the budget deficit; I support monetisation of the deficit only to the limited extent necessary to sustain money growth in the low single digits. My preferred course is strong action to reduce the budget deficit, combined with aggressive monetisation of the existing public debt.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold; maintain current £200bn QE target
Bias: To extend QE beyond February

The unorthodox monetary policy - Quantitative Easing - adopted by the Bank of England in March 2009 was successful in preventing the kind of multiple credit contraction and severe depression that the US experienced in 1931-33. The fact that real GDP in the UK was not showing clear signs of recovery by the third quarter of 2009 does not mean that the policy was a failure. Rather, the reason why monetary policy did not gain effective traction during 2009 - in the sense of ensuring a prompt recovery in real and nominal spending - is partly due to the standard lag-in-effect of monetary policy. But, more importantly, it is due to the continuing desire of households and financial firms to repair their balance sheets. After a bubble bursts and balance sheets are in need of repair, the tendency will be for growth and inflation to be lower than otherwise because debt repayment is inherently deflationary. The repayment of debt requires the debtor to write a cheque to his or her bank, while the bank cancels the loan. Both sides of the bank’s balance sheet decline. Money and bank credit in the economy are reduced. This slows growth and holds down inflation.

Evidence for the pervasiveness of this process can be seen in the very slow growth rates of money and credit - or in some cases absolute declines in credit – in the US, the Euro-zone and the UK, despite the fact that central bank interest rates in all these economies are close to zero. In other words, there is widespread debt repayment occurring, combined with an aversion on the part of households and firms to increasing their indebtedness, even if the cost of such debt is very low. During the process of balance sheet repair, the authorities can only respond in a reactive way. The fiscal authorities can replace private sector spending with government spending, but only at the cost of replacing private sector debt with public sector debt. The monetary authorities can engage in QE, substituting credit created by the central bank for credit created by the commercial banks, but only at the risk of rapid money growth when the private sector appetite for credit revives. In short, the ultimate driver of economic activity and spending is not the actions of the fiscal and monetary authorities, but the private sector’s income growth and the associated demand for credit, which in turn is dependent upon the state of its balance sheets.

Over the next few quarters QE must be calibrated to compensate for any further debt repayment and consequent credit shrinkage that will result from the process of household and financial sector balance sheet repair. Since UK households became significantly more indebted than their US or European counterparts during the credit bubble, it is natural that the repair process will take longer in the UK than elsewhere. Until that process is substantially completed, the Bank of England will need to continue with QE, and there will be little scope for rate hikes. However, once the balance sheet repair process is completed, QE will need to be withdrawn and rates will need to be raised – gradually - to levels that discourage the build-up of excessive indebtedness in the future.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold; no extension of QE
Bias: To further expansion and unchanged interest rates

The revised third quarter GDP figure, which now shows a quarterly fall of 0.2%, disappointed many City analysts who had convinced themselves on the basis of various business surveys that the UK economy had emerged from recession in that quarter. Of course, this figure may be revised again in due course – and possibly upwards - but a more likely explanation is that we have yet to see solid evidence of a return to growth. Indeed the real data so far available for the fourth quarter are disappointing. October’s services activity, some 75% of the economy, rose by an anaemic 0.1% in the month, October’s manufacturing output was flat and November’s retail sales slipped back after rising in October. In the meantime, inflationary pressures remain contained – despite the pick-up in November’s CPI, with more to come in January, and the undoubted pick-up in producer-price inflation. Earnings annual inflation was a meagre 1.5% in the three months to October.

The Pre-Budget Report was, as widely anticipated, mainly a political document with the general theme of soaking the rich. The Chancellor avoided any attempt to shore up the disastrous public sector finances, leaving this necessary but unwholesome task to his successor. Indeed, and despite the shocking state of the public finances, the Chancellor increased planned spending by around £15bn in total over the financial years 2011-12 and 2012-13 according to the Institute of Fiscal Studies, while recouping less than £9bn through new tax increases. It was another exercise in irresponsible procrastination. The Bank is well on its way to its targeted £200bn of QE asset purchases, over £190bn as at 17th December. Whilst I would not recommend a further extension of QE at January’s meeting, my bias is towards further expansion. The Bank Rate should stay at ½% - and should do so for a considerable time.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold; continue with QE for time being
Bias: Neutral

Worldwide recovery appears to have firmed up. Here in the UK the statistics have lagged behind the anecdotal signs of the same thing. No one believes in the peculiar decision by the Office for National Statistics (ONS) to call a revised GDP drop of 0.2% in the third quarter (now revised down from an initial estimate of 0.4%). We now have not merely surveys of purchasing managers but also employment, production and retail sales figures, all of which suggest that the economy levelled off in the third quarter and could have possibly also started expanding then, and was definitely expanding in the fourth.

The most troubling aspect of the recovery in western economies, including the UK, is the lack of credit growth to the non-bank private sector. However this has been accompanied by a general easing in monetary conditions as measured by other indicators, such as the rates of interest on corporate loans and bonds, and the cost of equity capital. So, it appears that the policy easing carried out by virtually all western central banks has succeeded in offsetting at least much of the effects of the credit crunch created by the banking crisis. Another feature has been the willingness of western governments to allow their budget balances to move into heavy deficit. The way to think of this is that governments will eventually have to pay off these deficits by either cutting spending services to the private sector or raising taxes on it. Hence these deficits are loans to the private sector to perform current services or avoid collecting current taxes; these loans will be paid off in the future. The government is effectively giving credit to the private sector that has dried up through the usual channels.

Some people would like to debate whether such government deficits are effective in supporting the economy; however, it should be obvious that, in a credit crunch, all credit provision is likely to be effective in offsetting the credit shortage. One can agree that in normal times deficit multipliers could well be low because rational consumers will work out that they must pay future taxes to pay for the deficits and hence they may well save in response, so offsetting the direct deficit stimulus. However, this argument is irrelevant in a credit crunch because the private sector is liquidity-constrained. So, monetary and fiscal policies have both been dominated by the need to provide a substitute for bank credit. They have done so and been rather effective in this. As long as the recovery does not raise inflation and require interest rates to rise, and money creation to be stopped and reversed, the government deficits have been costless because financed by money creation at zero interest rate therefore. The burning question is when is the turning point when ‘monetary exit’ must be started, turning these deficits into expensive processes that could violate sustainability conditions, and hence precipitating the necessity of fiscal exit also.

From the UK or US perspective, there is no real reason to rush to the exit. Both countries’ public debt to GDP ratios are quite low, in the region of 50% to 80% prospectively. There is no history of outright default, or of refusal to pay taxes. The main issue concerns the possibility of using inflation as a partial default tool. In the UK there has been a formal inflation target of 2% or so for seventeen years; in the US there is no formal target but a widespread assumption encouraged by the Federal Reserve that there effectively is one of the same order. Since debt has been issued over a long period on the assumption of such a target, the gain to the Treasury from a burst of inflation would be large; it would act like a windfall tax on bond investors. For example to reduce the debt/GDP ratio in the UK back to 40% from its current level of 56% would just require four years of inflation at 6%, only 4% over the target.

Tempting as this might sound, it is striking how little public interest there is in it. Inflation was highly unpopular in both countries when it was out of control in the 1970s and early 1980s; inflation targeting has proved politically successful for this reason. The reason seems to be that the operation of the ‘inflation tax’ is arbitrary and therefore seen as unfair. In particular, those who pay it are often the most vulnerable - for example, those with pensions invested in government bonds - while those with wealth and good advisors can usually avoid it. Ordinary taxation, however unpopular it may be, can be spread across the populace in a fair way, and so can normal ‘Treasury cuts’, which command wide respect as the only way of checking inevitable bureaucratic waste.

So what each of these governments needs to do is put in place a mechanism for the medium term that first brings down the deficit and then ensures that the debt to GDP ratio falls slowly with growth. Meanwhile, and for some time to come, there will be a need for monetary ease as the financial system is nursed back to health; this will keep the financing costs down. The growth rate of credit to the non-bank private sector remains exceedingly low; while other sources of liquidity have increased. However, it is still clear that liquidity is not generally available on competitive terms to many small firms and ordinary households. What has happened so far is that larger firms and wealthier households have benefited from low rates of interest while small firms and poorer households have found it difficult to gain access to finance at all. This is no basis for a modern economy to function well and recover confidently. Yet it is clear that restoring competitive finance when banks have been so damaged will take some time. There is no definite date when one can yet predict it will occur, what with the new capital required, the new procedures to be implemented, the paying-off of government to be done and so forth.

My conclusion is that quantitative easing has worked to partially offset the credit crunch and will continue to be needed as the banking system is rebuilt. Furthermore fiscal policy too will need to be supportive throughout the coming fiscal year, 2010/11- even though a process must be set in place to reduce the public deficit over the following five to ten years. The threat posed by the banking crisis was massive and has not gone away; and while it is premature to celebrate, the policy response has so far been effective. It needs to be continued. Therefore my vote on monetary policy is for unchanged interest rates and continued QE, its scale to be judged by measures of the general availability of liquidity on competitive terms.

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

A great deal of printer ink has been used up in explaining how quantitative easing works and how it has offset the negative impact of the credit crunch on domestic demand. The reality is that it is very difficult to evaluate the effect of QE. The theory is simple enough. The increase in liquidity from QE would manifest itself in an increase in the broad money supply and through a direct mechanism (the real balance effect) will stimulate domestic demand by encouraging consumer spending and drive the economy out of recession. An alternative view is that non-bank financial institutions will use excess cash balances to buy up assets such as stocks and commercial property driving up share prices and property prices. This ‘Keynes effect’ will stimulate domestic demand through an increase in investment spending. While share prices and property prices have reacted in the expected way, domestic demand has remained stubbornly muted. The reason is clear. Over-leveraged households are restoring net asset values by saving. Firms are using the buoyant stock market to restructure their balance sheets and not engage in investment. The banks have found that their good risk customers are repaying debt leaving their riskier customers to demand bank credit. The result is a higher risk premium, wider spreads and weak bank lending. All this has shown up in the third quarter results for GDP, which despite anecdotal evidence to the contrary, continue to highlight the weakness of the UK economy.

One glimmer of hope is the exchange rate. The evidence for the effectiveness of QE is in the near 25% depreciation of the sterling effective exchange rate (partly through a reversal of capital flows but also through an expectations effect). While net exports have yet to respond, signs of a recovery in global demand have begun to emerge and the UK is well disposed to exploit an upturn. An increase in external demand remains the best prospect for recovery. There is much we can learn from the experience of the inter-war period. The sterling real exchange rate depreciated by 18% between 1929 and 1934. Despite a subsequent appreciation, the real exchange rate in 1938 was 9% below its 1929 level. Exports which had fallen by 61% between January 1929 and September 1932 had risen 53% between September 1932 and December 1939. Of course exports never recovered their 1929 level and world trade did not go back to its 1920s levels, but the point is Britain fared better than many other economies with an annual rate of growth of industrial production higher than the average for advanced economies. Uncertainties concerning, budget deficits, taxation, interest rates and the election will hamper the recovery but sterling must be allowed to do its work. This means that quantitative easing must continue and the rate of interest should remain on hold for the time being.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: To expand QE and take other radical measures

The performance of the British economy continues to disappoint. The third quarter GDP headline figure is particularly disappointing - I had expected this to be revised up significantly after the revisions to the construction and business investment data. However, upward revisions to consumer spending and investment suggest that the economy is at least stabilising. The further draw-down of inventories means there is plenty of room for a turn in the stock cycle to support growth over the next few quarters. The big increase in the savings ratio since the beginning of this year is impressive. But it remains unclear whether this is voluntary or involuntary – the effect of much tighter credit markets. The monetary figures also continue to disappoint.

We remain the only G-20 country in recession but all indicators suggest that this will have finally come to an end in the fourth quarter of last year. I expect a positive GDP number as consumers bring forward planned purchases to avoid the increase in Value Added Tax on 1st January 2010. However, this will exert a considerable drag on growth in the New Year, given that the overall effect of this effective price rise will be negative. At the same time, support from other short term factors such as the car scrapping scheme and the stamp-duty holiday will wear off within a few months, and a bumpy and protracted recovery thereafter is in prospect. The Bank of England and HM Treasury forecasts both suggest that the growth rate will pick up to 4% by the end of next year, but I remain very sceptical and believe that more radical monetary policy measures should be considered in attempt to kick-start the economy in 2010.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Raise Bank Rate to 1% in February 2010; extension of QE beyond February should be made dependent on fiscal consolidation

The figures provided in the December 2009 Pre-Budget Report can be manipulated to reveal that general government expenditure will rise from 49.2% of factor-cost UK GDP in 2008-09, to 53.2% in 2009-10, and 53.7% in 2010-11, compared with the April 2009 Budget forecasts of 48.7%, 52.7% and 53.6% for the three financial years, respectively. The general government spending ratios set out in the Pre-Budget Report have no peacetime precedent and significantly exceed the 46½% recorded in the three years 1916 to 1918 when the maximum effort was being put into fighting the First World War (see: How Should Britain’s Government Spending and Tax Burdens be Measured?, IEA Economic Affairs, Volume 29 No 4, December 2009).The Pre-Budget Report further predicted that the deficit on the general government’s current budget would be 10.4% of factor-cost GDP this year, and 10.7% in 2010-11. These are below the deficits recorded during the two world wars, when the current budget deficit peaked at around 28% of national output, but are also without peacetime precedent. While most commentators have emphasised the parallels between the present monetary situation and that of the US in the early 1930s, it is equally plausible that the British monetary authorities are now confronted with the problems traditionally associated with wartime finance.

Aggregate supply and the private-sector tax base are both reduced by the diversion of real resources to the military effort in a major war at the same time as increased government spending widens the budget deficit even further. Governments often endeavour to fund the war effort responsibly through the bond market in the early stages of military expansion. However, only the private sector and overseas residents have a demand for government debt. It is usually impossible for the much diminished private domestic sector to absorb debt issuance on the scale required – the PSNCR will correspond to 31.8% of the non-socialised element of factor cost GDP in 2009-10, according to the Pre-Budget Report, for example – while overseas residents will be reluctant to hold ever larger amounts of a foreign government’s bonds because of currency and/or default risk. The next stage is that wartime governments then start to borrow from the banking sector, perhaps by passing regulations obliging banks to hold a higher ratio of government debt in the asset side of their balance sheets, a process that inevitably crowds out the private sector from access to credit and is sometimes called forced funding. Finally, governments start to directly borrow from the central bank, what used to be known as resorting to the printing press. It is not until this latter stage is reached that inflation has the potential to take off, perhaps only after quite a long delay, and hyper-inflation has not inevitably been the outcome. Annual inflation during the 1914-18 war never got much beyond the mid-twenties in Britain, a performance similar to that observed in the 1970s, before the 1976 International Monetary Fund loan.

The problem that faces any independent analyst of the UK monetary outlook is that there is almost exact observational equivalence between the hypotheses that: (I) the Bank of England is doing the right things to offset the adverse macroeconomic consequences of the 2008 financial meltdown and has remained resolutely independent of the government in so doing; and (II) the Bank and the Financial Services Authority have been politically captured by the government and are now resorting to the stratagems and dodges of traditional wartime finance, in order to keep the government spending show on the road until after the general election, regardless of the longer term consequences. One cannot blame the typical overseas holder of British government securities, who has taken an 18.9% currency loss on sterling over the past two years, from tending towards hypothesis (II). More generally, if the average international bond yield is around 3½% and overseas investors expect to go on seeing currency losses of 10% per annum from holding sterling then it is hard to see why UK bond yields would not eventually settle in the mid teens, in theory. The foreign exchange and global bond markets may be holding their fire for the time being because they believe that an adequate fiscal consolidation programme will be implemented after the 2010 general election. The risk is that the prospect of a hung Parliament, or an excessively limp-wristed response by a future Conservative government, could lead overseas investors to rush for the exits.

The conclusion is that the UK has probably suffered a supply-side withdrawal caused by the rapid increase in the tax and spending burdens and the politically-motivated preference for raising hidden but extremely damaging taxes, such as employers’ National Insurance Contributions. The output-inflation trade off in Britain has probably deteriorated in recent years, and further monetary stimulus is more likely to emerge as inflation rather than enhanced private sector activity. The main hope is that increased global activity will float Britain’s small open economy off the rocks and that a more responsible fiscal approach will be implemented after the election. If this happens, I would expect UK economic growth to average just over 1½% this year, 2¾% in 2011, and 2¼% in 2012, before settling in the 1¾% to 2% range subsequently, compared with the fall of 4¾% in 2009. The annual increase in the ‘double-core’ retail price index – this measure excludes mortgage rates and house-price inflation - accelerated from 1.9% in September to 3.0% in November. There is likely to be a further acceleration to 4½% in the first half of 2010, before a deceleration commences in the third quarter. It is important that higher inflationary expectations do not get locked in as a consequence. A hike in Bank Rate to 1% is likely to be appropriate when the new Bank of England Inflation Report projections become available in February 2010, although this obviously depends on economic developments in the intervening period. It is also vital that the limited gains from QE are not wiped out by misguided regulatory interventions. Recent speeches by senior officials have been somewhat perturbing in this respect.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%; persevere with QE
Bias: To raise Bank Rate

The release of revised third quarter national accounts data just before Christmas appears to confirm the suspicion of a lack of internal consistency evident in the earlier estimates for the same quarter. Real GDP is calculated as a compromise between the separate income-based, expenditure and output measures of whole economy activity and the output estimate is currently 0.9% below each of the others. This drags down the average estimate by 0.3%, or approximately £1bn per quarter. There is still room for revisions to bring up the third-quarter GDP growth estimate to flat or better. Indeed, it was disappointing that the upward revision to business investment, which is now estimated to be only 0.6% lower in the third quarter of last year than in the second quarter, and construction – this is now reported as making a 1.9% improvement in third quarter - was offset by a larger detraction from inventories than in the previous estimate.

Judging from the dynamics of visible trade in other countries, it seems probable that the UK inventory position stabilised in the closing quarter of last year, providing a much-needed lift to the final quarter’s outturn. Despite repeated denials by central bank officials, the global goods economy is recovering strongly, led by Asian trade. The UK’s participation in this ‘V-shaped’ recovery has been hesitant, but there is no reason to expect this sharp normalisation of business inventories to pass us by. A quarterly real GDP gain of close to 1% is expected in 2009 Q4, setting the platform for growth in the first half of 2010 of around 3% annualised.

It should be no surprise that this recovery, however technical in nature, has caught out the distribution and logistics sectors, and left them scrambling to meet seasonal demand. While the pricing power attached to a temporary misjudgement of improving demand conditions is unlikely to persist, rising world prices for energy and food will add to the momentum in retail prices that is already apparent. Despite some well-publicised price cuts by food retailers, UK food prices bottomed in September and the food inflation rate probably touched its low in November. Food carries a direct weight of 11.8% in the RPI, with catering adding a further 5%. The message is that the UK consumer faces considerable inflationary headwinds in 2010.

The November UK inflation data release registered another upside miss for the consensus. The untold story of 2009 has been the steady march of private sector inflation in the UK from 0.3% in January to 4.2% in November. Despite the gyrations of the headline RPI figure into negative territory, the deterioration in UK inflation performance has not gone unnoticed by international bond investors. From parity with 10-year Bund yields in mid-February 2009, the gilt premium has risen to more than 70 basis points. If there are hawks on the Monetary Policy Committee (MPC), they are keeping deathly quiet. Already behind the curve, few expect the MPC to embark on a rate increase before February, by which time the headline CPI inflation rate will probably exceed 3%. When union pay negotiators build their case in the next annual bargaining process, they will reflect upon a 2% to 3% fall in real earnings over the past year, with additional taxation to come. There may be trouble ahead.

As the public perceives an increased risk of higher inflation, the task of the MPC in restraining these expectations has already become significantly more difficult. The acute phase of the financial crisis is past and the opportunity should be taken to wean borrowers off the ultra-low interest rates that they have enjoyed in the past year. The option of extending and even strengthening the QE policy remains available should it be necessary, but the era of very low interest rates and supercharged bank profits has overstayed its welcome. With equity and property prices reviving, UK monetary policy should not remain so accommodative. The lack of timely or proportionate public spending cuts in the Pre-Budget Report has undoubtedly added to the pressures on the UK sovereign debt market. The Bank risks a further escalation of gilt yields and another drop in the value of sterling, with extremely uncomfortable feedback effects on the public finances and domestic inflation. Bank Rate should already be at 1% with a move to 1½% under consideration.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold; maintain QE programme
Bias: To raise QE limit to £225bn in February 2010

Economic data in December suggest that the UK economy will have expanded by around ¼% to ½% in the fourth quarter of last year. This projection is based on figures for industrial production, retail sales, service sector activity and the various surveys of firms’ and households’ spending intentions. House price figures remain resilient, continuing to rise amidst recovery in equity and credit markets. Headline M4 broad money showed a rise in October and November. However, the improved economic picture in 2009 Q4 is still hard to reconcile with a strong sustained economic pick up at this stage, as the actual October underlying money supply data, i.e. excluding securitisation, showed a 5.3% annualised decline. Minutes of the December MPC meeting indicated that this is worrying the Committee as QE seems to be boosting financial markets (helping spreads to narrow, keeping down gilt yields, the equity risk premium and raising share prices) and hence lowering the cost of capital for firms but is not yet leading to faster growth in the quantity of money. Of course, it is not clear whether the economy would be recovering even now, without the boost to M4 broad money from QE. Part of why money supply growth is sluggish seems to be that households are paying off debt, mainly unsecured personal loans.

The final UK GDP data for the third quarter of 2009 highlighted a rising desire to save on the part of households, with a rise in the saving ratio to 8.6%, the highest since the recession of the early 1990s. Some of the rise in the saving ratio is due to a reduction in borrowing as much as to a rise in savings. However, the end result is the same, less consumer spending than otherwise and weaker economic growth. Indeed, data show that the UK was still in recession in 2009 Q3, with a quarterly fall in GDP of 0.2%, making national output 5.1% lower than in the same period of 2008. Another fact worth noting is that the UK is now the last of the G20 countries still to be in recession. The detail of the data in the third quarter also made for unpleasant reading. There was no help to GDP from net exports, and the volume of stock holdings fell by £4.6bn when measured in 2005 prices.

What this all means is that the recovery in the level of GDP from six quarters of consecutive falls may be slow and protracted. A further slide in sterling cannot be ruled out as part of the necessary ingredient for recovery to become sustainable and, indeed, may actually be necessary. Yet another is further expansion of QE, which may be necessary to maintain a low cost of borrowing in an environment where public policy is likely to be unsupportive to growth as 2010 matures. My view is therefore that with election uncertainty ahead, the re-imposition of VAT to 17.5% and an increased propensity to save amongst households, interest rates have to remain at ½% but further QE may also be required when the current £200bn allocation is spent by February 2010.

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

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

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one to leave Bank Rate at ½% when the Bank of England’s rate setters meet on 10th December. The dissenting vote was to raise Bank Rate immediately to 1%, because of concern that underlying private sector inflation had accelerated to 3.9% in October, to reach its highest rate for fifteen years.

When asked to look further ahead, most SMPC members had a neutral bias where Bank Rate was concerned. This was largely because of the uncertainties involved. These meant that policy makers could only cautiously grope their way through the fog of events. In contrast, the dissenting SMPC member thought that Bank Rate would need to be raised again fairly promptly. Another had a bias to tighten if sterling weakened any further. This was partly because of concern that foreign investors would not be prepared to buy British government securities at their current low yields if they suffered further losses on the currency.

There was a divergence of views as to whether quantitative easing (QE) should be extended beyond February 2010. Some members of the shadow committee were keen to stick with QE until recovery was assured. However, others thought that QE should be terminated after February, because of the inflation risks involved.

One issue was that there seemed to be no accepted explanation of how QE was intended to work in theory. Some Bank officials have argued that its main aim is to support the financial markets, boost household wealth, and allow commercial companies to bypass the banking system. Other officials seem to see it a means of preventing a collapse in broad money of the sort that proved so catastrophic in the 1930s US Great Depression.

A number of SMPC members were concerned that current official proposals to force banks to hold more capital and liquidity would perversely reduce the supplies of credit and money as bankers re-organized their balance sheets.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold
Bias: Hold: QE should be varied to ensure that broad money growth stays positive

Central bankers and regulators interpreted the breakdown of the international inter-bank market from mid-2007 as being due to a lack of capital in the banking system and the consequent high levels of distrust between individual banks. Since the autumn of 2008, therefore, banks have been under pressure to raise their capital/asset ratios. Both the shrinkage of assets - which must be matched by a reduction in total liabilities - and the raising of capital (which reduces the ratio of deposit liabilities to total liabilities) destroy bank deposits. So the result of the regulatory pressure to force the banks to be better capitalised has been to lower the growth of the broad measure of money which is dominated by bank deposits. This process has now gone so far that, over recent months, the quantity of money has been flat or even falling in both the USA and the Euro-zone, which increases the risks of a downward debt-deflation spiral in 2010. By trying to make the banks safer, officialdom has paradoxically aggravated the deflationary dangers facing the leading economies and their banking systems.

The key individuals in the official institutions responsible for the capital-raising edicts of late 2008 and early 2009 either ignore or scorn the monetary theory of the determination of national income; the theory in which the quantity of bank deposits is so important. Examples of such key individuals include: Dominique Strauss-Kahn and Olivier Blanchard at the International Monetary Fund (IMF), Ben Bernanke at the US Federal Reserve and Timothy Geithner at the US Treasury, and practically any British Treasury or FSA official. A very large number of other economists – including probably a majority of the SMPC’s members – also scorn this theory and believe it to be irrelevant or wrong. But let us suppose that it is relevant and correct. Then it is clear that officialdom’s capital-raising edicts set in train a debt-deflation process. While the banks may have been genuinely short of capital in mid-2007, banks and their regulators are in constant contact, and regulators did not ring alarm bells about the subject in 2006 and 2007. Furthermore, 2009 has seen a surge in the value of the asset-backed paper that was supposed to be so ‘toxic’ in late 2008.

Moreover, as and when the process of bank de-leveraging is over, the cost of bank finance will be higher than it was in the years running up to mid-2007, if it is assumed that banks will seek the same return on capital. Logically, the equilibrium ratios of bank loans to national income will be lower. That does not necessarily imply that the quantity of money must shrink for a period and reduce equilibrium national income, because banks may acquire other assets. In fact, banks in the main countries are holding exceptionally large amounts of cash at present and their claims on government tend also to be rising. (The Bank of England’s quantitative easing programme has obviously had this effect.) However, my verdict is that – from an intellectual standpoint – policy-making is in chaos.

Bluntly, when the various panjandrums announced the capital-raising efforts in late 2008, they had no understanding of the wider implications of their actions. They had not for a moment thought about the repercussions of these actions on the quantity of money. Banks may or may not have had a serious capital problem but the focus of policy should have been to ensure that the quantity of money would continue to grow even as banks were sorting out their capital difficulties.

QE has rescued the UK economy from a debt-deflationary disaster, but I am far from persuaded that either ‘the main economies’ of the USA, the Euro-zone and Japan or the smaller British economy are out of the woods yet. Some help is on its way from the continued growth of money, credit and national income in the developing nations, including China. But Chinese M2 will grow more slowly in 2010 than in 2009, for example. In these circumstances, commentators who worry about an early and sustained rise in inflation need to have their heads examined. Bank Rate should be kept at ½% for many months yet, while the amount of QE should be varied – almost on month-by-month basis – to ensure that UK broad money growth stays positive. In terms of the structure of policy, it would be preferable that HM Treasury and the Debt Management Office (DMO) work with the Bank towards maintaining positive money growth, if necessary by suspending sales of long-dated debt so that the government has to finance its deficit from the banking system. More generally, my preference would be for the rapid reduction in the budget deficit, so that it is existing debt rather than new debt that is being monetised, but much Keynesian twaddle is going the rounds at present. Of course, the regulatory pressure on banks to raise capital/asset ratios has been fundamentally misplaced and should be wound down. A wider public debate is needed on the wisdom of the large increases in banks’ capital requirements that have been under way since the autumn of 2008.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold
Bias: To hold Bank Rate and further expand QE

The third quarter GDP data, now revised to a quarterly fall of 0.3%, were disappointingly weak and fell short of City expectations of a modest increase. One of the ‘explanations’ for the ONS figure being out of line with City expectations is that the Office for National Statistics (ONS) may significantly revise the GDP figure upwards and thus the City will be vindicated. But it would be unwise to rely on helpful ONS revisions to save the City’s face. A more plausible explanation is that forecasters partly rely on business surveys in order to make their forward estimates of GDP. And these surveys have intrinsic shortcomings. They are subjective and difficult to standardise over time. They do not provide direct and quantifiable estimates of changes in economic activity and their coverage is limited. Of course, the ONS data are imperfect but they are likely to be a better guide to economic developments than survey measures.

Given the ONS’s latest GDP data, Britain’s economic recovery seems far from firmly established. And even though growth should return in the next three to six months, it is unlikely to be robust given household indebtedness and the still fragile state of the banking system. And, of course, there surely has to be significant fiscal tightening in the pipeline. The Chancellor may even announce such measures in the Pre-Budget Report of 9th December.

Under these circumstances the authorities will be relying on monetary policy to continue to provide stimulus to the economy. Last month’s announcement of a further £25bn tranche of QE to take the total to £200bn was arguably less than expected. But the Bank can always extend QE next spring if it felt this was an appropriate policy action. And I would support this stance. Therefore, even though I would not recommend a further extension of QE at December’s meeting, my bias is towards further expansion. Bank Rate should stay at ½% - and should do so for a considerable time.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold and hold on QE
Bias: To hold until the second half of 2010

It seems to me that the issues at present fall into four categories: financial; recessionary; fiscal; and price level. Each will be taken in turn, starting with the financial. The situation in Dubai is a reminder that although (with the aid of in my view catastrophically misdirected support from governments) the prospects of UK banking sector firms - though not the market - are much brighter than they were a few months ago, it is by no means obvious that the sector is out of the woods. Estimates vary concerning the losses still to be crystallised, but they probably run into the hundreds of billions of pounds. The sector is in a race for survival, attempting to recapitalise through very high short-term trading profits being made as a result of extraordinarily low interest rates and high margins, in the hope that these high profits can materialise faster than the losses become manifest. That remains to be seen, and a new wave of sovereign debt crises could yet trigger further problems in a number of ways. It is possible to argue that this would suggest QE should be expanded in the short-term, so as to guarantee liquidity. However, this crisis is, at root, a problem of solvency associated both with past losses and reduced prospects of future profitability. Liquidity can, at most, provide a delay – and not a costless delay, for delay means denial, a failure to engage with problems swiftly and decisively, and larger losses in the end.

The UK is still in recession, at least officially. I am not inclined to share the certainty of many commentators that the Q3 figures are uniquely poor. However, it does seem plausible to me that, throughout 2009, GDP estimates have embodied assumptions about inflation/deflation that underestimated the degree of deflation in the economy, with the result that the figures in real terms will eventually be revised up, giving less recession, but more deflation. Two consequences would be (a) that deflationary risks are greater than has been thought; (b) that real wage rises are higher than thought. Be that as it may, I continue to expect that Q4 will show growth, and Q1 may do so also, but also that the economy will slip back into (mild) recession in mid-2010. This factor might again seem to provide a reason for QE to be extended. However, I don’t believe that this further phase of recession can be avoided, now, and neither do I consider it particularly desirable to attempt to do so. Indeed, I believe that it will be useful in encouraging consumers to deleverage more rapidly – which is highly necessary – and in restoring equilibrium in the prices of key assets such as housing. I would prefer to save my monetary ammunition in case it is needed to prevent the further slight slip I expect from turning into a darker extended depression or period of stagnation. However, I do not believe it will be necessary. The Bank of England now forecasts 4% growth for 2011. I consider that an under-estimate and expect the year 2011 to resemble the Heath-Barber Boom.

There needs to be a very sharp fiscal tightening, commencing next year, of the order of £100bn over a three to four year period (with further tightening to come – the structural deficit is estimated by the Treasury at £140bn; the total deficit will probably exceed £200bn this year (14% of GDP)). I do not consider it plausible that a deficit of 14% of GDP and public spending at above 50% of GDP - up from just 41% as recently as 2007/8 - is growth-promoting rather than growth-retarding. Provided that fiscal consolidation focuses overwhelmingly on spending cuts and can be accompanied by monetary easing, I believe that it will tend to encourage early recovery. This therefore suggests that available further monetary easing should be held back to accompany fiscal tightening. It would be better if fiscal tightening could commence immediately – perhaps even in the forthcoming Pre-Budget Report – and hence QE could continue. But I have no confidence or expectation of such fiscal tightening occurring.

The economy has now been in deflation for eight months – a fact that has received little attention in the press because of the fixation upon the policy rate of the consumer prices index (CPI) instead of the cost of living measure of the retail prices index (RPI). Deflation is with us, now, and the risks of further deflation are far from gone. Recent movements in monetary data are encouraging, but the wage data continue to deteriorate, down to just 1.2% in the year to September. I continue to urge that if nominal wage growth were to fall materially further, so that many people experienced nominal wage falls, there is a great risk that this would imply widespread prime defaulting on mortgages, and much further financial sector anguish, leading to severe monetary contraction. Deflation is the immediate concern. However, once strong economic growth commences at the back end of 2010, there will be inflation. This cannot be avoided without exacerbating the short-term dangers of deflation, and I believe policy-makers should simply accept that there will be inflation in 2011/2 on a scale the UK has not seen for at least twenty years, and perhaps thirty. That is not to say that RPI inflation in double digits will be desirable (a position urged by some commentators). It is that what we would have to do to avoid it would create such danger of worsening deflation, in a highly-leveraged economy in which high deflation would be disastrous, that we should not try. Aim off in the inflationary direction. That’s all there is to do. Overall, my judgement at this stage is that QE should be stalled until it can be combined with severe fiscal tightening commencing next year, and interest rates held, even though the expected consequence will be a money-fuelled inflationary boom in 2011/2.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Continue with QE at the present rate into 2010

The recovery is in progress across the world. Yet, the concern everywhere is whether it is robust enough to withstand the withdrawal of the massive government support measures, both fiscal and monetary, that have brought it about in response to the banking crisis of late 2008. The problem is that these measures have not revived credit growth in most economies. In the UK in particular, credit growth to firms is negative while that to households is negligible. But even though one can point to ambiguities in the official policy of the Treasury and the FSA, which may have encouraged this trend by accelerating the build-up of bank capital ratios, the truth is that the same behaviour is evident in the US and the Euro-zone where the regulatory attitudes have been overtly more permissive.

Meanwhile, other financial markets have seen renewed flows of intermediation, notably equities and corporate bonds - issues of both have increased sharply. So, savings have bypassed the banks, which have been unable to supply finance on attractive terms. The biggest concern about this pattern of intermediation is that it might leave small and medium-size (SME) firms starved of capital while big firms able to use the equity and bond markets enjoy plenty. However, this is to ignore the ingenuity of markets in exploiting opportunity - in this case, the re-intermediation of funds to SMEs via the large firm sector. A bit like ‘cash back’ from a supermarket, SMEs can get spare cash from their larger brethren. There is anecdotal evidence that such funds are available on the market.

Can there then be a credit-less recovery? It is an unusual idea, yet that seems to be what we are observing. Certainly, the market cost of capital has come down sharply in the past year for the average borrower. While that may be leaving some marginal borrowers out of the picture, it seems that for firms willing to try hard enough to find funds, find them they can. This still does not include first-time house buyers, for whom deposit requirements remain exacting. But this has not prevented a sharp bounce back in house prices over the second and third quarters - which has been no less than 7% on the Nationwide’s figures. As this housing recovery gets established, these buyers too will find the terms becoming easier.

It is likely that, as world recovery gathers pace oil, and other raw material prices will keep on rising. Already oil is around $80 a barrel. This has begun to show up in CPI figures which are getting closer to the 2% target. There is little doubt that this will give central banks some pause in the money creation programme. The ECB will probably be the first to tighten. The Bank of England and the US Federal Reserve will take longer, probably allowing inflation temporarily to go over the target, because of the special problems with the UK and US banking systems. The first part of the monetary easing programme to go will be money creation via the purchase of financial assets; interest rates will probably be raised later. At present, 2010 still looks like a year where interest rates will stay low, roughly where they now are, in the UK and US, but higher in the Euro-zone. However, this pattern will be highly sensitive to developments in the recovery.

The pattern of fiscal retraction will closely follow the path of interest rates. As these rise, the pressures to cut back public deficits will intensify because the interest cost of debt will start to bite. It is also possible that bond markets will tire of supporting governments that do not retrench sooner rather than later, so that long-term bond yields rise aggressively - also forcing retrenchment. As I have argued before, these fiscal and monetary developments are largely on automatic pilot under the inflation-targeting regime. Only if governments abandoned the target would this change; but there is no sign of that precisely because the inflation target was put there by popular demand in the face of past, highly unpopular, inflations. My views for the current monetary policy stance are: continue with QE at the present rate into 2010, with interest rates held at current levels. However, my bias is to tighten QE if as I expect the CPI rebounds on higher oil and raw material prices.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Neutral for both interest rates and QE

The most obvious effect of quantitative easing (QE) has been the rise in asset prices. The Bank of England has bought huge quantities of gilt-edged stock (British government bonds). The sellers have received money. Many investors, for example, life offices and pension funds, have reinvested the proceeds. The direct result has been a rise in the prices of the asset that they have bought. The ‘bears’, who had sold stock they did not own, have had to close, and asset-prices in general have risen. How large will be the stimulus to economic activity?

A rise in asset prices clearly stimulates economic activity. The increase in wealth encourages expenditure and confidence in financial markets spreads to the economy in general. History shows however that a rise in asset prices is a necessary but insufficient condition for economic recovery. In other words an economic recovery will not occur if asset-prices have not risen but the recovery may or may not occur if they have risen. The explanation is as follows. The supply and demand for money are rarely in line. If the supply of money exceeds the demand for money, as always happens before a recession ends, some of the surplus will be spent on goods and services and economic activity will increase. Some of the surplus will be spent on existing assets and asset-prices will rise. The rise in asset prices precedes the economic recovery because financial markets react more quickly than the real economy. If asset prices have not risen there will not be sufficient money to end the recession. If they have gone up, the amount of surplus money being spent on goods and services may, or may not, be sufficient to end the recession.

At the peak of a business cycle the demand for money from individual investors for savings purposes is usually higher than normal. The demand for bank deposits as a home for savings depends on how the rate of interest on bank deposits compares with the expected return on other investments, particularly on bonds and equities. At the peak of a business cycle short-term interest rates are usually higher than long-term ones and the income from a bank deposit is relatively high. Risk of loss is also relevant. Bank deposits have an advantage here too because perceived risk is high on bonds and stocks if markets are falling as they usually are at the peak of a cycle. The relative advantage of bank deposits is subsequently upset by either interest rates on bank deposits falling or the expected returns, allowing for risk, on bonds and equities rising. The latter usually comes first when investors judge that the bear markets are coming to an end. When the equilibrium has been upset, switching from bank deposits into risky assets during a typical cycle does not reduce bank deposits but merely transfers a bank deposit from the buyer to the seller of the asset. In normal times money is quite like the hot potato of the children’s game: one child can pass it to another but the group as a whole cannot get rid of it. Each time a bank deposit changes hands it is progressively more likely to be spent on goods and services. If the money stays in the system, the stimulus to economic activity continues.

QE has changed the timing of the bull markets in bonds and equities associated with a business cycle. It has been brought forward. The bull markets will end sooner than usual and with them the beneficial effects on economic activity. The next difference in the current cycle is that almost all of the money injected by the Bank of England was initially spent on assets and very little on goods and services. In the current cycle the amount of money being switched into risky assets has clearly been exceptional because interest rates on bank deposits are so low. An important difference is that much of the money has been invested in new issues by banks and in bonds issued by companies to repay bank loans. In both cases the money is destroyed and does not remain in the system. In the former case deposits fall and non-deposit liabilities rise on the liability side of the banking sector’s balance sheet, with no change in assets. In the latter case deposits fall on the liability side and loans fall on the asset side. In both cases the important continuing ‘hot-potato’ effect of money remaining in the system is absent.

The monetary data for September confirm that monetary ease has gathered little momentum. The rate of growth of M4X, which excludes transactions by quasi banks, was 1.9% during the last twelve months and has not risen as the annualised seasonally adjusted rate during the last three months has remained at 1.9%. The rate of growth of M4 holdings of household has however risen slightly from 2.5% to 3.9% and that of non-financial corporations has risen from 1.4% to 3.6%. The restructuring of balance sheets will undoubtedly be beneficial and assist economic recovery in due course. However, the monetary stimulus has not been gathering momentum. It will probably be wise to suspend further QE for the moment, whilst the effects of QE in the past are materialising. But a conclusion that more QE will not be needed in coming months is premature.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: Expand QE and take other radical measures

The third-quarter UK GDP figures revealed a fall of 0.3% on the quarter and 5.1% on the year. Surprisingly, stocks did not contribute to growth: it appears that this temporary boost may already have worn off. What was less of a surprise is that the car scrapping scheme appears to have boosted imports rather than domestic output. Net trade made a negative contribution to GDP growth in the third quarter. An increase in government spending was offset by flat consumer spending and the continued business retrenchment. Although these figures are at odds with the survey data for the same quarter, the performance of the economy over the last few months has been very disappointing.

Looking ahead to 2009 Q4, I still expect a positive GDP number as consumers bring forward planned purchases to avoid the increase in VAT on 1st January. However, this will exert a considerable drag on growth in the New Year, given that the overall effect of this effective price rise will be negative. At the same time, support from other short term factors such as the car scrapping scheme and the stamp duty holiday will wear off within a few months, and a bumpy and protracted recovery is in prospect.

The November Bank of England Inflation Report suggests that the growth rate will pick up quickly next year and reach 4% in 2011. However, I remain very sceptical and believe that more radical monetary policy measures should be considered in attempt to kick-start the economy. It seems clear that QE has boosted asset prices, but that there has not been the usual follow-through into spending. Cash has been injected into the wider economy, but has been used by companies and consumers to pay down debt rather than for spending. This gives a new twist to the old Keynesian idea of the liquidity trap.

It is hard to know what to do to get banks lending and people spending again. However, the minutes of the November Monetary Policy Committee (MPC) meeting reveal that the MPC discussed the possibility of reducing the rate of interest paid on commercial reserves held at the Bank. While they did not implement this policy, they saw this as an option if economic conditions did not improve. I think this should be implemented sooner rather than later. This might not stimulate lending but it would at least bring interest rates down by lowering the base of the structure. If zero did not do the job, I would consider a negative interest rate. The only problem that I can see is that a move to a negative interest rate on bank reserves would mean QE would turn into a tax on the banks, since they would find it difficult to pass this charge back to their customers. This would undermine the authorities’ attempts to recapitalise the banks and get them lending again. I have argued that the QE programme has allowed their best customers to run down their loan accounts, to the tune of perhaps £200 billion, effectively replacing them with these low interest bank balances at the Bank. Charging the banks for these holdings or even offering a zero interest rate would add insult to injury, especially since the aggregate amount is effectively set by the authorities.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold in December
Bias: To cautiously start tightening, especially if sterling weakens

A properly conducted monetary policy should have the stability of a tripod, with the setting of the official REPO rate, debt funding policy, and the regulation of the financial sector all being employed in a co-ordinated manner as part of one Central Bank toolbox. Unfortunately, the tri-partite dismemberment of the Bank of England in 1997, which resulted in the splitting off of its debt management responsibilities to the DMO and its regulatory responsibilities to the FSA, means that there is now a serious policy inconsistency between what should be the three main legs of monetary policy. It is needlessly cumbersome to have the DMO selling government debt on one day, only for the Bank of England to buy it back under QE the next. However, it is even more crazily inconsistent that the regulatory authorities are trying to get the commercial banks and building societies to hold more capital and reserves at a time when the need is to stop the broad money stock from imploding.

Fifty years ago, the economics text books of the day accepted that the reason banks held liquid assets was to protect against the worst-case scenario of a run on the bank. Once a bank run took place the whole point of liquid assets was that they could temporarily be run down to below their long-run prudent level, until the immediate crisis had passed. It was also accepted that the authorities should acquiesce in this behaviour and permit the reserve asset ratio be run down under these circumstances. It is discouraging that half a century later Britain’s financial regulators perversely appear to believe that they should be enforcing measures that can only lead to: a reduction in the size of the banking sector’s balance sheet; a smaller share of lending to the private sector within the reduced asset book; and less money supply, than if the regulators had left well alone.

Fortunately, Britain has a small open and trade-dependent economy and its national output moves more closely in line with the growth of the developed economies as a whole than it does with the policy levers controlled by the domestic authorities. The latest IFO World Economic Survey from the Munich based CES IFO group, published on 19th November, shows signs of a clear improvement in global sentiment, with a ‘V’ shaped rebound from the first quarter low point rapidly approaching (but not yet reaching) the 1993-2008 average from below. The IFO economic climate index for Asia is already above its long term average. However, business confidence in North America remains somewhat below, and in Western Europe well below, their long run averages.

Businessmen have suggested that one of their main problems has been that global supply chains collapsed after the Lehman bankruptcy because suppliers were no longer prepared to grant trade credit to each other. Since a typical consumer electronic good can have twenty or more suppliers in maybe half a dozen countries involved in its production, fear of default by a single counterparty – or their bankers – anywhere along this chain can cause the entire production process to jam up leaving suppliers and retailers with no choice but to ‘dash for cash’ by slashing inventories and employment and dumping stock at bargain basement prices.

While OECD broad money has not collapsed so far, the unmeasured ratio of international trade credit to broad money seems to have done so. This partly explains the limited leverage of conventional domestic monetary policy in the present crisis. Businessmen’s willingness to extend credit is likely to gradually return as general confidence is restored and experience reveals which of their counterparties are sound and unlikely to default. The subsequent recovery in intermediate demand as supply chains start cranking up again will initially appear as a rebound in inventories in the national accounts, and then in international trade, and private capital formation.

The problem facing the more mature western economies is that their supply sides are so sclerotic as a result of their high public spending and regulatory burdens that they will prove incapable of benefitting significantly from any global recovery. The US and Britain, in particular, have seen such large increases in their government spending ratios over the past decade that their sustainable growth rates have slowed down sharply. If this supply withdrawal is ignored, and central banks attempt to get back to the previous growth path, the outcome will be stagflation not recovery.

This policy error is now seen as having been one of the main causes of the stagflation in the US and Britain in the 1970s. There is a risk that both countries have repeated the policy error of the early 1970s that led to the catastrophic performance of the mid-1970s. A responsible policy of monetary stimulus has to be accompanied by measures to liberalise the supply side if it is not simply to end up letting the inflation genie out of the bottle. De-regulatory labour-market measures would not add to the Budget deficit and would be a useful first step. However, there will also have to be a reduction in the share of national output absorbed by the state. The 9th December Pre-Budget Report will clearly need to be closely scrutinised in this respect. The fiscal stabilisation literature strongly suggests that cutting public consumption expenditure from its present bloated level will not only reduce the fiscal deficit but also strengthen economic growth and employment.

Where does this leave the MPC? The answer is pulling policy levers that are probably no longer reliably connected to the wider economy and in many cases being tugged in an opposing direction by the regulators and fiscal authorities. The most likely scenario is that the British economy will be floated off the rocks by the rising tide of international recovery, but that domestic monetary policy will only marginally have helped the process and fiscal policy will have impeded it. Some MPC members appear to believe that the weaker pound will help the recovery. However, UK imports seem to be almost entirely insensitive to the exchange rate these days, and the price elasticity of demand for UK exports to be only around 0.4. The gains to exporters from a weaker currency also have to be offset against three drawbacks. First, the adverse movement in the terms of trade reduces national disposable income relative to GDP. Thus, in the year, to 2009 Q2 (the latest ONS figure available) Britain’s gross national disposable income at market prices fell by 8.1% when total GDP dropped by 5.5%. Second, and in a small-open economy like Britain’s, each 1% decline in sterling eventually comes through as a 1% hike in the price level, although this is usually a long-drawn out process. The 20½% drop in sterling over the past two years, and the 4% drop over the past year, represents a serious inflationary threat unless one believes that the overseas price level is likely to fall by a corresponding amount. Finally, overseas investors in British government securities will not be prepared to fund the fiscal deficit at anywhere near the present 3.6% on a ten year gilt, if they believe that they will take continuing foreign exchange losses. It is probably getting close to the point where Bank Rate should be raised in any case. I would certainly raise it if the sterling index, which was 80.1 (January 2005=100) on 27th November threatened to ease any further. The QE programme has now been extended to the end of February, but is really doing little more than offset the ‘crowding-out’ effects of the Budget deficit. The uncertainties are such that it makes sense to reserve judgement until nearer that date but a cessation of the programme would probably be appropriate. Finally, the politicians and the regulators must ensure that the perceived threat of a more onerous regime does not cause bankers to start re-trenching their balance sheets straight away in anticipation of future increases in capital and liquidity requirements. That really would produce a vicious second downwards leg to the recession.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate to 1%, persevere with QE
Bias: To Raise Bank Rate

Whereas the UK appears to be a laggard in the global economic rebound, it is becoming clear that the third quarter of 2009 showed a significant improvement in activity in a majority of Western countries. Asian economies had generally begun a recovery in the second quarter. Shipping container volumes scored their second successive quarter of double-digit percentage growth and annual growth rates should turn positive in the final quarter. Cargo rates for shipping and air freight have soared in recent weeks. Suppliers’ delivery times have lengthened in recent months, which is unusual for the early stages of a recovery. There is every indication that a powerful inventory rebuilding exercise is underway in the global goods economy.

In the additional national accounts detail released on 25 November, UK money GDP at market prices rose by 1% in Q3, led by a 3.2% gain in the gross operating surplus of corporations. The surprise in this data was the continued decline in business investment (down 3% on the quarter, 18% on the year) and the extension of the rapid depletion of inventories (another £3.6bn, making a total of £16.8bn or 4.8% of GDP) in the past four quarters. The timidity of the UK corporate sector looks to be seriously misplaced and the purchasing manager surveys suggest than an urgent normalisation of output schedules is underway. The October manufacturing Purchasing Managers Index (PMI) was at its best level for two years, and the new orders component index was even more impressive. Inventory change could rise to zero in Q4, propelling a sizeable increase in GDP. Notably, pricing pressures have also increased, reflecting the turn in energy prices.

In the monetary statistics, October brought the welcome news of a 1% monthly rise in M4 lending and a 1.8% increase in M4. The three-month annualised growth rates have recovered to more than 7% for M4 lending and to 11% for M4. In both cases, the three-month annualised growth rates now exceed the twelve-month growth rates, indicating that the latter are also poised to stabilise and grow. In short, the UK’s deflationary panic is over and the Bank of England’s MPC should not delay in taking action to remove the emergency setting of Bank Rate.

On a fundamental level, it is time for the pendulum to swing back from borrowers to savers. Mortgage borrowers have enjoyed a year of bonanza as their base tracker rates have tumbled from an average 7% in October 2008 to 3.9% in August and discounted two-year fixed rate mortgages, from 6% to 3.2%. Retail savers have suffered declines in Cash ISA rates from 4.4% to 0.4%; instant access accounts from 2.4% to 0.2% and notice accounts from 3% to 0.4%. While some embattled institutions are offering substantially better rates in order to attract deposits, the centre of gravity in the savings market is painfully low. If Bank Rate is left unchanged, the real rate on retail savings could be as low as minus 3% by next April.

Our familiar decomposition of the RPI reveals that private sector inflation of goods and services (excluding fuel and light) reached 3.9% in October, up from 0.3% in January, to record its highest inflation rate since 1994. There is a clear upward bias to UK consumer prices that will be painfully obvious to all once the extraordinarily favourable base comparisons of last summer disappear from the reckoning. Petrol and oil prices are already giving up their benefit to the RPI and CPI and soon fuel and light prices will follow suit. Another breach of the upper band of the official CPI inflation target, so quickly after the last (2008), will undermine what remains of the Bank’s policy credibility.

In conclusion, the gloomy mood of the past two years is beginning to lift, even if this is largely because of the significant forms of government support in place. This acute phase of the financial crisis is past and the opportunity should be taken to wean borrowers off the ultra-low interest rates that they have enjoyed in the past year. The option of extending and even strengthening the QE policy remains open should it be needed. But the era of very low interest rates and supercharged bank profits has overstayed. With equity and property prices rising, UK monetary policy cannot remain so accommodative. Otherwise, the Bank runs the risks of an escalation of gilt yields and another drop in the value of sterling, with extremely uncomfortable feedback effects on the public finances and domestic inflation.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: To hold Bank Rate but extend QE beyond February

High frequency data suggest that the UK economy will post positive growth in the final quarter of this year. The second estimates of the 2009 Q3 performance saw the initial fall of 0.4% moderated to one of 0.3%. Many argue that it will eventually be revised up to show positive growth, but that is moot at this time. Of much more significance is that the breakdown of the third-quarter data showed that net exports detracted from growth. Exports rose in the three months to September but imports were up even more. This is not good news for the pace of recovery in 2010, as it suggests that the currency is not weak enough to be supporting exports and/or the mix of UK exports is such that it is unable to benefit from the recovery taking place in world trade.

Either way, the end result is the same: there is little to prop up the economy in the absence of growth in domestic demand; and with consumer spending under pressure and an unsupportive fiscal picture looking ahead, recovery will be weak and muted at best. That is why it is so crucial that there is sufficient liquidity around to fund what growth impulses there are. Robust growth in money supply is therefore a prerequisite for any sustainable economic recovery. To that end, preliminary figures for October were encouraging, showing that broad money M4 rose by 1.8% in the month to stand 11% up on the year, down from 11.6% in the year to September.

It is true that Purchasing Managers Indices (PMI’s) are encouraging; retail sales look better, and industrial production is recovering from its lows, but it is also true that these may not last. Inflation is set to rise in the next few months, albeit temporarily, and hence will hit spending in the first half of 2010. Taxes are set to rise and some of the rise in industrial production may just be restocking after a bout of destocking. This is even more likely as there is not enough of a rise in exports to justify a sustained pick up in company output. Unemployment is set to rise further and both companies and households seem determined to repay debt and save more. In other words, the recovery may peter out if it is not sustained by continued low interest rates and abundant liquidity from the central bank and government.

As a result, it is too soon to say for sure that further QE is not required, and it is certainly too soon to even think of raising short term interest rates. Bank rate should therefore stay at ½%, and the decision on QE should be decided in February, when the current allocation is due to be exhausted. I have a bias to more QE, if required by a weakening economy after what is likely to be a return to positive growth in Q4 2009 after six quarters of decline.

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

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

Following its latest quarterly gathering on 20th October, the Shadow Monetary Policy Committee (SMPC) voted by eight votes to one to leave Bank Rate at ½% when the Bank of England’s rate setters next meet on 5th November. The dissenting vote was to raise Bank Rate immediately to 1%, because of concern that inflationary pressures were building up in the private sector of the economy.

When asked to look further ahead, most SMPC members had a neutral bias where Bank Rate was concerned. This was because of the uncertainties involved, which suggested that ‘wait and see’ was the safest option. In contrast, the dissenting SMPC member thought that Bank Rate would need to be raised to 2% fairly promptly.

There was a widespread view on the SMPC that quantitative easing (QE) needed to be extended for some months beyond November, when new Inflation Report forecasts will be available and the present schedule expires. However, there was disagreement about whether QE should be persisted with in the medium term. Some members were keen to stick with QE until the underlying growth of core broad money – the so-called M4X – was rapid enough to ensure recovery. However, others thought that QE should be terminated after one final tranche, because of the inflation risks involved if it was continued for too long.

Despite the earlier date of the SMPC gathering, the final poll was not ‘frozen’ until Tuesday 27th October. This meant that most SMPC members knew of the disappointing UK growth figures released on 23rd October and some referred to them in the final edited submissions. Informal soundings revealed that several SMPC members thought that the official figures were unreliable and likely to be revised. One member was concerned that regulatory proposals to increase bank capital and liquidity would cause commercial bankers to cut back their balance sheets in anticipation, leading to a renewed collapse in money and credit and a second leg to the downturn.

Minutes of the Meeting of 20th October 2009
Attendance: Tim Congdon, Kent Matthews (Secretary), Gordon Pepper, David Brian Smith (Chair), Trevor Williams, External observers: David Henry Smith (Sunday Times), Hiroshi Oka (Minister for Economic Affairs, Embassy of Japan), and Hajime Yoshimoto (Senior Economic Analyst, Embassy of Japan)

Apologies: John Greenwood, Ruth Lea, Andrew Lilico, Patrick Minford, Peter Spencer, Peter Warburton, Mike Wickens.

Chairman’s comments
David B Smith began the meeting by suggesting to the Committee that, after more than twelve years with a remarkably stable membership, they needed to consider the recruitment of some younger people under the age of thirty or so. This was to ensure the continuity and sustainability of the Committee in the medium term. He then called upon Tim Congdon to provide his analysis of the global and domestic monetary situation.

The Monetary Situation
The International Situation – Plummeting Global Activity
Tim Congdon referred to his prepared slides which can be obtained on request from timcongdon@btinternet.com. He began by outlining the disequilibrium money interpretation of recent events and highlighting the implications for broad money demand. The view that banks were undercapitalised and suggestions of increasing capital-asset ratios have had the perverse effect of reducing loan growth and broad money growth. Current policy was being driven by two erroneous models of the monetary process. The first of these is the ‘Creditist’ theory based on the work of Bernanke and Blinder. The disastrous policy of recapitalisation was a direct response to the ‘Creditist’ theory. The second of these is the focus on money base which has led to the Fed not monitoring the broad money aggregates. Bernanke had scrapped the M3 figures in 2006 on the grounds that the Fed no longer monitored them. The trouble is that the US banking system has been shrinking its asset base at such a rate that M2 and M3 deposits have been falling. The Federal Reserve has conducted credit easing policies and purchased assets from non-banks which in effect have subsequently raised M2 and base money. Gordon Pepper questioned the US M3 figures shown by Tim Congdon in his presentation. His view was that the reality was even worse than that shown on the charts because the figures were not adjusted for the shadow banking system.

Within the EU, the ECB has certainly helped the banks but some banks were heavily reliant on the interbank market, in Tim Congdon’s view. Euro-zone M3 growth is hampered by the policy problem of which specific EU government’s debt the ECB should buy. In Japan QE has been conducted by buying bank assets and not by purchases from non-banks. This has pushed up monetary base and M1 but not broad money. China has seen a tremendous upward blip in money growth which has stimulated an asset price bubble. India has money growth of 15% to 20% and Brazil is in relatively good shape. In the Western economies, the shrinking banking sector has seen declining money growth.

The UK Economy – better outlook for 2010
Turning to the UK, Tim Congdon said that in 2006 M4 was rising in the order of 12% a year. There were symptoms of an asset price bubble in the making. Inflation would have increased and was above target in March 2007. But by the autumn of 2007, interbank markets had seized up. Company sector money holdings have been highly volatile. Money holdings in the household sector are always in equilibrium and household money growth has been falling. The shrinking assets of the banking sector would have been converted into falling bank deposits if it were not for the contribution of the public sector.

Summary of Presentation
Tim Congdon said that as a result of the QE measures, the stock market is buoyant, house prices are beginning to recover and in particular the commercial property market has shown signs of improvement. He said that he was relaxed about the outlook for the UK in 2010. Unemployment was no longer rising. The only worrying factor for the UK is the world outlook. He said that the Bank of England should engage in a policy of selling short term bills for cash allowing the balance sheet of commercial banks to return to a more normal structure. The UK economy will still be below trend in 2010 and it is therefore premature to talk about exit strategies.

Discussion
Quantitative Easing (QE) is the correct policy
David B Smith thanked Tim Congdon for his presentation. In order to open the debate, he said that he had largely re-estimated both the international and UK sectors of his macroeconomic forecasting model since the summer, in large part because of extensive changes to the official statistics. However, by fitting dummy variables to each quarter from 2008 Q1 to 2009 Q1 or Q2, when the data expired he had been able to quantify to some extent when, and in which relationships, there had been breakdowns since the financial crisis got under way. In general, he had found little evidence of a breakdown in the price equations, and believed that the recent falls in OECD consumer prices were consistent with historic experience and the unprecedented size of the OECD output gap. However, there were large and highly significant negative departures from historic relationships in OECD output and UK real expenditure equations in 2008 Q4 and 2009 Q1. There was little evidence of a breakdown before then, however. The main exception was in the case of OECD industrial production where output in the second and third quarters of 2008 was somewhat weaker than expected. He suggested that the statistical evidence was consistent with the widespread view that it was the panic caused by the collapse of Lehman Brothers in September 2008 that had transformed a mild growth recession into a potential global slump. The extent of the loss of international output involved suggested that the decision to let Lehman Brothers collapse was a very expensive mistake from the viewpoint of the world as a whole, if not necessarily that of the US taxpayer.

David B Smith added that his UK model contained widespread feedbacks from broad money to a range of real and financial variables. He had replaced the old M4 broad money series with a break-adjusted series for M4X, which excludes deposits held by other financial corporations, in his re-estimation. The fact that the model seemed to track better with M4X than with the old headline M4, suggested that the Bank of England were justified in concentrating on the narrower definition. Finally, he advanced the hypothesis that the current slowdown might not just be the result of the financial meltdown but could also reflect a supply-withdrawal caused by the sharp increase in the government spending burdens in the US and Britain since 1997. If one applied the usual rule of thumb from panel data studies, that each 1% increase in the government expenditure ratio slowed the growth rate of GDP per capita by 0.125 percentage points, then the increased spending burden in the UK between 1997 and 2010 (OECD forecasts) would have slowed the growth rate in Britain by 1½ percentage points and that in the US by ¾’s of a percentage point. Such a growth slowdown would be expected to provoke a financial crash because the associated reduction in the net present value of future income streams would lead to a collapse in equity valuations and property prices. In other words, he was hypothesising that the global financial crash was partly a symptom of the slower potential growth rate caused by increased government spending burdens, particularly in the US and Britain since the mid 1990’s, as well as a cause of the downturn. He then threw the meeting open to discussion.

Tim Congdon said that policy was in a terrible muddle with QE being the right approach but raising capital having the effect of reducing lending. If not for the existing QE measures the overall effect would have been much worse. Trevor Williams said that policy was meant to be counter cyclical but raising the issue of capital adequacy has made it pro-cyclical. He added that there is a limit to which the banks will be able to take government debt as a substitute for the private sector. The government debt to GDP ratio is already high and is expected to rise even higher.

Gordon Pepper said the missing part of Tim Congdon’s analysis was the impact on the money supply of non-resident and foreign currency transactions. Leaving that aside, he was concerned by the recent collapse in the rate of growth of M3 in the US. Before drawing a conclusion it was important to check for distortions and special factors. The crucial factor was whether the supply of money was greater or less than the demand for money. Adjustment for the shadow banking system indicated that supply was probably even lower than indicated. A fall in the stock of unused credit facilities suggested that the demand for money might have risen because people would want to hold more money when credit was not freely available. In other words the squeeze was probably even tighter than Tim’s presentation suggested. Tim’s graph for the growth of broad money in the Euro-zone also showed a sharp fall, which was worrying. In the other direction Chinese monetary growth was very buoyant. Monetary growth in the UK was about right. QE was working. Sterling had fallen, which would stimulate exports and encourage import substitution. Asset prices had risen. Commercial banks had been able to raise new capital and industrial companies had been able to strengthen their balance sheets by issuing bonds to repay bank loans without the money stock falling. Further, there were early tentative signs that the money created by QE was starting to filter through to the household sector.

Kent Matthews said that the theoretical argument for quantitative easing is that it is supposed to have a powerful direct effect on spending via the real balance effect. In current circumstances, ‘the real balance effect’ may be weak and QE would work through the ‘Keynes effect’. He said that he was mindful of Patinkin’s paper in the American Economic Review in 1948 where he showed that real balances increased by 19% in 1930-31 in the USA but consumer spending fell by 13%. Admittedly, Patinkin was using M1 as a measure of balances and he argued that what was needed was an active policy of monetisation and money financed deficits. Tim Congdon said that he had a lot of trouble with the suggestion that the real balance effect is weak. He said that the key to understanding this cycle - as others - is that agents have a stable demand function for real money balances (give or take) and that fluctuations in the growth of bank assets have caused them to have excess and deficient real money balances etc. QE has boosted nominal/real money (certainly relative to what would otherwise have occurred) and therefore eliminated – or had gone a long way towards eliminating - the squeeze on real money in late 2008 and early 2009, giving us the recovery.

Kent Matthews said that his take on the real balance effect is that it works as a direct expenditure mechanism in the sense of Patinkin (1966), whereas the Keynes effect works by altering the cost of capital. Given the state of uncertainty regarding future income growth and private sector wealth, any unexpected money balances that come to the private sector, particularly households, will be used for repaying debt and precautionary saving. He agreed that QE has generated an increase in money but it was still insufficient to generate an increase in domestic demand. QE had generated a boom in the stock market and the corporate bond market and made it easier for companies to raise capital at low cost. So far, this has not generated investment spending but it is likely that this will come first, before households start to spend again. What is needed is a lot more QE but, even with a lot more QE, the impetus for an increase in domestic demand will come through the ‘Keynes effect’ first and then followed by the real balance effect.

Tim Congdon said the Keynes effect is said to be distinct from the real balance effect, because the Keynes effect operates via ‘the rate of interest’ to investment. But what is this ‘rate of interest’? In Keynes it is clearly the long bond yield. So is ’money’ meant to be base or broad money? Keynes is ambiguous, although on the whole he was a broad money man. If money increases, long bond yields fall and the economy recovers in this Keynesian approach. In reality, there were many assets other than long bonds in Tim Congdon’s view. There were, for example, equities and real estate. His belief was that - if broad money rises - all asset yields (and not just ‘the rate of interest’) fall, with positive effects on both investment and consumption. However, it was obvious that in Tim Congdon’s approach - where assets are not restricted to long bonds - the distinction between real balance effects and a Keynes effect disintegrates.

Votes
The Chairman then asked each member present to make a vote on the monetary policy response. In addition, since only five SMPC members had been present at the meeting there was a need for four votes in absentia. These were supplied by Roger Bootle, Andrew Lilico, Patrick Minford, and Peter Warburton.

Both the in absentia votes and the votes of those who were present at the
20th October SMPC gathering are listed in alphabetical order below. This is partly because the order in which votes were cast at the meeting simply reflected the arbitrary seating arrangements at the time. The Chairman traditionally votes last.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold: more QE
Bias: Even more QE

In his written submission, Roger Bootle stated that the economy was recovering but that it was still fragile. There remained a serious risk of a slip back into recession in his view. The banks had a long way to go to rebuild their balance sheets and consequently remained reluctant to lend. Next year, there will probably be an intense fiscal tightening. In these circumstances, the Bank of England should extend QE. It should extend it by £50bn to £100bn now and be prepared to do more if necessary later. Roger Bootle believed that the Bank of England should also consider whether it was feasible to lower interest rates still further, perhaps combining this with a charge levied on commercial banks’ cash balances that were held at the central bank.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Keep rates on hold. QE to be sufficient to deliver M4X growth of 5%
Bias: Neutral

Tim Congdon told the SMPC meeting that QE will have to rise to £200bn but it will depend on how the market reacts and what happens to bank lending. It is premature to talk of exit strategies. He said that he was concerned about the sharp deceleration in broad money in the USA but that he was not hysterical.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold interest rates: extend QE by a further £50bn
Bias: Thereafter pause with QE

In his post-meeting submission, Andrew Lilico said that the economic situation was dire, and if anything expectations were deteriorating. The current GDP data marked this as possibly the worst recession in terms of GDP contraction since the 1920s, albeit subject to revision. The unprecedented contractions in output per worker in the first and second quarters of 2009 imply that unemployment would have to rise by nearly 7 percentage points to well over four million just in order to restore productivity to its end-2008 level.

He added that It will, presumably, be the case that deflation abates somewhat in the New Year, from its current rate of minus 1.4%, which represents the eighth straight month of deflation, as VAT rises back to 17.5%. But this would be only a temporary effect. A double dip in GDP growth, with probably two more quarters of contraction in the New Year, and unemployment rising rapidly throughout the year will both place considerable downward pressure on wages - which may yet experience outright falls - and the widespread prime defaulting that would imply. The UK banks were in a race against time. Foolish imprecations for banks to lend more and urging consumers to spend more were extremely unhelpful. UK consumers were not deleveraging remotely rapidly enough, in Andrew Lilico’s opinion. The enormous money printing exercise, interest rate cuts, currency devaluation, and fiscal stimulus had merely bought the economy time to deleverage - time that was not being well-spent yet. The moment of reckoning could come for many consumers in later 2012, and the government would have run out of ways to smooth the process.

For now, then, Andrew Lilico believed that QE should be further extended. But a critical juncture was being reached because quantitative easing could not continue indefinitely. And next year there would need to begin a massive fiscal contraction. Government spending would need to be cut by an order of £80bn over a three-year period and taxes to rise by perhaps £20bn. Past evidence suggests that the path of fiscal contraction was considerably eased if it was accompanied by monetary easing. Would it be enough if monetary policy was merely loose? Or would it need to be actively loosened? Could we afford to do all the QE possible before the process of fiscal contraction even began? Andrew Lilico concluded with the statement that he was becoming nervous, and was therefore inclined to recommend a pause to QE after the next three-month round.

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

Kent Matthews said that he would like to see QE being increased further and not just an increase in the flow through money financing the deficit but further monetisation of the debt. The current recession has the potential to go as deep as the recession of 1930-31 if QE is not expanded further.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral: there is an equal chance that the recovery could strengthen or weaken more than expected

In his absentia vote, Patrick Minford stated that the measures to offset the credit crisis had been highly effective. They had consisted of four parts: sharp interest rate cuts, direct support for bank balance sheets, fiscal support (essentially credit provision directly by government to the private sector), and large-scale purchase of financial assets by central banks (QE). The latter assets had included mortgage packages and corporate bonds, as well as government bonds. It was true that these measures had not revived credit growth in most economies - this languished in the US, the UK and in the Euro-zone, according to Patrick Minford. But cash had become available again in large quantities and this had raised the prices of a wide range of assets, making it easier for firms to raise money by a variety of channels, especially equity and bond issue - both of the latter had increased sharply. In effect savings had bypassed the banks, which had been unwilling, unable, or simply not allowed by regulators to make loans easily available. Like floodwater, money had found ways to flow into the economy and stimulate spending.

Patrick Minford anticipated continued QE and fiscal deficits, until growth strengthened. He did not expect strong growth in 2010 for the simple reason that raw materials remained in short supply with oil prices already back up to $80 a barrel. What strong growth was possible in the world economy would be pre-empted by China, India and other emerging market economies. These countries’ growth would ‘crowd out’ in Milton Friedman’s phrase the growth in developed countries. Nor would the Euro-zone or Japan be exempt from this weakness. Their currencies had appreciated sharply against the dollar because policy in both areas had been less stimulatory than in the US.

Confident generalised world growth would not be possible again until the raw material shortage has been eased by technological advance in Patrick Minford’s opinion. While the cries of the global warming lobby and the Kyoto process appeared to have run well ahead of the empirical evidence on the effects of manmade CO2 generation, nevertheless they were pushing technology in the right general direction to enable renewed strong growth at some point in the future. The implication of this reentry process is that for now there was no reason to tighten monetary conditions, as we were still in the stage where inflation was well below target. Patrick Minford correspondingly preferred to leave interest rates unchanged and continue with QE; as the evidence from equity and corporate bonds markets was that the latter was having definite and beneficial effects, He would support the programme being added to as asset purchases used up the existing £175bn facility. He had no bias because he believed there was an equal chance that the recovery could strengthen or weaken more than expected.

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

Gordon Pepper agreed that QE is working. Quantitative easing should continue so as to deliver a 5% increase ± 2% in M4X or M4 holdings of households and OFCs. The assessment each month should be based on the latest information for broad money growth. He added that if the US broad money figures continued on their current downward path in the next three months his concern for the future of the global economy would rise to ‘alarm’.

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

David B Smith said that there seemed to be near-lunatic policy inconsistency between the employment of the controversial and potentially dangerous policy of QE to boost broad money and credit and the regulators’ desire to raise the capital and liquidity requirements of the commercial banks. This was because the latter would almost inevitably cause banks to both restrict the size of their total balance sheets and substitute government debt for private lending within their diminished total asset books. There was a parallel here with the argument in supply-side economics that the announcement - or even mere expectation - of future tax increases would cause a supply withdrawal well before the tax change was implemented. If he was the general manager of a clearing bank, he would already be giving instructions to reduce lending to the private sector so as not to be caught short of capital and/or liquidity when the new regulatory controls currently being discussed were imposed. He was also profoundly concerned that regulatory shocks imposed by international agreement would cause the entire global banking system to take a similar view, leading to a synchronised global downturn that would be similar to, but worse, than the US recession that followed President Roosevelt’s misguided decision to double the reserve asset requirements of US banks in 1936. (Editorial note: these concerns are set out more fully in David B Smith’s 12th October pamphlet from the London think tank Politeia, Crisis Management? How British Banks Should Face the Future www.politeia.co.uk). The solution to the ‘too-big-to-fail’ problem was to use existing anti-monopoly legislation to break up the big banks, or at least those dependent on state guarantees, not to pile new legislation on new legislation until the whole global and domestic credit creation processes ground to a halt.

In David B Smith’s view, banking regulation, QE and the setting of Bank Rate were all part of one monetary policy problem. He also thought that far too much attention had been paid to the question of QE, which is a useful policy tool but not a miracle worker, compared to the potential damage that could be done by misguided regulatory interventions. He could see no immediate case for a rate change in November but thought that some modest hikes would be appropriate before too long. This was as much for the signal that this would provide to the foreign exchange markets that the authorities were serious about inflation, as it was for any objective difference that it would make. He would also be prepared to extend QE if it looked as if the growth of M4X was too weak to support activity. However, his statistical research suggested that there could also be an attempted move out of money balances caused by the very low real rates of interest paid on bank deposits, in which case slow monetary growth would not be inconsistent with a recovery in effective demand. Ultimately, it was hard to see any strong recovery in the British economy without improved fiscal discipline. The fiscal policy stance in Germany over the past decade seemed to him to be far more intelligent than Britain’s. This probably explained why Germany was already emerging from recession and the UK was not.

Comment by Peter Warburton
(Economic Perspectives)
Vote: Increase Bank Rate to 1%
Bias: Extend QE, but increase Bank Rate to 2%

In his written submission, Peter Warburton stated that the release of the September data for the consumer and retail price indices confirmed that inflationary pressures are building rapidly within the private sector. While the headline annual CPI inflation rate fell back to 1.1% and headline RPI inflation remained negative, various exceptional factors were masking an underlying deterioration in the inflationary context. His calculation of the rate of private
sector inflation (excluding household fuel and light) has broken above 3%, its highest level since 1994. As the favourable base effects evaporated over the next six months, and other price increases took effect, headline RPI and CPI inflation rates were likely to soar well above 3% again.

The UK was experiencing more pronounced inflationary effects than elsewhere, in Peter Warburton’s opinion, due to the abruptness of the currency depreciation that had occurred last year. In the past few weeks, there had been a reminder of the vulnerability of sterling to further bouts of weakness. Since the credit crisis erupted over two years ago, global supply conditions had tightened very significantly, restricting the supply of very cheap goods from Asia. This was showing up in the reversal of longstanding deflationary trends in Asian export price indices. Moreover, the ability of foreign exporters to hold their sterling prices had been undermined by the crisis. Sizeable price increases were being routinely passed along to UK consumers.

The Bank of England’s MPC had some important decisions to make regarding its commitment to the CPI inflation target, according to Peter Warburton’s written submission. While a majority appeared to believe that the Bank could adopt a ‘wait-and-see’ attitude to the return of inflationary forces, this might prove extremely detrimental to the MPC’s credibility and to overseas perceptions of sterling assets. The time had arrived to address these concerns with a 50 basis point Bank Rate increase. Rate increases in Australia and Israel had been well received by financial markets; monetary authorities in other countries with independent currencies (e.g. Canada, Norway and Sweden) were clearly considering similar moves.

The weak provisional GDP data for the third quarter should not distract from the much greater issues at stake in Peter Warburton’s view. These figures might well be revised upwards, perhaps significantly, when more complete information becomes available. In any case, the slump in August industrial production was probably due to planned temporary shutdowns rather than an indication of renewed weakness. September data should help to clarify this matter. The primary effect of raising Bank Rate would be to limit profit-making opportunities by large banks. There should be only a negligible effect on the borrowing costs of banks’ individual and small business customers. Meanwhile, the expansionary thrust of UK policy could be maintained through the extension of the QE programme of asset purchases, which was holding down gilt-edged yields by approximately 50 basis points. The time to raise Bank Rate was now.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold: increase QE and purchase gilts from the non-bank sector.
Bias: To ease further

Trevor Williams said that QE had to increase but also needed to be broadened further with gilt and non-gilt paper purchases from the non-bank sector generally and not just from the financial institutions. Broad money growth needs to be around 8% to 10% per annum before economic recovery is assured. To get to that point, the MPC may have to take risks with inflation. And therefore the risk of overkill may be high, but there seems to be few realistic options but to pursue QE further to ensure that, once it is started, economic recovery is sustainable. It is good news that the signs are that QE appears to be working; the bad news is that those signs also suggest that once recovery is underway, it may have to be withdrawn as quickly as is feasible.

Policy response
1. Eight SMPC members voted that interest rates should stay on hold. However, one wanted an immediate increase in Bank Rate to 1%. Some two-thirds of the SMPC thought that QE had to be maintained in the immediate future.

2. Some SMPC members said that QE should be increased in the medium-term. However, others thought that further increases would either not be appropriate or should only be continued for a limited period. One member of the shadow committee wanted a further rise in Bank Rate to 2% to accompany any extension of QE.

3. Two members said that the extent of QE should be conditional on the growth of the M4X definition of broad money and/or the closely related concept of household and non-financial corporate money holdings.

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.

In its latest e-mail poll, the Shadow Monetary Policy Committee (SMPC) unanimously voted to leave Bank Rate at ½% when the Bank of England’s rate setters meet on 8th October.

There was a widespread view that the present schedule of quantitative easing needed to be persisted with and extended beyond November, when new Inflation Report forecasts will be available. Looking further ahead, most members of the committee had a neutral bias. However, one thought that Bank Rate needed to be raised to 2% before the end of 2009.

Two further SMPC members suspected that monetary policy would need to be tightened before too long. However, another believed that Bank Rate should be held at ½% until the end of 2010. There was a strong undertone of ‘wait and see’ in the recommendations of all the members.

The SMPC poll was ‘frozen’ on Tuesday 29th September, although many submissions had arrived earlier. Most members of the shadow committee believed that the downwards momentum in the UK economy was ameliorating and that positive growth would be resumed in the third quarter and fourth quarters of this year.

However, there were also fears that there might be a relapse in the first half of 2010, because of the tax increases that have been announced but not yet implemented. There was further concern about the implications of the adverse fiscal background for monetary policy.

Some SMPC members thought that the urgently needed fiscal retrenchment would create a ‘hole in demand’ that would have to be offset by an expansionary monetary stance. However, there was a contrary view that the fiscal stabilization literature suggested that a reduction in the budget deficit brought about by reduced government consumption would be expansionary where output was concerned.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold; maintain current QE targets
Bias: Extend QE beyond £175bn after November

Since June the UK economy has begun to show signs of stabilisation, but that stability is hugely dependent on government-supported expenditures. Signs of a sustainable private sector recovery are still scarce. Unlike France and Germany the UK failed to show positive growth in 2009 Q2, with real GDP declining by -0.6% over the quarter, and dropping by 5.5% year-on-year.

The severity of the downturn was highlighted by business investment figures for the year to Q2 which declined by10.2% over the quarter and 21.8% year-on-year, the sharpest annual decline since records began over forty years ago. The stabilisation has been mostly based on government expenditure, some restocking, and an improvement in net exports. There has also been a continuing improvement on the production side of the economy as manufacturing orders and sales are restored following the Lehman-induced collapse in trade and industrial production last autumn and winter. The manufacturing Purchasing Managers Index (PMI) recovered to 50.2 in July but fell back to 49.7 in August, while the services index increased to 54.1 in August. An overall composite PMI is now consistent with growth of 1% to 2%.

However, consumer spending (down 3.6% in real terms over the year to the second quarter) remains vulnerable as unemployment has continued to rise, with the claimant count hitting 5.0% in August (or 7.9% on the International Labour Office (ILO) basis in July), and whole economy wage growth (excluding bonuses) slowing to 1.0% in July (compared with 3.7% a year ago). Household consumption has been helped by the government’s car-rebate scheme, which has just been extended and expanded.

Monthly house prices have also improved a little recently, but with mortgages granted rising only to 50,123 per month in July (compared with 120,000 at the peak in 2006-07) it seems unlikely that the upturn is anything more than a temporary respite. Over the year as a whole it is likely that the UK real GDP will contract by 4.3%, and CPI inflation will end the year below 2%, falling less than in other major economies due mainly to the weakness of sterling.

On the policy front the MPC kept interest rates at ½% in August and September, but increased the amount of Quantitative Easing (QE) by £50bn in August, to £175 billion by November. Following the G-20 meeting, proposals are likely to emerge soon requiring substantially higher levels of capital and liquidity for banks. Raising more capital and requiring banks to hold more gilts will almost certainly slow lending and balance sheet growth in the months ahead. Combined with recent data showing that UK consumers and businesses are now actively repaying debt and thereby contributing to a slowdown in money growth, it seems likely that the Bank will need to maintain QE for longer than market participants currently expect. The August data for M4x, which is still only the second set of monthly data, suggest that the annual growth rate is still in the 3% to 4% range, inadequate to support nominal GDP growth of 4% to 6%. QE will need to be extended, expanded and rates kept low after November.

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

Optimism about ‘green shoots’ appears to be mounting with even the Governor of the Bank of England proclaiming that there were signs that economic growth “had resumed” between July and September and, therefore, “the recession may be over”. And, as the Bank’s Minutes for the August meeting noted, M4, excluding the money holdings of institutions that intermediate between banks, had picked up slightly to 5.3% (on a three-month annualised basis) in July compared with 4% in June – an encouraging development. The Bank, however, continued to caution about the restricted supply of credit as the pressures on the banks to shrink their balances had continued to impose monetary restraint on the economy.

But the key factor now for macroeconomic policy is how to maintain some economic recovery into next year, given what now appears to be a political consensus that there will have to be severe fiscal tightening from 2010/11 onwards. The Treasury’s objective at the time of the Budget was to balance the cyclically-adjusted current budget by 2017/18. And the tax and spending measures announced and projected in the 2008 Pre-Budget Report and the 2009 Budget would deliver a fiscal tightening equal to 6.4% of national income by 2017/18 (over eight years including Fiscal Year 2010-11 when restraint is due to start) relative to the projections set out in the 2008 Budget.

Putting aside the issue of whether the public sector finances have deteriorated even faster than expected in the Budget, which they probably have, there is the matter of the wisdom of having so distant a target for balancing the budget. But if a less distant target is picked then the tightening will, of course, have to be even more stringent. According to my calculations, if a target of zero public borrowing by 2015/16 is chosen for illustrative purposes, another £70bn to £90bn of fiscal tightening would be required over the period 2010/11 to 2015/16.

Under these circumstances, there has to be the danger that the higher taxes and/or spending cuts will undermine the economy’s recovery – if not throwing it back into recession. But I take the view that the financial position is so dire that the most sensible objective would be to get the tightening over as quickly as possible and trust that the Bank of England could maintain overall spending power in the economy at a satisfactory level by keeping interest rates low, extending quantitative easing if necessary. The pound too will remain weak – thus aiding the all-too-necessary rebalancing of the economy from excess domestic expenditure and large current account deficits to a more sustainable domestic sector and a more balanced external sector. In the meantime I support the Bank’s policy of keeping interest rates very low and continuing with quantitative easing – up to the full £175bn, as announced in August, with a view to extending if considered appropriate.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold Bank Rate; extend QE at £25bn per quarter
Bias: Further extension in QE to be announced in November

Broad money growth continues to be quiescent; average earnings continue to grow at below 2%; unemployment is rising very rapidly and will accelerate further next year (indeed, disastrous productivity data suggests that there is a considerable backlog of unemployment implicit in the system). Banking sector losses on past loans continue to accumulate and future losses seem likely to dwarf those already declared. Thus, the deflation risk is far from gone, and no-one should be complacent on this point.

Of course, recent real economy data and financial market performance give some grounds for near-term optimism – say, over a three to six month timescale. I suspect that there will be positive GDP growth for Q3 and probably stronger growth in Q4. However, I believe that this is heavily attributable to a combination of policy response, inventory snap-back effects, and the weakness of the pound. These factors will not be repeated, and I continue to believe that GDP growth will turn negative again in the first half of next year, for one or probably two quarters, before more sustained recovery begins in the latter half of 2010 and into 2011.

There is an underlying desperate need for consumers to deleverage. I believe that the economy is in a race against time, which is not clearly being won at present. I was amongst the first to recommend quantitative easing, and I believe that it should be extended further. But we should pursue this policy without illusions. The core objective is to avoid deflation, but in doing so we will need to overshoot into inflation. I consider that inevitable and (although the inflation is not intrinsically desirable) appropriate because of the asymmetric risks involved – deflation of 5% would be much more dangerous to us, given our high indebtedness, than inflation of 10%.

But in due course policy will need to tighten considerably in order to prevent inflation spiralling entirely out of control. At that point (I suspect sometime in late 2011 or early 2012), consumers that have not adequately deleveraged in the interim may face considerable financial distress. Quantitative easing is buying the economy time to deleverage. But that deleveraging must be done. The attitude of many politicians appears to be that if consumers could just get back to consuming and borrowing more, all would be well. That is dangerous.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral on rates; persist with QE

Much ink is currently being spilt on the question of when governments and central banks should ‘exit’ from their policies of fiscal support and monetary ease. Some are suggesting that exit should be fairly soon, because otherwise inflation could become once again embedded in the economy. They argue that the pain of curing embedded inflation is far greater than any pain from prolonging the recession. The main problem with this view is the assumption it makes about the inflationary process. In effect it harks back to the view of Milton Friedman that the ‘lags are long and variable’ between policy and its effects.

Yet Milton Friedman’s ideas were apposite for a period when there was considerable confusion about both the aims of government policy and the workings of the economy. He adopted ‘adaptive expectations’ as his main assumption for the crucial process by which people formed their inflation expectations. This is a good model of learning. It does give rise to those long and variable lags, in the sense that policy shocks create long-lasting cycles in the economy and in inflation; these cycles are also hard to predict accurately, as the effects of sequences of policy shocks overlap each other in a way hard to disentangle.

However this approach does not apply to the new regimes of inflation targeting put in place since the onslaught on inflation in the 1980s. People now understand that government is committed to the control of inflation through monetary policies (with the discipline on fiscal policy that these in turn imply). Central banks have been in consequence given the job of running these policies with full political backing, backed in turn by a public opinion for which inflation remains a seriously unwanted threat. Finally, there is no learning any more about the inflation and policy process. That happened in the 1980s and once something is learnt it does not need to be re-learnt unless the current policy framework were to be jettisoned for some time - which is improbable because it is what both public opinion and politicians are committed to.

How does an economy work under these circumstances? Quite simply: people form their expectations with reference to those commitments (‘rationally’). In short they expect something like 2% inflation to be reverted to in due course. That this is so in the main western economies is obvious from both the inflation expectations implied by longer term interest rates and the short term ones implied by wage settlements. One may criticise inflation targeting for various shortcomings but one thing it has achieved rather clearly is this ‘anchoring’ of expectations for inflation. Provided it is clear that these policies are not going to
be abandoned, for the reasons given above, then people will continue to expect inflation to come back to 2% and this in turn will ensure that it does. Actual policies can even deviate in the short run quite a bit from their long run setting for this purpose, without upsetting the inflation process.

Applying this to the question of exit strategies, we can see that there is an automatic exit strategy built into monetary policy, in that as the economy recovers and inflation starts to pick up in response money will be tightened to ensure it comes back to target. While the amounts of debt taken on by the central bank are large, they can be sold off as easily as they were bought; and as they are they will tighten monetary conditions. Fiscal policy is not so constrained by automatic exit since it is not directly related to inflation. However, it is constrained by solvency in the context of monetary policy that cannot indefinitely be used to buy government debt. In the inflationary 1970s government budgets were widely financed by printing money (i.e. the central bank bought government bonds). This made it easy for governments to run deficits cheaply (without incurring interest on bonds to private sector holders) but it also caused high inflation. Once inflation is constrained by its target, the government must borrow in the private markets and so maintain its solvency or the borrowing will dry up.

We have begun to see what this means in practice from the changed tone of the UK public debate as people have seen the huge deficit to be financed. Plainly no government wishes to precipitate a sudden large cut in public spending or large rise in taxes when the economy’s recovery is fragile. But a gradual programme of tightening will be forced by solvency considerations. The next government will have to formulate a several-year plan that effectively brings the deficit down to the level at which the debt/GDP ratio is at least stabilised and then provide additionally for some downward pressure on it over a long period to ensure it drops back again to a healthy level.

So we can see that exit strategies are virtually spelt out by the policy context under inflation targeting. On the one hand there is plenty of scope in the short term to support the economy’s recovery; on the other once this is robust the pressures will develop to bring monetary and fiscal policy back into their normal mode. While a recovery is under way it is still vulnerable to fresh shocks and one of those would be premature exit, such as has occurred repeatedly in Japan during its long deflationary era since 1989. Hence I support the continuation and extension of the Bank’s asset purchase scheme for the time being, with no change in rates and no bias.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold
Bias: Neutral; QE should continue at the current rate or more

The aim of Quantitative Easing is to ensure that monetary growth is adequate. According to the latest monetary data, M4 excluding Intermediate Other Financial Corporations (M4x) has continued to grow too slowly. More precisely, in August it grew at an annual rate of 0.2% seasonally adjusted compared with 3.7% p.a. in the second quarter of 2009 and 3.3% in the year ending in the second quarter.

M4 holdings of households, however, grew at annual rate of 7% in August, which was the fastest monthly rate of growth since June 2008. Overall, there is insufficient new data to alter last month’s conclusion. Quantitative Easing should continue at least at the current level.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Neutral for the next month or so; adverse fiscal backdrop could require monetary tightening

This is an uncomfortable time to be commenting on UK monetary policy because it is difficult to do more than advocate more of the same, at least for the next few months. If economists are to add value under these circumstances it can only be through questioning some of the implicit assumptions under which the current policy debate is conducted. One such assumption is that monetary policy, fiscal policy and supply-side considerations can all be allocated to separate boxes and that the feedbacks between them can be ignored. However, the reason that QE is widely feared as a step on the road to the ‘Mugabeisation’ of the British economy is that there is observational equivalence between: 1) the monetary-policy hypothesis that the MPC is doing the right thing in adopting QE because the alternative is a collapse in broad money, debt deflation, and a downward spiral in activity; and 2) the political-economy hypothesis that the Bank is supinely doing the bidding of the present government and irresponsibly trying to maximise activity ahead of a 2010 election, regardless of the longer-term consequences. Expansionary open-market operations (QE) could be safely used in the 1920s because the commitment to a balanced budget and the fixed parity implied by the gold standard meant that there was no inflation threat, while the public debt being bought and sold had been generated by the historic accident of the Great War, not current fiscal profligacy. It is not only the fiscal background that breaks these 1920s conditions in present day Britain but also the Bank’s insouciant attitude to the downwards movement in sterling, whose effective exchange rate on 28th September was 13.1% down on the year and 23.4% lower than two years’ previously. This might appear to be more consistent with the second, political-economy, hypothesis than the first.

The second implicit assumption that should be challenged is that pruning public spending and government borrowing will inevitably create a hole in demand that needs to be counter-balanced by a laxer monetary policy. This seems to ignore the extensive literature on fiscal stabilisation and the distinction between Type 1 and Type 2 stabilisation packages. There is evidence from numerous international case studies that Type 1 packages – which do not raise taxes, do not cut government investment but do rein in government consumption and welfare payments to the population of working age – are followed by an officially unanticipated burst of output growth and a substantial improvement in the public finances. In contrast, the politically more attractive Type 2 stabilisation packages – which rely on attempting to raise taxes and cutting government investment but allow current spending and welfare payments to grow unchecked - almost inevitably lead to an unexpected reduction in activity and a noticeable deterioration in the budget deficit. The fiscal measures being implemented by the present British government clearly represent a Type 2 package, with the government committed to large cut in investment and an increase in the viciously job-destroying National Insurance tax but a 4.7% increase in the volume of current expenditure in calendar 2009.

The third implicit assumption that needs to be questioned is the view that the current global recession has a simple mono-causal explanation in the form of the banking crisis that commenced in the late summer of 2007. The international literature on the sources of economic growth suggests that the 11.8 percentage point hike in the share of British government expenditure in GDP between 1997 and 2009 would be expected to slow the growth rate of UK real GDP per head by some 1.5 percentage points, while the 6.2 percentage points rise in the US over the same period would be expected to have a growth-retarding effect of around 0.8 percentage points. The Euro-zone has seen a more modest 1 percentage point hike in its socialisation ratio over this period, while in Germany there has been a reduction of 0.7 percentage points. This may help explain why GDP in Germany expanded in 2009 Q2 while UK national output fell by a revised 0.6%. Supply-side theory suggests that a reduction in the sustainable rate of economic growth would lead to sharp falls in the levels of property prices, equities and private investment - because the net present value of the expected future returns on these assets has been cut in line with the reduced prospect for economic growth. There is evidence that financial crashes are followed by long periods of disappointing growth. But it is also probable that a slowdown in the potential rate of growth caused by excessive government spending and ill-thought out regulations helped bring about the financial crash initially. In addition, the populist measures politicians introduce in the aftermath of a financial crisis seem guaranteed to have an adverse impact on future productive potential, the recent proposals by the Group of Twenty (G-20) leading industrial countries being a classic example of the genre.

One explanation of how the problem of stagflation became so acute in the 1970s is that the global monetary authorities failed to realise that there had been a slowdown in the growth of productive potential, wrongly assumed that there was a demand shortfall rather than a supply withdrawal, and attempted to get the economy back onto its old growth path by pursuing inappropriately expansionary policies. There is a significant risk that this policy error is now being repeated in both the US and Britain. The maintenance of current easy monetary conditions in the UK should be made conditional on the rapid implementation of a Type 1 fiscal retrenchment package. If this is not politically feasible, the MPC cannot afford to let sterling weaken further if it wants the financial markets to consider it to be serious about its commitment to low inflation and should be thinking of a modest normalisation of rates sooner rather than later.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold; persevere with QE
Bias: To increase Bank Rate before the end of the year

Provisional data for the third quarter national accounts are expected to show a resumption of nominal and real economic growth. The restoration of nominal GDP appears to have become an implicit objective of the Bank of England. This rebound in nominal and real GDP is being driven primarily by the corporate sector, whose net cash flow has improved beyond recognition since a year ago. The rebuilding (or even stabilisation) of inventories and work in progress will have a markedly positive effect on sequential GDP. Capital expenditure projects that were shelved last year may be revived in the final quarter of 2009. The monthly figures for job loss may surprise positively.

Most of this improvement will be invisible to the consumer, whose disposable income is under severe pressure and will remain so. Here, it is the extravagant financial support provided by the government that is the mitigating factor, and the level of this support is set to diminish next year as budgetary disciplines bear down. In the UK, the household saving rate has begun to revive but the gross national saving rate has plunged to a sixty-year low of 12% under the weight of public sector dis-saving. In order to persuade non-residents to hold more gilt-edged securities, it may be necessary for sterling to revisit its year-lows and possibly new lows in the coming months.

The dilemma for the MPC, now with a dual mandate that sets financial stability on a par with inflation control, concerns the process for signalling alarm over the inflation outlook. UK CPI inflation is already higher than in most other large industrialised economies and unfavourable base comparisons will carry headline inflation above 3% by the New Year. In August, private sector inflation, excluding fuel and light, rose to its highest rate since 1998. It is clear that the policy of QE continues to enjoy the support of a majority of MPC members and is likely to be extended well into 2010. The only recourse left to the committee is to begin to raise Bank Rate from ½% towards a more realistic level of around 2%.

It is my understanding that the beneficiaries of ½% Bank Rate are few and far between. Transactions activity in the interbank market remains subdued and most banks are willing to pay well over 2% to attract retail deposits. Apart from damaging bank profits marginally, there would be little to lose from a Bank Rate increase and much to gain in terms of policy credibility and the perceptions of sterling.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold
Bias: Neutral in near term; tighten in longer term

Economic growth is slowly picking up but inflation is still low and is likely to remain below target in the near future. The immediate danger for monetary policy is that the asset purchase scheme is fuelling the current stock market recovery and that the recovery does not reflect economic fundamentals. The Bank must be careful not to encourage investors to return to the market solely on the basis that the market is rising, whatever the reason. As a consequence, I vote for holding interest rates at their present level. My bias is still towards neutral in the near term but for an increase in the longer term.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Hold rates through 2010 and extend QE in November

UK economic indicators are suggesting that, after lagging the recovery in the rest of the world somewhat, the UK, along with the US, will achieve positive growth in the third and fourth quarters of this year. On top of this, financial markets have staged a strong comeback from their March lows. The FTSE is up by over 40%, credit spreads have narrowed, inter-bank rates are back to where they were in 2008 and bond markets are showing remarkably low and stable yields despite the recovery signs in the economy. The need to absorb the official debt issuance required to fund the expansion in public spending seems not to be causing digestive problems for the markets currently. But can it last? The answer is that we do not know. The first test will be when the monetary and fiscal authorities begin to withdraw the extraordinary measures put in place to inject liquidity into a range of agents in the financial markets.

Before that point is reached, however, the authorities must make sure that the economy is on a solid enough footing to withstand the inevitable rise in short and long term interest rates and a tightening of credit conditions as liquidity provision from the public sector is curtailed. Yes, some economic data look good at the moment; manufacturing output is recovering; retail sales are still going up; the services Purchasing Managers Index (PMI) is above 50, and therefore indicates expansion; surveys of the residential housing market show that prices are rising modestly and the Investment Property Databank (IPD) figures showed a rise in commercial capital values took place in August.

But there are doubts about the sustainability of some of these trends, with unemployment rising, the recovery in the residential property market may not be maintained as arrears and defaults are likely to rise further. Is the recovery in manufacturing output down to restocking after massive destocking and so it will it last and how much of the recovery in financial markets is due to the virtually free money that is still flooding from the public sector?

Borrowing trends suggest that, big picture, households and companies are still busy repaying debt. The growth in the money supply excluding the deposits of Other Financial Corporations suggests that there simply is not enough monetary expansion to support a sustained a return to vigorous economic growth. The headwinds in the first half of 2010 will be very strong, with higher taxes due, some from a return to 17½% VAT, and further increases in unemployment. At the same time, there are likely to be increased bankruptcies from households and businesses. This suggests that monetary policy should stay loose until is clear that the uncertainties in the first half of 2010 will not undermine the nascent signs of recovery being seen at present. If this risk is as high as seems likely, further QE will be required to maintain the recovery in financial markets and allow business confidence and balance sheet restructuring to progress further. Bank Rate in such an environment can stay low through most, if not all, of 2010 as ample spare capacity means that the upside risk of inflation remains very low. My vote is to maintain Bank rate at ½% and extend QE in November.

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

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

In its latest e-mail poll the Shadow Monetary Policy Committee (SMPC) voted to leave Bank Rate at ½% when the Bank of England’s rate setters meet next on
10th September.

The unanimous SMPC vote reflected the belief that there was no immediate case for a rate increase – although one member thought that Bank Rate needed to be raised to 2% before the end of this year if inflation was to remain subdued through 2010 - combined with the view that Quantitative Easing (QE) still remained the most effective monetary policy instrument available to the authorities.

A strong majority of SMPC members believed that the total assets purchased under QE would ultimately need to be raised to significantly over £200bn and, perhaps, up to £300bn. These figures are well above the £175bn to which the Bank of England committed itself at its August meeting and also greater than the £200bn that the Governor and two external MPC members had argued for, although they were outvoted in the event.

The SMPC poll was largely completed before the late-August bank holiday weekend, although most members were aware of, and some referred to, the revised second quarter GDP figure, announced by the UK Office for National Statistics (ONS) on 28th August.

Most members of the shadow committee believed that the downwards momentum in the UK economy was ameliorating, and that recent surveys painted a more promising picture for activity in the third quarter. However, there was also concern that the restoration of the higher 17½% rate of VAT next January, the increased National Insurance Contributions to be implemented next April and the pressing need for a major fiscal retrenchment would all act as a serious drag on home demand during the course of 2010 and 2011.

Comment by Roger Bootle
(Deloitte and Capital Economics Ltd.)
Vote: Hold
Bias: To hold rates indefinitely and to increase QE further

Although some sort of recovery seems to be underway, it is probably extremely fragile. The chances that it will fizzle out are very high. Moreover, next year there will surely be announced a very severe fiscal tightening. In these circumstances, it is imperative that monetary policy be kept highly supportive of demand. It would not surprise me if interest rates needed to be kept at the current near-zero level for five years or even longer. And the Bank of England should stand ready to increase its Quantitative Easing (QE) programme massively.

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

Recent announcements from the Bank of England on QE and interest rates are encouraging in substance. Official policy is clearly to ensure that broad money growth stays positive enough both: 1) to deliver an economic recovery; and 2) to prevent the UK being visited by the deflation that already afflicts most of the industrial world. This is good news for UK equity and real estate markets, but unhelpful for gilts.

However, the accompanying publications – the August Inflation Report and the latest MPC Minutes – are riddled with qualifications, reservations and provisos. Any commentator has to wonder whether the MPC’s members and Bank staff really believe in the new official emphasis on the desirability of a positive and steady rate of broad money growth. The main worry is that banks’ efforts to raise capital/asset ratios may – by causing them to shed assets and so reduce the growth of their deposit liabilities – neutralise or even offset the increase in deposit liabilities (i.e., in M4) that arises from QE. The subject is technical and journalists will allege that the slow money growth shows that “QE has failed”. Officialdom ought to tell the banks that the move to higher capital/asset ratios can be phased in over several years, so that any resulting contraction in their balance sheets proceeds slowly and is outweighed by expansionary influences.

As has been widely recognised, the money holdings of so-called intermediate Other Financial Corporations (OFC’s) need to be deducted from M4 to arrive at a M4 number (i.e., “M4x”) relevant to behaviour by private sector non-banks. In the four months to June the change in M4x was rather disappointing, with no increase in its growth rate compared with the previous four months despite the huge official purchases of gilts. But this does not mean QE was pointless. Without QE money balances would almost certainly have fallen, implying continuing severe pressures on company liquidity. The initial July money numbers were for a rise of 1.0% in M4, which seems to be encouraging, but we need the M4x figure and other information to be fully confident that a positive rate of monetary growth is being restored.

The Bank of England is ‘muddling through’, in typical British fashion. The UK is likely to come off lightest, of the main advanced countries, in the Great Recession of 2008 and 2009. I largely agree with the conduct of monetary policy at present, including keeping base rate at ½% and pursuing a further £50bn or so of asset purchases before the end of October. My main caveat – as before – is that it would be simpler for the government to borrow from the UK banks and for the state to create money that way, instead of the key operations being conducted by the Bank of England.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate at ½%; maintain current QE target
Bias: Extend QE beyond £175bn after November

QE is not raising the level or growth of M4x (M4 excluding intermediate OFCs) as quickly as the Bank of England or some of its proponents had hoped. The reason is de-leveraging. When some households and commercial and industrial companies acquire additional deposits, they are using those funds to pay down debt. This causes the balance sheets of banks to shrink by a corresponding amount and monetary growth to be slower than it otherwise would be. Unless banks replace those loan repayments with other assets (e.g. new loans or additional holdings of securities), bank balance sheets will shrink, and money supply growth will slow or actually decline.

Using a few simple assumptions, we can estimate how much de-leveraging might be undertaken by the household sector and, consequently, how much QE will be needed to replace that amount of household debt repayment. The Bank’s estimate of M4x in 2009 Q1 was £1,532bn. Assume that household’s disposable income grows at 3% p.a. over the next few years. Suppose also that households wish to reduce their gearing from a debt-to-disposable income ratio of 172% in 2009 Q1 to 142% by the end of 2012 (approximately the same level as in 2004). This implies that households will need to de-leverage by £123bn. If there is no change in UK non-financial corporate borrowing and no growth in bank holdings of securities, then on its own this household de-leveraging would reduce M4x to £1,409bn, a decline of 8.0% over three and three-quarter years. It is this tendency for the money supply to shrink under de-leveraging that QE must counterbalance.

This also explains why, in my view, the majority (six-member) vote in the recent August MPC meeting to increase Asset Purchases by £50bn to £175bn by November was inadequate and accompanied by too short a time horizon. The minority vote (three members including the Governor) was for a larger £75bn increase in Asset Purchases or QE to £200bn. But even that would not have been enough. The brief analysis above suggests that QE will be needed for several years to offset what is likely to be a prolonged period of de-leveraging. A more appropriate outcome would therefore have been to have extended QE by another £150bn (over the original £150bn) for a total of £300bn and to have set the target date for accomplishing this as mid-2010, which would have allowed the gilt market and other related fixed income markets a longer period of stability. Instead there will now be another series of shocks to the gilt-edged market in the run-up to end-November, just as there was in the run-up to the August meeting of the MPC whenever MPC members discussed in public whether or not they would be extending QE.

After a prolonged period of over-borrowing, the UK private sector requires an extended period of balance sheet repair. It is impossible to know in advance how much de-gearing this entails, but the brief discussion above shows that it could be substantial and prolonged. The MPC can help the process by making sufficient funds available over a reasonable time period and not vacillating over small, incremental increases of the Bank’s balance sheet every quarter.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral on rates but QE programme should continue at present rate until credit/money growth returns to normality.

The indicators have become generally more positive in the past months. This, as I have argued throughout this crisis, is not surprising, given the size of the monetary and fiscal stimulus that has been applied across the world. The doomsters have now switched to muttering about ‘double dips’. But the truth is that we have no basis for expecting economies to ‘double dip’. The dynamics of economies that are recovering from shocks are fairly straightforward: gradual improvement, radiating out through the usual channels of transmission.

To get a double-dip one needs a further negative shock, quite a large one given the size of the ongoing public stimulus. However, this is now unlikely. The main candidate would be a further financial collapse but with government committed to supporting financial institutions, that fox has been shot. In any case, the financial sector has been recovering fastest. Another possible candidate would be a sudden withdrawal of public support. Some commentators would like to see this happen - as they put it, ‘exit strategies’ should be implemented soon to avoid a resurgence of inflation. However, central banks and governments are naturally and rightly cautious about premature ‘exit’ when the indicators while improving remain far from robust. Indeed, there were plenty of examples of premature exit during Japan’s ‘lost decades’ which have meant that Japanese deflation has not to this day been cured; this has come on top of a damaging absence of supply-side reform.

I have argued before that automatic exit strategies are supplied by the inflation targeting commitments of most governments today. While there has been some discussion of using the ‘inflation tax’ to erode rising levels of government debt, it has not been given much encouragement either by major politicians or by public opinion which remains very hostile to inflation. The most likely scenario is that recovery will proceed and strengthen over 2010 and sometime during that year or early in 2011 interest rates can rise again and renewed restraint be put on credit and money growth. Inflation will continue to fall in the near term in most economies and even as the recovery reaches this stronger stage it will be held down by expectations of tightening monetary conditions. As this tightening occurs, so central banks’ balance sheets will contract as loans they have made are repaid. There is no ‘inflationary cliff’ opening up at our feet.

One argument one hears is that fiscal debt positions are unsustainable and must precipitate an inflationary crisis. However, public opinion in the US and the UK, where debt is rising fastest, is braced for cuts in spending growth, even in absolute spending levels, after years of profligacy. Also recovery will restore revenue growth, just as it is recession that has destroyed it. We have seen again in the UK, as in the 1990s, just how responsive the public finances are to the business cycle. Public debt will level off at a much higher percentage of GDP and it will not fall from this percentage until there is another boom in the economy.

Such a boom is a long way off because of raw material shortages. There will need to be a decade or so of innovation in materials and their use before the world can once more grow at the heady rates of 2003-2007. Already oil has risen back over $70 a barrel even while the world economy is still in the early tentative stages of a return to health. The crisis of 2007/8 put paid to such fast growth, not because of the aftermath of demand collapse in the crisis but because of solid supply-side constraints that were shown then to be fatally binding.

Comment by Gordon Pepper
(Lombard Street Research and Cass Business School)
Vote: Hold but Government should purchase assets from the private sector
Bias: Neutral but increase QE to £200bn

The aim of quantitative easing (QE) is to ensure that monetary growth is adequate. The growth of broad money should be kept as close as possible to the range of 6% to 8% per annum. The correct way of judging whether QE is too much, too little or about right is to monitor current monetary growth.

A difficulty is that current data for M4 are distorted by quasi inter-bank transactions. The Bank of England is now publishing data for M4x that excludes them. The M4 holdings of households and of private non-financial corporations should also be monitored. It should be stressed that the monetary series are inherently erratic and that fluctuations that last less than about six months are irrelevant. Attention should be focused on twelve-month rates of growth. The six and three-month rates of growth do however provide some indication of whether a recent trend in the twelve-month rate is likely to continue or reverse.

The conclusion is that quantitative easing has been inadequate. The MPC were wrong to discontinue it in July and the members who out voted the Governor last month, arguing for a £50 billion increase rather than £75 billion, were incorrect to do so.

Comment by Peter Spencer
(University of York)
Vote: Hold
Bias: Expand QE and take other radical measures

Asset markets have continued to recover strongly over the summer, especially the equity markets. This will support the economy by reversing the pressure on personal wealth and the cost of capital. However, there seems very little to support such strong optimism. The Bank of England’s Asset Purchase Programme may have been supportive, but this effect has surely been overwhelmed by the contraction of lending to the private and overseas sectors, which leaves credit and monetary aggregates looking dangerously weak. It seems that expectations of recovery are running well ahead of reality, leaving the markets prone to relapse.

The Bank of England’s August Inflation Report continued to warn of a “slow and protracted” recovery. However, in spite of the downbeat tone of the press conference, the GDP projections were revised up, particularly for 2010. These seem highly optimistic, even when taking into account the boost from the weak pound. The Governor stressed the rapid increase in the margin of spare capacity, suggesting that firms would want to reverse this quickly. However, I must be missing something. With consumers cashed-out, government in serious deficit and our major export markets in the doldrums, it is hard to see any serious potential for a recovery in demand. Credit remains restricted and this is putting increasing pressure on companies and consumers. Funding costs have fallen back, but spreads continue to widen. The Bank’s latest Trends in Lending publication reported that net lending to UK businesses fell by £3.4bn in May, on top of a £6bn decline in April. New mortgage approvals are edging up, but lending to households also remains severely restricted.

Although inflation has surprised on the upside, the Inflation Report still sees significant downside risks there and acknowledges that the CPI may undershoot the 2% target by more than 1% for a sustained period. Reflecting this, the Monetary Policy Committee voted 6-3 to expand the quantitative easing (QE) programme by £50bn at its August meeting. The option of a £75bn increase in the quantitative easing programme was also debated. This should have come as little surprise. The minutes revealed that the MPC believed “The potential adverse consequences of adding another large monetary stimulus might be less severe than the possible costs of acting too cautiously.”

I am of a similar persuasion. The weakness of demand and the large margin of spare capacity will exert significant deflationary pressure on the economy. I suspect that the QE programme will have to be expanded further once the current round of purchases is completed in October. Other radical measures should also be considered. Charles Goodhart has suggested that a negative interest rate should be paid on bankers’ balances, and the Swedish Central Bank has already announced a rate of minus ¼%. Bank Rate could be further reduced as part of such an announcement. Certainly there is very little prospect of a higher base rate until at least the end of next year.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Neutral: M4x data is inadequate to monitor QE and must be improved

The Organisation for Economic Co-operation and Development (OECD) and the UK Office for National Statistics (ONS) both re-based their economic data series this summer, obliging a wholesale re-estimation of the statistical relationships in the Beacon Economic Forecasting (BEF) model of the international and UK economies. All macroeconomic modellers hate such data enforced re-estimations because it is impossible to maintain appropriate statistical rigour when re-estimating numerous equations against a deadline. However, one benefit from re-estimation is that it is possible to test individual statistical relationships for the impact of the financial meltdown that commenced in 2007. None of the world’s model builders appear to have anticipated the global financial meltdown and its effects on the economy. However, it is one thing to know that forecasting models have broken down in some vague general sense, and quite another to be able to say where and when the breakdowns occurred. The technique adopted was to include separate dummy variables for each quarter from 2008 Q1 onwards up to 2009 Q1, when the published data largely runs out. The data employed for estimation ran back to the 1970s or earlier and included several previous recessions.

The residuals about the fitted relationships were also inspected to see whether there was any sign of shocks before 2008 Q1. However, such shocks have to be larger than the normal ‘noise’ in the data to count as significant and most dummy variables were insignificant before 2008 Q4. The main place where it was possible to pick up significant effects before 2008 Q4 was the relationship for OECD industrial production, where output started to fall away from its fitted relationship in 2008 Q2 and Q3 before plummeting in 2008 Q4 and 2009 Q1. Otherwise, it was generally not possible to uncover any discernible impact before 2008 Q4. All the statistical relationships for the components of UK GDP showed significant negative shocks to quarterly growth in 2008 Q4 and 2009 Q1. These were of the order of 2¼% to 2½% in the case of real household consumption, 2¼% and 1¾% for the level of real inventories in 2008 Q1 and 2009 Q1, respectively, and around 4¼% in both quarters where UK private investment was concerned. British exports were almost 4% lower in 2009 Q1, than historic relationships would have suggested, but there was no evidence of any significant deviation where UK imports were concerned. These findings are consistent with the accepted view that the collapse of Lehman Brothers on
15th September 2008, led to a catastrophic loss of confidence and the spending cutbacks that turned a normal recession into a potential slump.

There was little indication that the relationship for OECD consumer prices had broken down, with a ½% undershoot in 2008 Q4 being offset by an equivalent rebound in 2009 Q1. This indicates that the ‘output-gap’ model of inflation remains valid and implies that global inflation may remain subdued for some years. However, the quarterly change in ‘double-core’ UK retail price inflation - which is closely related to the target CPI but available for longer - was higher in 2009 Q1 (by 1.4%) and in 2009 Q2 (1.9%) than the model predicted. This may be because the temporary VAT reduction has not been fully passed on – the effect of the weak pound was already allowed for in the equation concerned. UK real house prices were some 3¾% lower in the second half of last year than predicted, but appear to have returned to track this year. The world three-month interest rate was significantly higher in 2008 Q4 and 2009 Q1, than the model predicted. However, this was because the combination of low/negative inflation and an unprecedented OECD output gap meant that the historic relationship was trying to generate a negative interest rate. The current 0.5% world short rate possibly represents the effective lower limit for three-month interest rates everywhere. The unconventional measures resorted to by central banks seem to have successfully propped up the OECD broad money supply, which increased by some 2% more in 2008 Q4 and 1½% more in 2009 Q1 than might have been anticipated. The room for manoeuvre provided by Britain’s positive inflation has also allowed the MPC to keep Britain’s real interest rates lower in relation to overseas than would normally be expected.

The Bank of England has still not put a workable series for M4x into the public domain. This is surprising given the importance of M4x as the intermediate target for QE. However, a quasi-consistent unofficial series has been put together by subtracting the Bank’s implied figures for Other Intermediate Other Financial Corporation (OIOFC) deposits from their break adjusted M4 series. This has been used to re-estimate the BEF model, where broad money has a pervasive influence, in place of the ‘old’ M4. A demand-for-money relationship was also estimated for price-deflated M4x over 1972 Q1 to 2009 Q1. This statistical equation explained 83% of the quarterly changes in real M4x and had a standard error of 0.72%. The steady state of the dynamic ‘error-correction’ equation concerned has the properties that the logarithm of price-deflated M4x equals a constant plus the logarithm of household consumption minus 0.063 times the three-month inter-bank rate minus 0.072 times the difference between the twenty-year gilt yield and inter-bank rate. The M4x equation also included short-term effects from changes in the logarithmic price index. Most bank deposits now pay interest. Putting the two inter-bank-rate terms together implies that a 1 percentage point cut in the short rate reduces – not raises - the demand for money by 0.9%, other things being equal. However, the current 334 basis points excess of the gilt yield over inter-bank rate reduces real M4x by 24% compared to a situation where the two rates are equal. In this demand-for-money context, QE looks like an attempt to offset the indirect negative effect of the Budget deficit on M4x arising from the need to fund the fiscal deficit. This suggests that M4x growth may not recover until public borrowing is reined in, unless the Bank is prepared to acquiesce in crude inflationary finance.

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

The Bank of England’s Asset Purchase Programme (APP) has made a decisive contribution to the stabilisation of national income and spending since its inception in early March 2009. While there are well-founded reasons to believe that nominal GDP growth will resume during the July-September quarter, uncertainties will persist for a few more months. Hence, the extension of the policy on 6th August by £50bn to £175bn should be viewed as a sensible precaution. Further extensions seem likely to be requested and granted.

The key accomplishments of the quantitative easing (QE) programme, to date, are: the relief of pressure on the sterling capital markets, allowing non-financial corporations to issue debt and shares on more favourable terms; the mitigation of the impact of the government’s fiscal deficit on medium to long-term government bond yields; the positive public sector contribution to the growth of the broad money supply and the replenishment of commercial banks’ balance sheet liquidity. The net repayment of non-financial corporate sector bank loans in the April-June quarter (£14.7bn) reflects numerous factors and does not constitute an outright failure of the QE policy. One use of bank facilities is to finance inventory and capital expenditure and the severe economies made by the corporate sector have naturally lowered their demand for bank finance. Wholesalers and retailers were responsible for £6.3bn of the net repayments and manufacturers for £4.5bn.

Other Financial Corporations (OFCs) continue to place large demands on the UK banking system, raising lending by £11.3bn and deposits by £16.5bn in the June quarter. The normalisation of the mortgage sector is being hindered by the departure of foreign lenders and the tight restrictions imposed on banks partly or wholly in state ownership. However, mortgage lending is regaining momentum. Meanwhile, broad money supply growth has remained positive throughout the credit crisis, although the growth rates of money holdings of households and firms remains unusually low. Even so, it is important to bear in mind that this deceleration is due in part to the ‘interest-credited’ component of deposits, which is negligible at current interest rates. The headline growth of 1% in July M4, not yet allocated by sector, is the latest encouragement. More generally, the removal of financing constraints on the corporate sector at a time of massive primary gilt issuance has contributed to a much more positive tone in financial markets, evidenced by the spirited rally in UK equity prices.

UK consumer prices continue to defy predictions of weakness. The headline CPI inflation rate held steady at 1.8% in July and the core CPI rate rose from 1.6% to 1.8%. Despite a favourable comparison for food prices, private sector prices, excluding food and light, fully compensated. The decomposition of retail price inflation reveals a jump from 1.7% in June to almost 2.4% in July. This is the fastest rate of increase since April 1998. Household goods price inflation jumped back from 2.1% to 3.6%, and motoring expenditure recovered from 1% in June to hit 3.2% in July. Leisure goods deflation dropped to 1% from 2%. The overall picture confirms the stickiness of retail prices and casts considerable doubt on the ability of high unemployment and low capacity utilisation to moderate inflation. As the extraordinary price movements of last year wash out of the annual comparisons, another upward breach of the Bank of England’s 3% limit is to be expected next year. If the Bank of England’s MPC remains serious about hitting its inflation target, then the reign of ½% Bank Rate should be brought to an end within the next three months. By November, it should be clear that the deflationary emergency is over. A restoration of Bank Rate to around 2% should be accomplished soon afterwards but my vote is to hold interest rates at ½% for the coming month.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Hold rates at ½% and extend QE to a total of £250bn

The UK economy is showing strong signs of stabilising, but not yet of an overall recovery that is likely to be sustained at this time. Yes, the Purchasing Managers’ Indices (PMI’s) for manufacturing and services are now above the 50 level that indicates expansion, at 50.8 and 53.2, respectively, but the PMI for construction is well below 50 at just 47.0. Meanwhile, the volume of retail sales was up by 0.3% in July, to stand 3.3% higher than in the same period of 2008, while industrial production rose by 0.5% in June but remained 11.1% lower than in the year before. This means that the severity of the recession is clearly easing and, on the surface, the economic tide has turned. Not surprisingly, business and consumer confidence have perked up from their lows, with consumer confidence lagging the upturn. Growth in the third quarter may show the first positive number since 2008 Q1, but it is not yet clear that it will be sustainable.

The financial markets continue to stabilise. Equity prices are higher than a month ago, as measures of risk indicators in the equity and credit markets fell back and cash spreads have narrowed. Bond yields have come down further and the US dollar was modestly sold across most currencies pairs in the past month, suggesting a lessening of perceptions of risk about the world economy generally.

However, below the surface there are reasons for real concern, particularly if the ultra loose monetary position were to be reversed too soon. Chief amongst these concerns is that money supply growth is still weakening. Companies are reducing debt and households are borrowing less. This was shown up clearly in the M4 data for June and the provisional figures for July. Whilst the headline M4 figure in July showed a rise of 1% on the month, adjusted for other financial companies, (OFCs), there may in fact have been no growth in M4 itself - if the pattern of recent months persisted into July. Certainly, on the M4 lending side, there was a repayment of £1.1bn in July and there was a further fall in the annual rate of increase from 8.3% in June to 7.8% in July. It appears that companies that have been raising finance from equity or bond issuance have been using it to pay down their earlier bank loans. The 10.4% fall in business investment in the second quarter, which was down 18.4% on the year, is a sign that firms are still savagely cutting investment as it recorded its steepest fall since records began some forty-three years ago.

The second ONS estimate of 2009 Q2 GDP growth – which showed the detail of the spending components - confirmed a sharp fall in investment spending (down 4.5%), consumer spending (down 0.7%), and stocks (down £4.5bn). These falls were only partly offset by a rise of 0.8% in government spending and a positive impact from net trade of 0.2%, as imports fell more than exports. There was little in the data for private sector final demand (consumer spending and business investment) to suggest that economic growth was about to make a sustained comeback in the second half of 2009, despite the likelihood of a temporary boost from restocking after the savage destocking of recent quarters.

Bearing in mind that VAT has to be raised back to 17½% in January 2010, that tax rises are set to come into force in April and that the boost to real household incomes this year from falling commodity prices will not help real incomes in 2010 at a time that unemployment is set to rise further and government spending is set to slow markedly, monetary policy will likely remain loose for some time to act as an offset to some of these negative forces. The good news is that a very large negative output gap means that inflation is not a concern in the near term and so further QE can be adopted if necessary and Bank Rate can stay at its current ultra low level well into 2010 or beyond.

What is the SMPC?

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

SMPC membership

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

Following its latest quarterly gathering on 21st July, the Shadow Monetary Policy Committee (SMPC) voted to leave Bank Rate at ½% when the Bank of England’s rate setters meet on 6th August. The unanimous SMPC vote reflected the belief that there was no immediate case for a rate increase – although one member thought that Bank rate could be safely raised to 2% within the next six months - combined with the view that Quantitative Easing (QE) was the most effective monetary policy instrument available.

Some SMPC members believed that an additional £100bn to £300bn of debt re-purchases was required once the current program had run its course. This represented a more enthusiastic view of the case for QE than the greater agnosticism revealed in the July Bank of England minutes, which were published the day after the SMPC gathering.

The SMPC poll was carried out before the UK Office for National Statistics (ONS) announced a very weak second quarter GDP figure, on 24th July. This seemed to confirm the view expressed at the SMPC gathering that the green shoots of recovery might be wilting.

However, subsequent e-mail correspondence revealed that some SMPC members thought that the ONS data were too weak to be valid, possibly because of excessive price deflation. A noteworthy aspect of the 21st July meeting was the amount of time devoted to discussing the risks of sovereign default or another major collapse in the international financial sector. Some members feared that the possibility of another adverse credit-market ‘event’ this autumn should not be ruled out.

Minutes of the Meeting of 21st July 2009
Attendance: Philip Booth, Tim Congdon, Ruth Lea, Andrew Lilico, Hiroshi Oka (Embassy of Japan observer), David Brian Smith (Chair), David Henry Smith (Sunday Times observer), Peter Warburton (Acting Secretary), Trevor Williams, Hajime Yoshimoto (Embassy of Japan observer).

Apologies: Roger Bootle, John Greenwood, Kent Matthews, Patrick Minford, Gordon Pepper, Peter Spencer, Mike Wickens.

Chairman’s comments
The timing of the next meetings was discussed and the suggested timing is Tuesday 20st October at 6pm. The chairman then invited Trevor Williams to present the monetary situation.

The Monetary and Economic Background
Despite some encouraging signs of stabilisation in recent months, the stark reality is that global economic growth has fallen sharply and the downturns in advanced, emerging and developing economies are synchronised. For advanced economies a GDP decline of 4% is probable for 2009, while emerging and developing countries may experience mildly positive growth of the order of 2%. The UK has experienced its first recession in sixteen years with the slowdown led by the corporate sector. A sharp inventory correction has been achieved through the reduction in manufacturing output to levels more than 10% below a year earlier. However, signs of recovery have appeared in recent months, lifting the construction sector Purchasing Managers Index (PMI) from sub-30 readings to the mid-40s; manufacturing PMIs from around 35 to 47 and services PMI from 40 to 52. UK manufacturing output is no longer falling and CBI output expectations have risen markedly in the past three months. As yet, measures of business and consumer confidence have recorded slender gains from the early-year lows.

The latest Lloyds TSB (Business in Britain) survey reports a marked recovery in business confidence based on firms’ expectations of orders, sales and profits over the next six months. Regionally, the most positive reading is for London and the most negative are for the Midlands and the South East. By sector, the most resilient is business services and the most vulnerable were construction and retail. There was also a clear differentiation of confidence between small and larger businesses. Those with annual turnover of under £5m reported negative balances whilst those with more than £50m turnover showed more positive readings.

There are tentative signs that the UK housing market may have stabilised with a pickup in mortgage approvals. The volume of UK retail sales is lower than a year ago but the CBI retail survey suggests that an improvement is close at hand.

There has been considerable interest in the parallels between the current economic downturn and its predecessors. An International Monetary Fund (IMF) study of 122 recessions reveals that downturns linked to financial crises are more protracted and the subsequent recoveries are more gradual than for ‘normal’ recessions.

Examining the experiences of Scandinavia in the early 1990s and Japan from 1997, suggests that lending growth takes three years to return to positive territory. Another factor bearing down on the prospects for economic recovery is the high level of indebtedness of UK households and non-financial corporations. A desire to limit these exposures may make the private sector less willing to borrow.

The latest data show a decline in the pace of OECD monetary growth to around 7% per annum with further declines in prospect. Meanwhile the central banks have created liquidity to varying degrees. Indexing the size of each central bank’s balance sheets to 100 in January 2007, the Bank of England leads the way with 270 followed by the US Federal Reserve at around 230.

The European Central Bank (ECB) has risen to 170 while the Bank of Japan scores slightly less than 100. It was observed that headline measures of broad money growth are well in excess of the increase in nominal GDP, suggesting a relaxed stance of monetary policy in all of the four contexts referred to above.

There has been considerable discussion regarding the use of an adjusted series for the UK M4 money supply, with the adjustment removing the effect of intermediate other financial institutions (OFI) transactions. This measure is currently showing annual growth of less than 2% as opposed to more than 14% for the headline M4 series.

Trevor Williams inferred that loose monetary policy is not a short term threat to inflation but may be a long term threat. Similar inferences were made for the US, the EU and Japan. A disaggregated comparison of trends in bank lending for these countries reveals that lending to non-financial corporations and households has decelerated everywhere apart from Japan.

However, there is an anomaly regarding lending to other financial companies where the UK trends are strongly positive but the US, Japanese and EU trends are negative. This was attributed to the severity of the securitisation crisis in the UK. It was observed that the Customer Funding Gap (CFG) remained at a high level of £800bn, of which foreign banks accounted for approximately half.

The gradual downsizing of foreign banks’ lending activities in the UK has rendered the government’s targets for incremental lending superfluous as UK banks cannot readily increase their lending to those borrowers who lose access to a foreign bank. In short, the UK has been borrowing abroad and now that foreign flow has fallen the costs of borrowing have increased and the supply diminished.

On the basis of relative money supply growth differentials, Trevor Williams observed that Sterling appeared significantly undervalued in relation to the US Dollar; the Yen was overvalued in relation to the US Dollar, and the Euro was significantly overvalued in relation to the US Dollar.

The Bank of England has recently released a new quarterly survey of trends in lending. The availability of credit to UK borrowers in the form of mortgages has improved since the extreme negative readings of a year ago. A more recent improvement has recently occurred in respect of households’ unsecured borrowing and for corporate borrowing. The survey indicates that the availability of credit is expected to improve further in the next three months, especially for corporate borrowers.

The default rates on loans remain a serious concern, particularly for mortgage lending. Correspondingly, lending spreads are expected to widen for personal borrowers in the next three months. Net funds raised by UK businesses from all sources have turned positive in the most recent month (May) with equity and bond issues more than offsetting the reduction in bank borrowing.

Discussion
Global banking sector still at risk
The Chairman thanked Trevor Williams for his thought-provoking and thorough presentation and then threw the meeting open for discussion. In response, Andrew Lilico stated that he was concerned that there might be a repeat of the credit market difficulties of last September. He wondered whether refinancing problems could trigger another major failure in the financial system. He observed that such an event would cast extreme doubts on the usefulness of bank stress tests and illustrated his concerns by the example of Ireland. Trevor Williams agreed that this was conceivable and suggested that the risks were evenly balanced.

Peter Warburton thought that a repeat credit market ‘event’ was rather less likely on the basis that the declaration of losses in the global banking system had evolved to the point where approximately 70% of potential losses had occurred. The greater visibility of banking sector problems, notwithstanding the lack of transparency in the European banking system, has reduced the likelihood of a major credit shock. Tim Congdon commented that the widening of net interest margins is allowing banks to rebuild their capital. As asset values recover, this would also allow banks to write back some of the loan loss provisions that they have made.

Andrew Lilico then raised the issue of prime defaulting in the US or European contexts, should deflationary forces persist. Tim Congdon drew the distinction between internal and external debts. Internal (e.g. between local residents and government) debts were easier to deal with through the reflation of the asset collateral. He acknowledged that external debt presented a more significant problem, citing the predicaments of Latvia, Lithuania and Ireland which lack the ability to reflate away external currency debt.

Andrew Lilico suggested that a bout of wage deflation could trigger a default crisis in Ireland. Tim Congdon agreed that banking losses were often associated with a declining standard of living - for example Iceland’s banking losses represent between 50% to 100% of GDP - and an implied reduction in living standards over an extended period unless there is a dramatic easing of policy. Trevor Williams wondered whether the Irish banks would be supported by foreign parents or whether the losses would be absorbed by the Irish government. The discussion was broadened to consider the implications of default in Eastern Europe where much of the debt was denominated in foreign currencies. Tim Congdon noted that if governments assume the debts of the banking sector then they may risk sovereign default, as almost happened in South Korea in 1997.

David Brian Smith suggested that there was a difference in kind between the very small EU members who could be bailed out by their larger neighbours without too much trouble and the larger ex-communist nations where this would not be practical. Ultimately, this depended on the political decisions of Germany. German politicians would not want trouble in their own backyard but almost three quarters of the country’s electorate appeared to oppose bailing out other countries according to recent polls.

He then said that the dilemma from a forecasting perspective was that there was a strong risk of OECD deflation in the short term, based on an output-gap analysis, but the excessive growth of broad money in relation to trend output implied an inflationary outlook in the medium term. He added that the shortfall of OECD industrial output about its trend in the first quarter of 2009 was twice as large as in any previous recession since the early 1960s. At the same time, OECD broad monetary growth in the year to April was a reasonably robust 7.7% - or 7.4% if high inflation countries were excluded. A ‘P-Star’ calculation for the OECD area as a whole suggested that the region’s broad money growth was currently funding trend inflation somewhere in the 4% to 5¼% range.

Tim Congdon countered that the growth of broad money is not rapid in the UK once interbank transactions have been netted out. Following the implementation of Quantitative Easing (QE) he believed that the underlying growth of M4 was about ½% a month. David Brian Smith commented that there were inconsistencies in the Bank of England’s monetary data that clouded their interpretation.

We were now in the unfortunate position of using QE to stabilise a monetary aggregate, M4 less Other Intermediate Other Financial Corporation (OIOFC) Deposits, where the monthly figures differed from the quarterly data and the levels data were inconsistent with the published changes. He had discussed the matter with the Bank’s data compilers.

The conclusion seemed to be that the best way of putting a consistent broad money series together was to subtract the Bank’s estimate of OIOFC deposits from the break-adjusted M4 series available on the Bank’s statistical data base. He hoped to carry out statistical research using this measure in the near future. Tim Congdon then questioned the accuracy of the adjusted M4 growth series in Trevor’s presentation, which had used the Bank’s estimates, arguing that there had been a distinct monetary acceleration in 2006-07, driven by corporate sector deposits.

Andrew Lilico suggested that if the Bank of England drew its QE program to a close that there may be a funding problem for the government. Tim Congdon disagreed, asserting that the government can always borrow directly from the banks. He queried the implementation of QE, whereby the banks accumulate bank reserves at the Bank of England. He asked why the government could not borrow directly from the banks without inflating the Bank of England’s balance sheets.

He pointed out that monetisation can occur in the presence or absence of a large government deficit; it was not necessary to monetise new borrowing. Andrew Lilico reiterated his concern that public spending might be encouraged by the QE program. David Brian Smith said that the golden era of Open Market Operations (OMOs) in the 1920s occurred because there was a large stock of government debt left over from the Great War, which could be bought or sold according to the needs of the economy by the central bank, at the same time as a credible balanced budget rule and commitment to the gold standard meant that bond holders did not have to fear that expansionary OMOs/QE posed a longer-term inflation threat.

The empirical evidence for both the UK and the US suggested that sustained debt sales of 1% of national output eventually raised the real long-term government bond yield by some 0.2 percentage points. The scale of the prospective fiscal imbalances in Britain and the US suggested that real bond yields could rise to the point where increasing debt servicing costs lead to an aggravation of budgetary problems.

The Sunday Times observer, David Henry Smith then commented that market expectations have changed appreciably since the MPC declined to take up the remaining £25bn of asset purchases at the July meeting. There is a presumption that the MPC would not have paused without good reason and that this will become clear when the August Inflation Report is released. Regardless of whether this marks the end of QE, there has been a marked shift of expectation as to its longevity.

Peter Warburton thought it important to consider the US context of QE, where the US$1.75trn programme of asset purchases was approximately half-completed. It seems likely that the Fed’s balance sheet will grow materially over the coming months as offsetting factors (the run-off of short-term funding instruments) become less significant. US bank reserves have been falling in the past three months, suggesting that more lucrative uses are being found for the funds. The initial indications are that the seeds of a monetary acceleration have been sown. Parallel concerns over the Fed’s exit strategy have prompted Fed chairman, Ben Bernanke, to submit a long explanation in an article in the Wall Street Journal (21st July).

Roger Bootle commented (by an e-mail submission circulated in advance of the meeting) that there are already signs that the “green shoots” of recovery are starting to wilt, with May’s drop in industrial production being a prime example. Indeed, there are several reasons to doubt that a strong and sustained recovery is on its way. A severe fiscal consolidation was looming, probably involving both tax rises and public spending cuts.

Banks were likely to remain cautious about lending for some time yet, not least because a raft of recession-related bad debts was heading their way. Slowing pay growth was offsetting any boost that falling inflation might have given to households’ real incomes. And the real benefit from the lower pound was unlikely to be felt until global demand strengthened significantly. Even if the recovery did turn out to be stronger than he expected, it would take a prolonged period of rapid economic growth to use up the large amount of spare capacity that was building up in the economy – even accounting for the fact that the credit crunch had probably knocked potential output. Accordingly, deflation, not inflation, would remain the big risk for some time.

Votes
The Chairman then asked each member to make a vote on the monetary policy response, apart from Roger Bootle who had submitted his vote earlier (by e-mail). In addition, to Roger Bootle’s submission there was a need for a second vote in absentia, since only seven SMPC members had been present at the meeting. This was provided shortly after the meeting by Patrick Minford. The votes are listed alphabetically rather than in the order they were cast, since the latter simply reflected the arbitrary seating arrangements at the meeting. The Chairman traditionally votes last.

Comment by Philip Booth
(Cass Business School)
Vote: Hold
Bias: Neutral

Philip Booth expressed unease at the way the policy of QE was operating. He believed that the government should give the Bank of England free rein on the extent of QE, which should be set in order to deliver the appropriate growth of the money supply. The government's role should be to monitor and set limits on the sorts of assets that are bought as a result of QE because the taxpayer ultimately underwrites the risk. Still lacking is a coherent strategy as to the purpose of QE, its predicted effects, its relationship to the inflation target and the framework for deciding when the policy should be reversed.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold
Bias: Neutral on rates but announce £300bn increase in QE

Roger Bootle believed that deflation, not inflation, will remain the big risk for some time and that interest rates should be kept at their record low level of ½% for a sustained period and that QE should be extended further. The MPC should start by using the last £25bn of the £150bn originally sanctioned by the Chancellor. It should also ask for this upper limit to be raised, given that he thought that it will probably have to do more than £150bn of QE in total. Indeed, in order to convince the market that it is prepared to do whatever it takes, the MPC should ask for a huge amount of extra QE, perhaps well in excess of what it thinks it is likely to do, say £300bn, and then proceed to do QE steadily in £25bn slabs.

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

The policy of QE should be extended to the full amount agreed (£150bn) and the Bank of England should be given the option to extend by another £50bn by October. The purpose of QE is to achieve a steady positive growth in the quantity of money held by household and non-financial companies. The advent of QE has thrown into serious doubt the relevance of the remit of the Debt Management Office (DMO). It was time to consider transferring the DMO’s functions back to the Bank of England, which had successfully managed the gilt-edged market from 1694 to 1997, in order to ensure that official operations in the government bond market were not at cross purposes, as at present, and compatible with the broader needs of monetary policy.

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

Ruth Lea’s assessment of the economic outlook has grown more pessimistic in recent months due to the lack of visibility of drivers for growth. With unemployment rising, personal balance sheets in disrepair, a prospective increase in VAT from January and higher rate income tax in April next year, her concern was widespread. She had no concerns on the re-emergence of inflation for the foreseeable future and supports the continuation of QE and believed an extension of the policy should be considered.

Comment by Andrew Lilico
(Europe Economics)
Vote: Hold
Bias: Neutral on rates but extend QE by £150bn

In view of the risk of a repeat adverse ‘event’ in the credit system, and the associated risk of a second dip in economic activity, it was appropriate to carry on with QE and seek permission from the Chancellor for another £150bn of capacity in Andrew Lilico’s view. He remained concerned that deflation risk had not been eliminated. During the course of this crisis, the inflation target had lost credibility and his preference was to shift to a price level target for the duration of QE. Andrew Lilico remained concerned at the absence of a coherent exit strategy from QE.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Hold
Bias: Neutral on rates and continue with QE

Patrick Minford stated in his e-mail submission that, based on the Cardiff model of the economy, we should be observing a turning point after the crisis. Indeed, this is what we were seeing, with the usual variations between regions and countries. Unusually it was China - where QE has been most striking and determined, with state-mandated credit revival - that had lead the recovery. He had argued before that fiscal ‘packages’ must be seen as essentially credit packages, not conventional fiscal policy ‘stimuli’ (which were probably quite ineffective normally).

In a credit crisis, the only agent able to provide the credit that was unavailable from the banks and the markets was the taxpayer. While central banks provided cash to the markets in exchange for whatever assets the markets could offer – they were permitted to do so because the taxpayer picked up the risk on those assets - governments themselves were providing credit and capital to the banks and the private sector via their greatly increased deficits. These deficits were a form of credit because they had to be paid off in due course through cuts in spending or higher taxation. This overall provision of credit by the government, whether through the central banks or directly, has been vital in staunching the wounds caused by the credit crunch.

The issue now was turning to the timing of ‘exit strategies’. Patrick Minford’s view was that the priority was to consolidate the still highly fragile recovery. Indeed, credit growth was still low or even non-existent in wide swathes of the world. This implied that the creation of money in exchange for a wide variety of assets in short demand (QE) must be continued vigorously.

In this respect, he was alarmed by the tepid attitude of the Bank in indicating that QE may not be extended beyond the current limits set by the Treasury. Since the lags in effects from both the credit shock and the response were quite short, a matter of two or three quarters to their peak effect on both output and inflation, it was a mistake to dwell on exit strategies when we had yet to see through the recovery process. Once the recovery was quite assured there would be plenty of time to put into effect the necessary tightening of money supply that will raise interest rates once more and prevent any inflation resurgence.

It has been said that the lack of an exit strategy threatened a resurgence of inflation. This was true, but there was an explicit exit strategy in the UK and in most major economies: this was inflation targeting according to whose logic money will automatically be tightened to achieve target inflation. There was really no need to do anything other than reiterate that this structure remained in place.

Despite the loose talk of how nice it would be to use inflation to soak up rising government debt, there had been no official encouragement of this view. Politically, inflation targets remained popular everywhere. There was no reason to expect governments to sacrifice their popularity by using the ‘inflation tax’. He had been struck by debates in Europe and the UK where it had simply been assumed, without explicit discussion, that inflation targeting was in place.

As far as fiscal policy was concerned, this was integral to the revival of credit. Here too premature tightening and panic about debt levels was misplaced. Fiscal policy should remain as it was until recovery was assured. There should then be a careful and measured return to fiscal balance, with the debt overhang allowed to be reduced naturally by future cyclical improvements. His conclusion was clear: an exit strategy was there and would be implemented calmly as conditions changed. Meanwhile, it was essential that current policies to restore recovery continued with determination.

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

Unfortunately this shortage was not quickly or easily remedied. It required major technological change that cut the use of raw materials per unit of GDP, as occurred after the oil crises of the 1970s and 1980s. Extra supplies of raw materials may be brought on stream with a lag but the main need was to curb demand. This could take a decade to come to fruition. Hence we should expect growth to be held back until this has happened. Capacity that was viable at the old raw material prices will prove uneconomic at the new ones; cars, aeroplanes, factories etc. will need to be replaced with more resource-efficient ones.

The Cardiff forecasts looked for a resumption of growth but not back to the same path that we were used to in the mid-2000s. It seems likely that there had been a permanent loss of capacity and that there would be slower growth from that lower level. The policy conclusion was that interest rates should be kept on hold with no bias either way. QE should continue at current rates of growth in assets until there was a revival of credit and core M4 growth. Since the exit strategy was already in place: no further discussion of it was required other than to emphasise and explain what inflation targeting already implies.

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

David Brian Smith thought that there were still lessons to be learnt from the successful policy combination operated by the UK in the 1930s and contrasted this with the policy mix today. In the 1930s, the UK abandoned the gold standard early, and combined a tight fiscal stance with a loose monetary policy. This had the effect of crowding in private sector activity and minimising the economic damage caused by the collapse in overseas demand for UK exports. The undesirable aspect of interwar policy was the state-sponsored cartelisation of the British economy, whose adverse supply-side legacy lasted until the 1970s.

David Brian Smith considered that the fiscal-monetary policy mix was less intelligent today but the interventionist instincts are no less prevalent. He expected mildly negative inflation rates in the UK and the OECD over the next three years and was unconcerned about inflationary risks over the next year or so. He was agnostic on the case for an extension to QE and would like to see more research on the transmission mechanism of the policy. He regretted the poor quality of the monetary data which stood in the way of clear analysis. Without better indicators of the underlying monetary stance, he believed that policy was flying blind to an undesirable extent.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold
Bias: To raise Bank Rate over the next six months

During the next six to twelve months, nominal economic activity is likely to be bolstered by the heady combination of low interest rates, QE, credit guarantees, special liquidity provision, accommodative fiscal policy and a weakened exchange rate. A powerful, but temporary, rebound in activity is probable as the UK participates in a global rebuilding of inventories and a partial recovery of industrial output and exports. However, the structural issues have yet to be addressed and de-leveraging is a prospect not a fact.

The greatest threat to the UK economy in this interim phase is a further widening of the budget deficit which could undermine sovereign credit perceptions and the willingness of foreigners to hold sterling assets. An urgent and significant tightening of the fiscal stance is required, in the context of the extension of the QE policy for another year. In current circumstances, Bank Rate at ½% confers little benefit to the financial system and could safely be raised towards 2% without jeopardising the economy.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold
Bias: Neutral but expand QE by a further £100bn

The remaining £25bn of QE should be used and the scope of QE should be expanded by a further £100bn. In view of the large output gap, inflation should be expected to fall in the short term, reinforced by de-leveraging in the personal and corporate sector. Trevor Williams supported a faster pace of money supply growth in the near term but shared concerns around the practical issues of unwinding QE over the coming years.

Policy response

1. The committee voted unanimously to hold Bank Rate at its current ½%.

2. One member had a bias to raise Bank Rate within the next six months. All the others had a neutral bias, in part because of the uncertainties involved.

3. There was a widespread view that QE needed to be extended, although there was disagreement as to the precise amount involved.

What is the SMPC?

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

SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A Late Surge in Capital Issuance

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

From The Sunday Times, February 22 2009

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

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

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

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

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

The Monetary Situation

The International Situation – Plummeting Global Activity.

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

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

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

The UK Economy – Slowing Nominal GDP Growth

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

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

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

Summary of Presentation

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

Discussion

Quantitative Easing to Avert Depression

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

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

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

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

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

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

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

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

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

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

Votes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The other half of the explanation is that there are three sources from which the government can borrow to finance a deficit, namely: (i) banks; (ii) the non-bank private sector; and (iii) non-residents. It follows that borrowing from banks - that is, mainly changes in banks’ holdings of treasury bills and gilts - is equal to the public sector net cash requirement (PSNCR) less sales of gilts, etc. to the non-bank private sector and to non-residents. In the mid 1980s, banks’ holdings of government debt fell when sales of gilts to non-banks exceeded the PSNCR because the then Chancellor, Nigel Lawson, was following a policy of overfunding to control the money supply. At the time the discount market existed and commercial bills guaranteed by a discount house and ‘accepted’ by an acceptance house (i.