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

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

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

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

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

The Monetary Situation – world credit market conditions remained intense.

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

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

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

Discussion

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

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

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

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

Votes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Votes in Absentia

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

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

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

Policy response

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

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

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

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

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

What is the SMPC?

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

SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Monetary and credit market conditions remain very tight. The end-year crisis in the money markets has passed, but three month inter-bank rates are still 40 basis points above bank rate, reflecting the shortage of bank capital. The bank reporting season should help to ease the problem of counterparty risk in the banking system, but will do little to resolve the problem in the hedge fund and Structured Investment Vehicle (SIV) sectors, which remain completely opaque. It will do nothing to ease the pressure on regulatory capital.

Mortgage lenders are very short of funds and have been tightening their loan criteria and pushing up their lending rates, despite the recent reductions in Bank Rate. This situation could have serious consequences for the housing market unless it is resolved quickly. The housing market and the high street have held up remarkably well in the face of these pressures, but Bank Rate may have to be cut sharply if the situation deteriorates.

To set against this, world food and energy prices are pushing up the CPI and the pound has fallen back against other currencies. Public perceptions of inflation appear to be on the increase. In view of this, I would keep Bank Rate on hold in March. However, the weakness of the domestic market should make it difficult for importers to pass their higher costs on to the consumer, allowing rates to be cut at a measured pace over the next few months. Retailers’ prices are already under strong downward pressure.

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

The sterling index is currently some 8¾% lower than it was a year ago, while the pound has fallen by 11¼% against its main trading partner, the Euro, although it has risen by not quite ½% against the weak US$. The extent to which one is concerned by this development depends on ones’s fundamental model of inflation. Where the MPC is concerned, the prime determinant of inflation appears to be the domestic output gap, which can be influenced by its interest rate policies, so the main effect of the weaker pound is to allow a much needed re-balancing of the UK economy from domestic consumption towards net exports. In an alternative ‘international–monetarist’ model of the inflation process, however, one would expect that the logarithm of the domestic price level would eventually equal the logarithm of the overseas price level less the logarithm of the exchange rate plus a constant term. The empirical evidence suggests that the latter model provides at least as good an explanation of the movements in the UK price level over the past four decades as the output gap. However, the two approaches can be combined, with the output gap being used to explain short-term accelerations and decelerations in the rate of inflation, while overseas prices and the exchange rate are used to explain the long-term low frequency trends in the price level. The main reason for not panicking at this point is that it seems to take a long time for movements in the external value of sterling to be completely reflected in the domestic price level, although the effect of overseas price level trends appears to be far more rapid. Indeed, there is evidence that inflation trends are increasingly being generated at the global level and that the external world output gap is an increasingly important influence on inflation in individual countries.

If one regards the depreciation of sterling over the past year as being the equivalent of a ‘half devaluation’ under the old fixed-exchange rate system, then it is clear that none of the measures required to make a devaluation work, without risking a serious feed through into domestic inflation, have been implemented. In particular, fiscal policy has been loosened, not tightened, interest rates have been cut not raised, money and credit growth have not been reined in, and the labour market has not been rendered more flexible by de-regulation and other supply side reforms. The massive expansion in the size of government employment over the past decade - and the sharp reduction in the numbers employed in important net-export producing sectors, such as manufacturing - also imply that the British economy no longer has sufficient supply side flexibility to make a devaluation work. In particular, the price elasticity of demand for UK imports appears to be approaching zero these days, while the overseas price elasticity of demand for UK exports appears to be too low to offset this and ensure that the volume gains from a de facto devaluation of sterling offset the adverse effects on the terms of trade.

All of this suggests that the UK economy could be on the brink of something extremely nasty, particularly now that the entire political class appears to have lost its authority, and the credibility of the Bank of England has been damaged by the Northern Rock debacle, albeit unfairly so. The risk of a sudden rupture in the foreign exchange market’s confidence in sterling, or simply an inability to continue funding the current account deficit at anything like the present level of sterling and/or real interest rates, suggests that the MPC is now treading on egg shells to some extent. A minor mystery with the January CPI figure was why it was only 2.2% up on the year when the ‘double-core’ retail price index (which excludes both mortgage rates and house price depreciation) rose by 3.1%. The normal gap between the two series is 0.5 percentage points and not 0.9 percentage points. There may well be an explanation for this – it is definitely not being suggested that the figures were fiddled - but it may also be that CPI inflation was fortuitously low in January, and might blip the other way in subsequent months. The March MPC decision will be announced six days before the 12 March Budget. It must be presumed that the MPC will be given some indication of the main fiscal balances likely to be involved, as has been the practice in previous years. There seems little reason to expect that Bank Rate will be altered in March, and there is certainly almost no justification for a further cut. Longer-term, I maintain my bias to tighten.

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

Last month’s Bank Rate reduction, to 5¼%, leaves the overall posture of UK macroeconomic policy much too restrictive. The 12 March Budget will confirm a more stringent fiscal policy stance, making an even stronger argument for the easing of monetary policy.

Purchasing manager survey responses for January may not have plummeted in the UK, as elsewhere, but there is ample evidence of a material loss of economic momentum dating back to last August. Comprehensive data for the UK private service sectors are available only to November but it will be very surprising if the outcome is not a more decisive confirmation of the downturn when the December and January readings arrive. Business services and finance have slipped to barely a 2% annual growth pace, from 7% recently, and a composite of post, telecom, hotels, restaurants and motor trades have shifted below the zero line, from having 9% growth momentum in the early part of last year. This leaves only distribution and transport to carry the growth flag. The message from the retailers after their busy season suggests that their trade has also suffered. The January GfK consumer confidence reading, at minus 13, was the weakest for any year since 1993.

In the industrial sectors, the level of output has edged lower since last summer. Government and other services continue to contribute modestly to GDP, but even this stimulus is in doubt as fiscal policy is forced into pro-cyclical mode: tightening into a private sector contraction. The Institute for Fiscal Studies estimates that an extra £8bn per annum in taxation would be required to restore credibility to the Treasury’s fiscal arithmetic over the coming year. While such stringency is unlikely in March, this is the probable direction of adjustment. Bearing in mind that the private sector’s CPI inflation annual rate has fallen to 1.5% (ex-heating and lighting), a real interest rate of 3% should be more than sufficient to contain inflation expectations. An easing of monetary policy is not only desirable for its own sake, but as a necessary foil to the inadvertent tightening of the fiscal noose.

Moreover, the risk of fuelling inflationary pressures should not be considered a serious obstacle to a further 75 to 100 basis points of easing in the context of the non-linear threat to domestic economic activity, particularly in the sectors strongly connected to asset market turnover. The prevailing loss of potential for securitising loans is roughly equivalent to a 25% to 30% cut in lending capacity in the residential property market: this is already bearing fruit as a sharp decrease in mortgage approvals and will soon affect housing transaction volumes. Alliance & Leicester went further, indicating that they planned to shrink their mortgage book over the next twelve months. Commercial property is likewise.Finally, it should be noted that little if any of the decrease in short-term market interest rates between August and December has been reflected in the interest rates faced by households. The February Inflation Report (Table 1A, page 14) reports that interest rates for new loans and mortgages averaged 14 basis points higher in the period and for the outstanding stock of loans, 4 basis points higher despite a 25 basis point Bank Rate cut and a 77 basis point reduction in 2-year swap rate. If the purpose of Bank Rate cuts is to alleviate pressure on marginal borrowers, then it will require deeper cuts to achieve this. My vote is for a ¼% cut at the March meeting, notwithstanding the imminent impact of higher utility prices on the consumer price index.

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

The UK economy is not slowing down as fast as many seem to have been warning about and expecting. Data in the past month has been strong overall; from the labour market data - the Labour Force Survey (LFS) jobless rate fell to 5.2% from 5.4% and employment rose 175,000 in the three months to December; to money supply, which accelerated to 12.9% year on year in January and to retail sales volume, which accelerated to 5.6% year on year in January. None of these, it seems to me, suggests an economy on the verge of recession, albeit slowing. With pipeline inflation pressure still high – there were surges in the producer input and output price inflation data for January and surveys suggesting that companies are trying to pass on more of their higher prices – this is not a time to be cutting rates any more than seen so far. Indeed, there would be no case for a rate cut from the earlier 5¾% at all, if not for the ongoing credit crisis and the weakness in the US. Actual annual retail price inflation rose to 2.2% in January, with an even bigger rise likely in February when the data are released in March.

You do not have to be a monetarist to worry why, with so much liquidity in the system, should there be a negative economic impact from the banking and credit crisis at all? In fact, the opposite may be true, and a policy mistake is being made with too much monetary loosening and liquidity being added that - if not drained off at the right time - will lead to an even bigger inflation and asset price problem in future. With this backdrop, it is no wonder that inflation expectations remain high in the UK. Without the benefit of benign labour markets, the UK Bank Rate profile would not justify even the easing of the monetary stance seen so far. I therefore vote for rates to remain on hold in March and have a neutral bias thereafter.

What is the SMPC?

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

SMPC membership

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

At its latest meeting, the IEA’s Shadow Monetary Policy Committee (SMPC), a group of leading monetary economists that monitors developments in UK monetary policy, voted narrowly to cut the UK Bank Rate by ¼%, rather than hold it at its current level.

All members of the SMPC were concerned by the problems that had arisen with sub-prime lending, the consequent impact on the property market, and the softening of economic activity. However, a substantial minority felt that earlier policy mistakes, which had led to British interest rates being kept too low for too long, meant that a reduction in rates should not take place now.

Those wishing to hold rates were concerned about a number of trends in the UK economy including: strong broad money growth; the large balance of payments deficit; the depreciation of sterling; the lax fiscal background; and output appearing to be above trend. The holders consequently felt that the Monetary Policy Committee (MPC) had to stay focused on its core inflation objective.

This view was summed up by David B. Smith, Chairman of the Shadow Committee who said, ‘The December rate cut was an error because it risked de-stabilising sterling…Furthermore, inflation expectations had been rising, both in Britain and overseas…There is a real danger of global “stagflation”’.

However, the majority view, which was held by the five SMPC members who wished to cut rates, was that the deteriorating credit market conditions would lead to a serious slowdown in the economy. John Greenwood, Chief Economist at Invesco summed up the views of those wishing to cut rates commenting: ‘Events in the market for credit are sufficiently severe to create a significant downturn in economic activity.’

The SMPC meeting was held on 15 January. However, all committee members were given the chance to re-consider their vote following the 22nd January US rate cut. One switched from a ‘hold’ to ‘down ¼%’ as a result.

The minutes of the meeting are attached below. Minutes of all recent SMPC meetings are available from the SMPC section of the IEA website at www.iea.org.uk. The SMPC, which has shadowed the MPC since its creation, meets quarterly but also conducts a regular e-mail poll in intervening months.

It normally publishes this, together with a poll on the Committee’s view on interest rates, on the Sunday before the Thursday Bank Rate announcement.
The results of the latest Shadow Monetary Policy Committee (SMPC) quarterly gathering (carried out in conjunction with the Sunday Times) are set out below. The rate recommendations are with respect to the UK Bank Rate decision to be announced on Thursday 7th February.

Minutes of the Meeting of 15 January 2008

Attendance: Philip Booth (IEA observer), Tim Congdon, John Greenwood, Ruth Lea, Andrew Lilico, Kent Matthews (Secretary), David Brian Smith (Chair), Peter Warburton, Trevor Williams, Melanie Powell (Derby University observer), Eugen Mihaita (Derby University observer).

Apologies: Patrick Minford, Gordon Pepper, David Henry Smith (Sunday Times observer), Alistair Heath (The Business observer).

Chairman’s Comments

David B Smith welcomed Melanie Powell and Eugen Mihaita from the University of Derby as observers to the meeting and reminded members to complete the mini-biographies for the media contacts list.

David B Smith invited Peter Warburton to give his assessment of the world and domestic economy.

The Economic Situation

The International Economy – increased risk environment and softening of economic activity.

Peter Warburton referred the committee to the briefing charts and began by stating that world economic activity in the third quarter of last year, when much of the published data expires, was not a good guide to what is to follow. The third quarter figures confirmed that growth of world economic activity was solid. However, a composite leading indicator is signalling a sharp downturn in the seven largest developed economies. Another indicator of world trade was the Baltic Freight index which was showing a severe downturn, even after allowing for seasonal effects. Similarly, exports from the three major far Eastern exporters - China, Korea and Taiwan - were also showing a growth slowdown.

Peter Warburton added that US consumer spending in the third quarter was still strong but unemployment had edged up with layoffs in the financial sector showing the largest rise. Non-financial corporate profits growth has turned negative.

Even so, a weighted measure of broad money supply for fifty of the largest nations had accelerated in October. One interpretation was the repatriation of credit market debt back onto bank’s balance sheets. But global core and headline inflation has risen in recent months. Indicators of US inflationary pressure picked up in November but worsening inflation indicators have not prevented ten-year yields in US Treasury bonds from declining. The riskier environment is reflected in corporate bond spreads which have widened and credit default spreads which have increased markedly. Fed funds futures indicate that further cuts in interest rates. The market is currently expecting a further 60 basis points (0.6 percentage points) reduction by the end of January.

The Domestic Economy – A softening outlook

Peter Warburton began his discussion of the economic outlook for Britain by stating that: indicators of consumer confidence had shown a sharp decline, despite the fact that the spread of the London Inter-Bank Offer Rate (LIBOR) over the official Bank Rate had settled down to a more familiar level; mortgage lending was running at a slower pace than in the previous year and growth in retail sales had softened in recent months; and overall house price inflation had softened with commercial property values showing a sharp decline.

M4 growth slowed sharply in October and November, although the latter figure was subsequently revised upwards. The year-on-year growth of M4 broad money was reported as 11.7% for November and the rate of growth of M4 lending remained steady at recent levels. A significant portion of bank assets are unaffected by interest rate cuts because of securitization. Cuts in rates are not being fully passed on to customers as financial intermediaries seek to restore margins. Sterling has depreciated suddenly in response to market expectations of future interest rate cuts.

The recent national accounts figures confirmed that the British economy suffered from serious imbalances. The third-quarter current account deficit, at 5.7% of Gross Domestic Product (GDP), was one of the worst on record. Credit tightening will weaken activity in the private business and financial service sectors, which together generate 60% of GDP growth. Consumer Price Index (CPI) inflation is at 2.1%, close to the 2% reference rate, and core CPI inflation at 1.4%. Headline Retail Price Index (RPI) inflation is 4% and RPI excluding mortgage interest (RPIX) runs at 3.1%, showing no change over the last three months. The decomposition of RPI shows that it has been externally-determined and administered prices that have been growing sharply in recent times while the rate of private sector generated price inflation has been falling.

David B Smith thanked Peter Warburton for his presentation and opened the meeting up for discussion.

Discussion and Policy Response

Discussion
Growth slowdown in 2008

Trevor Williams started the discussion by asking for clarification on the US broad money supply figures. In replying, Peter Warburton said that financial innovation has created synthetic demands for short term assets that have created shifts in both the demand and supply of money. The potential for this type of money to migrate to consumer spending is low. Tim Congdon agreed that, in the case of US broad money, there had been some artificial inflation of bank balance sheets but China and India has strong money growth as indicated in the world broad money figures. He said that he expected world economic growth to slow to 3% against a traditional 4%.

David B Smith said that to him the current economic situation felt more like the period in the late 1960s and early 1970s, after Richard Nixon had broken the US$’s link to gold and world inflation was taking off, than it did to a re-run of the Great Depression. People who wanted to cut rates aggressively in the UK were doing so on the basis of the, as yet untestable, hypothesis that the global credit crunch was going to drive down UK growth very sharply indeed. He did not deny that this could happen. However, there was no evidence in the data that it was happening so far, or that money and credit growth were turning sharply negative. David B Smith added that, if one was discussing the 1930s slump, it was worth bearing in mind that not one bank in the then British Empire had gone bust during this period, whereas several thousand had gone under in the US, and that the severity of the inter-war recession in Britain was only approximately half that recorded in the US and Germany. He did not deny that the US may be heading into recession, but he thought that the UK was already so far into the overheating zone that it should not simply follow US monetary initiatives. He reminded the committee that the size of the balance of payments deficit in relation to GDP was a prima facie indicator of the excess of domestic demand over home supply in a small open economy, such as Britain’s.

Andrew Lilico asked to what extent are the downside risks interdependent and to what extent are the inflation risks interdependent? Peter Warburton said that, if the tightness of credit continues, he believed that things will go badly wrong for the economy. The UK is more highly geared than the USA so if credit gets re-priced the impact is stronger in the UK. He also added that while the spread between LIBOR and Bank Rate has fallen back to normal levels this could widen again in the future. He said that the increased risk would be priced into spreads as hidden losses emerge. Ruth Lea said that central banks might now respond faster - if that were to happen - and make liquidity available, while Tim Congdon said that banks use write-offs strategically. He added that the extent of write-offs may be overdone and that write-backs may occur. Trevor Williams suggested that spreads are like speculative bubbles which eventually burst.

John Greenwood stated that there are huge amounts of liquidity outside the banking system. When the Japanese bubble collapsed, non-bank finance imploded which resulted in strong effects on the real economy. The avoidance of Basle regulations had led to the fast development of non-bank credit. Peter Warburton agreed that the proliferation of credit channels has confused the operation of monetary policy. Philip Booth said that he was sanguine about the cycle. Low rates of interest, strong credit growth, and fast house price inflation that had not as yet fed into goods price inflation had to be slowed and that is what is happening.

David B Smith stated that this was one of the most interesting SMPC meetings that he could recall – in large part because of the genuine uncertainties involved and the fact that the standard macroeconomists toolkit had little to say on issues such as credit rationing – but that time was now running out, unfortunately.

Individual Votes

David B Smith then asked the members of the committee to vote on a rate recommendation.

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

Philip Booth said that previous unduly low UK rates of interest, strong credit growth, and fast house price inflation had arisen partly because the Bank of England had been asked to target a price index – the CPI - that excluded the cost of housing and gave greater than proportionate weight to goods whose relative price was falling, such as tradables. This has had inevitable consequences that must be allowed to unwind.

Loosening monetary policy to deal with the consequences of the losses from sub-prime etc. was not the right approach though, if there were a sharp change in consumption and savings behaviour, this might well justify a fall in interest rates. Given the downward international pressure on interest rates, and Britain's status as a small open economy, he thought that a 0.25% cut would seem to be in order now, but no more.

Comment by Tim Congdon
(London School of Economics)
Vote: Hold
Bias: Neutral

Tim Congdon said that during the credit crisis he had asked for a ½% cut, but the situation has changed with the fall in the value of sterling. The UK economy has a positive output gap of perhaps ½% to 1%, which argues that a relatively mild slowdown will be sufficient to keep inflation on target. At current rates there will be a sharp slowdown in broad money growth. Asset price weakness has been severe in some areas (such as commercial property, and property, financial, retail and cyclical sectors of the stock market). But – given the apparently ample money balances – this seemed to be best explained as a shock to confidence (i.e., a rise in the desired ratio of money to assets). He voted to hold, with a neutral bias.

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

John Greenwood said that events in the market for credit were sufficiently severe to create a significant downturn in economic activity. He voted to cut by ¼% in February with a neutral bias thereafter.

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

Andrew Lilico said that the December cut in rates was due to credit market conditions and was clearly an error. The Bank of England had not allowed interest rates to rise high enough and therefore the possible extent of any rate reduction is limited. The inflation target is more important than slowing growth. The dominant risk to growth comes from falling house prices leading to weakened consumption. He voted to hold in February and had a neutral bias subsequently.

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

Ruth Lea said that the Bank faced a clear dilemma. On the one hand, there were signs of slowdown and the housing market seemed to be turning down. But it was worth remembering that an overheating economy (and housing market) was the reason for the Bank to raise rates from mid 2006 to mid 2007 and indeed, before August’s ‘credit-crunch’ crisis, it was widely expected that official interest rates would be raised further. The surprise was that the housing market was as resilient for as long as it was.

On the other hand, inflationary pressures were intensifying reflecting high commodity prices exacerbated by a weakening currency – which may, in turn, help Britain’s appalling trade data. Too little attention had been paid to the falling pound. Under these circumstances, the Bank should behave cautiously and, on balance, hold rates in February. Bank Rate at 5½% was, however, on the high side and her bias was towards cuts.

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

Kent Matthews said that he was persuaded by the argument that credit market conditions would translate into a significant slowdown in the economy. However, it is also clear there are dangers in cutting interest rates too rapidly. Therefore the Bank’s policy of cutting interest rates in stages is the correct policy. Bank Rate cuts are unlikely to be translated into cuts in lending rates on one-for-one basis and therefore the cuts in rates are a means of shoring up declining consumer confidence and housing market pessimism. He voted to cut Bank Rate by ¼% in February with a bias to hold thereafter.

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

David B Smith said that the December rate cut was an error, in his view, because it had risked de-stabilising sterling, and wondered whether the Monetary Policy Committee (MPC) would have sanctioned a rate cut had they known the size of the current account deficit in the third quarter and the adverse revisions to earlier data. Broad money growth in the UK and the OECD had been rapid, and in the case of the OECD area as a whole had been accelerating. This was not at all like the collapse of around one quarter in the absolute levels of bank credit and money seen in the US in the early 1930s. Furthermore, inflation expectations had been rising, both in Britain and overseas. This meant that, not only was the supply of real broad money balances growing rapidly in the world as a whole, but the demand for money might well be falling, because of the reduced real return from holding interest bearing deposits caused by lower money-market rates and higher inflation.

There was also a serious issue of policy inconsistency in Britain, with fiscal policy already far too lax and likely to be relaxed further in the next few years because of the postponed general election. The risk was that people believe that a 1930s type slump was imminent when the real danger was a global ‘stagflation’, similar to the one observed after Nixon went off gold. He voted to hold Bank Rate in February with a bias to raise rates in the future. He added that a necessary pre-condition for easing monetary policy in Britain, without taking undue inflation risks, was the implementation of a ‘Type 1’ fiscal retrenchment package, in which government spending was reined back, there was no increase in the tax burden, public capital formation was not cut, and labour market regulations were reduced. From a political perspective, he could see no prospect of that. Rather, he feared that a surreptitious, but highly damaging, ‘Type 2’ package of tax-raising measures would be attempted by the present government. He was surprised that more people were not concerned by the fiscal constraints on the MPC’s freedom of action.

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

Peter Warburton said that the credit crisis has tightened monetary conditions, as borne out by the Bank of England’s relatively new ‘Credit Conditions’ survey. An adjustment of 50 basis points is needed to allow for a widening of banks’ margins. Otherwise retail and commercial borrowers will find little relief. He expected a sharp slowing of economic growth. He said that action is needed now to forestall the downturn and voted to cut by ½% with a bias to further easing. He thought that Bank Rate had scope to fall to 4½% during the course of this year.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Cut by ¼%
Bias: Neutral

Trevor Williams said that rapid broad money growth remained a worry. The world economy is reacting to a bubble correction in the US economy, in housing and credit market. From the British perspective the higher inflation path occurs because of the openness of the economy. The output gap is not the sole drive of inflation and other factors, such as the exchange rate, also matter. This argues for interest rates to be held, as a weaker currency may drive up inflation pressure. But immigration in recent years has made the capacity of the economy a lot more flexible. Thus the output gap measure may be positive, but increased immigration had increased the capital stock though this was not yet being fully factored into measurements of the output gap. This link explains the current low rate of wage inflation, even as unemployment continues to fall modestly. He voted for a cut with a bias to hold if the economy did not slow down but he believed that the economy will slow down.

Votes in Absentia

The SMPC sometimes allows a small number of votes to be cast in absentia and adds their written submissions to the record of the meeting, to ensure that exactly nine votes are cast. On this occasion no such vote was required since nine SMPC members were present at the physical meeting.

Policy response

1. On a narrow vote of five to four the committee voted to cut Bank Rate by ¼% in February.

2. In particular, four members voted to cut the base rate by ¼% and one voted for a cut of ½%.

3. Of the five who voted for a cut in February, four had a neutral bias from March onwards and one had a bias to further cuts.

4. Four members voted to hold Bank Rate at its current position, with two having a neutral bias, one having a bias to cut, and one having a bias to raise interest rates.

What is the SMPC?

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

SMPC membership

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

The outcome of the most recent Shadow Monetary Policy Committee (SMPC) monthly E-Mail Poll (in conjunction with the Sunday Times) is set out below. The recommendations are made with respect to the UK Bank Rate decision to be announced on Thursday 10 January.

On this occasion, four SMPC members voted to leave Bank Rate unchanged, while five members voted for a reduction. As happened last month, the rate cutters were split, with three desiring a reduction of ¼% but two wanting a cut of ½%. This would deliver a rate cut of ¼%, if the normal Monetary Policy Committee (MPC) voting procedure was adhered to. The same was true of the December SMPC recommendation, which was in line with the ¼% rate cut announced later on 6th December.

However, the shadow committee endeavours to say what should happen to rates, rather than what will. All of the SMPC members were worried about the global credit crunch and the danger that this could lead to a cracking of the robust UK economic conditions reported in the recent data. Several were perturbed by the poor current account balance of payments figures released on 20th December, however, and some thought that this could limit the scope for rate cuts.

Comment by Tim Congdon
(London School of Economics)
Vote: Cut by ¼%
Bias: Wait and see

The monetary situation is puzzling. Clearly banks will react to the crisis of summer and autumn 2007 by restricting balance sheet growth, and that signals slower money growth in 2008. But asset prices should still be benefiting from the high money growth of the 2004 to 2007 period. Instead the last few months have seen a sharp fall in property values and bear markets in some sectors of the stock market. Apparently wealth holders want a higher ratio of money to non-money assets, which is a ‘confidence effect’. Given that the Bank of England has already cut rates by ¼% (when I had advocated a ½% cut), I am in favour of another ¼% cut and continued action to bring inter-bank rates back into line with ‘the Bank Rate’ (as, at long last, it is again being called). But I do not expect 2008 to be a particularly bad year for the economy, with only somewhat beneath-trend growth.

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

The coordinated action of central banks to offer longer term credit facilities to commercial banks by means of a series of auctions has helped to ease money market conditions in the last week or two, but concerns about counterparty risk in the inter-bank market remain acute. These signs of sustained stress in the money markets point to fears that the balance sheets of banks and other financial institutions are still burdened with structured securities that are either overvalued or of uncertain value. In the case of some banks this requires further balance sheet repair and, possibly, more recapitalisations. Until such concerns have eased, the wide spreads between yields on Treasury bills and money market interest rates will persist.

More broadly, the overheating of the underlying housing market needs to cool further. Signs of such cooling have become more evident in the past three months as - by most measures - house prices have continued to fall on a monthly basis (e.g. according to Halifax, Nationwide and Rightmove, as well as the Royal Institution of Chartered Surveyors poll), and mortgage approvals have declined by 31% over the past year to the low levels of early 2005.

However, when bubbles burst they normally spill over to affect other sectors. Not surprisingly there has been greater price discounting by retail stores against a backdrop of softer official sales figures in October and November, and weaker survey data (e.g. from the Confederation of British Industry). On the industrial and business side of the economy order books have held up so far, but business expectations for future output have slipped, while all service measures were weaker in October and November. As yet employment and unemployment data outside the financial sector have not been affected, but economy-wide earnings have been more subdued than at any time since the period of the global downturn in 2001-03.

These data on economic activity and wages are supplemented by weakening monetary data: in November £M4 broad money again rose only 0.1% over the month, slowing to 11.1% year-on-year. My conclusion is that, at current interest rates, the economy is likely to undergo a more extended period of weakness. This will require a lower level of interest rates to restore credit demand and economic activity - even if bank balance sheets are repaired quickly.

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

If a week is a long time in politics then a month is a long time in economics. The gloom over economic prospects, in general, and the housing market, in particular, has sharply intensified since the end of November. This mood seemed to be encapsulated in the minutes of the December Monetary Policy Committee (MPC) meeting which cast aside inflationary concerns and focussed on worsening growth prospects. The deteriorating situation in the credit markets (which has since improved following concerted central bank intervention) and the potential knock-on effects for consumer spending and business activity clearly influenced the MPC’s decision.

There is little doubt that various surveys of business and retail activity have, on balance, turned negative recently but the latest official data on the economy (admittedly always retrospective) were relatively robust. November’s retail sales were firm – they were 4.4% higher than a year earlier – and the overall assessment by the Office of National Statistics (ONS) was that “positive underlying growth (was) sustained”. The current howls of anguish from the retail sector may, however, be justified. But it should be remembered that the retailers are prone to a seasonal cry of “wolf, wolf” and we will have to wait until the official December data are released on 18th January to find out what has actually happened to retail sales in the Festive month. The housing market continues to weaken and will almost inevitably weaken further next year as the “reset crunch” kicks in.

Even though inflation measured by the target Consumer Price Index (CPI) remained at 2.1% year-on-year in November there are undoubtedly further upward pressures coming through from food and energy prices. The MPC, of course, cannot afford to ignore the inflationary implications – especially as the pound is weakening. There is still a case for moderation in easing monetary policy. I vote for no change in January – though my bias is towards further cuts.

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

I believe that the December rate cut was a mistake, and that we should certainly not be contemplating further rate cuts at this stage. One way to express why is the following: it seems to me that from our current situation there are two paths, and neither of them merits a rate cut yet. Along the first possible path the recent credit turmoil and the turnaround in the housing market are short-lived, minor events. Broad money growth, which has stalled in recent months, resumes its 11-14% growth rate, GDP growth slows to perhaps a shade below 2%, the housing market drops no more than 5-10% peak-to-trough, and consumption sails through the recent difficulties fairly serenely. On this scenario, once the recent turmoil has passed, our attention will turn back to above-target inflation, and we will be looking at interest rates rising up above 6% once again. Cuts now will just mean greater rises later.

Along the other possible path, recent events are more lasting in impact. Broad money growth does not resume - perhaps banks reconsider their prudential liquidity ratios for themselves, or maybe new legislation (or interpretation of Basel II requirements) forces a rise. The housing market falls 20% or more, peak-to-trough. GDP growth slows much more sharply, to perhaps a little more than 1% in 2008, and households start to save more and borrow less. If this is how matters are going, I do not believe that interest rate cuts now will achieve anything. Experience of the past twenty years suggests that house price trends, once underway, are very difficult to affect with interest rates. If banks must adjust their prudential liquidity ratios, interest rate cuts won't change that. Instead, it would be better to leave interest rates where they are until changes can be made decisively in order to have a material impact, and to ensure that below-trend growth does not turn into recession. I am not sure which of these scenarios is the more likely, though I incline towards the latter. But, either way, interest rates should remain on hold for now.

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

If the economy is in a credit crunch of the Bernanke-Gertler variety, then cuts in interest rates will not necessarily reduce the ‘external finance premium’ proxied by the spread between the London Inter-bank Offer rate (LIBOR) and bank rate. Credit rationing is a rational outcome of increased uncertainty which can only be alleviated by the availability of funds. To some extent the Bank of England, in concert with the US Federal Reserve and the European Central Bank (ECB), has addressed this issue. The problem then reduces to an evaluation of the effect of further interest rate cuts. It can be argued that large cuts are needed to restore confidence in money markets. The counter-argument is that large cuts signal a loss of control and panic reaction - much like the Bank’s behaviour during the Exchange Rate Mechanism (ERM) ejection crisis of September 1992 - which ultimately will have negative implications for the Bank’s credibility. The alternative is to restore confidence by signalling a controlled and measured approach, in other word cutting rates in stages. The Bank has taken the first step in this direction. It is ready to take the next.

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

Since last month, the central banks have injected large amounts of liquidity in a coordinated way in order to bring down the differential between three months’ LIBOR and the rates on government bills. This operation has had some success but it has been only limited. Therefore, the need for a cut, of 0.5% now, remains. Between these operations and further cuts I suggest that the monetary authorities aim for market rates of around 5%, which is still well below current rates.

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

The New Year is a traditional time for looking ahead and it seems appropriate to summarise the latest projections for 2008 and 2009 generated by the Beacon Economic Forecasting (BEF) macroeconomic model. These employ the raft of official statistics for the third quarter of 2007 published on 20th December and the fourth quarter financial market prices. The result is that UK GDP is expected to follow last year's annual average increase of 3.1%, with rises of 2.1% in 2008, and 1.9% in 2009. This is slower than the projected growth rate for the OECD area as a whole of 3.0% in 2008 and 2.8% in 2009, compared with a part predicted 2.8% in 2007. The root cause is the tax and regulatory induced sclerosis of the supply side of the British economy.

The outlook for inflation is determined by the imbalance between the supply of, and demand for, broad money in the long run but it is influenced in the short term by the price of oil (a figure of US$90.5 per barrel of Brent Crude in 2008, rising to US$91 in 2009, has been assumed, compared with US$72.9 in 2007). UK CPI inflation is expected to average 2.9% in 2008, and 3% in 2009, compared with the 2.4% projected for last year on the basis of data for the first eleven months. Equivalent figures for the old RPIX target measure would be 3.7% in 2008, and 3.6% in 2009, against a likely outcome of 3.3% in 2007. OECD inflation is expected to average 2.7% in 2008 and 2.6% in 2009, compared with 2.3% last year.

One factor helping to constrain British inflation in the longer term is that the growth of M4 broad money is expected to slow from an annual average of 12½% last year, to 8¾% this year, and 5¼% in 2009. Such a deceleration has long been a feature of our forecasts, and it is now, rather belatedly, beginning to appear in the data. Britain’s rapid monetary growth has buoyed asset prices, stimulated home demand, and boosted tax receipts in recent years, but poses a long-term threat to sterling, which may be an accident waiting to happen. Apart from the risk of a run on the pound, the other main monetary danger is that the re-entry from the money and credit boom will be accompanied by rising bad and doubtful debts, stepped up credit rationing, a private sector recession and a ballooning fiscal deficit. This is the possibility that the financial markets and the media have concentrated on, and also the MPC, if the December minutes are any guide. However, anyone attempting to traverse a narrow ridge in a blizzard can fall off on either side of the mountain. An exclusive concentration on the risks in just one direction makes a serious accident more likely, not less.

One problem facing the monetary authorities is that Britain’s public finances are in dire shape for an economy that has not yet suffered a recession. This gives rise to problems of ‘policy inconsistency’, and limits the scope for using Bank Rate to stabilise the economy, unless the MPC are prepared to take undue risks with inflation. Public Sector Net Borrowing is expected to be £41¾bn in 2007-08, £50¼bn in 2008-09, and almost £56½bn in 2009-10. However, the really bad news in the 20th December ONS data release was the large upwards revision to Britain’s other twin deficit, that on the balance of payments, for 2006 and the first half of last year, and the very large deficit recorded in 2007 Q3. The current account deficit is now expected to deteriorate from £67¾bn in 2007, to £78¾bn in 2008, and £82½bn in 2009, before easing in 2010. The latest published consensus forecasts for the current account deficit in 2007 and 2008 are £43.5bn and £45.8bn, respectively. There are likely to be a rash of adverse revisions to these figures as the pre-Christmas ONS data are incorporated into published forecasts.

This suggests that the MPC will not have an easy time over the next few years. Three month inter-bank rates, which drive the real economy in the BEF forecasting approach, are expected to settle at around 5½% in the second half of this year and remain broadly at this level through 2009. Bank Rate does not play such an active role and is expected to end 2008 at 5¼%, and hold this level through 2009. The main constraint on rate cuts is likely to be a weakening of sterling, particularly if overseas central banks buy less of it for their reserves. House prices have enough momentum to go up by not quite 3½% 'through' 2008 (Department of Comunities and Local Government index, Q4 to Q4) and 1½% through 2009 but are expected to be broadly flat for some years thereafter. This represents modest declines in real terms from 2009 onwards.

Overall, while recognising that there are serious downside risks to the credit creation process and economic activity, I do not believe that the subsequent data retrospectively justified the unanimous MPC decision to cut Bank Rate in December, and suspect that more damage will be done if inflationary expectations take off, or there is a run on the pound, than will be averted by further rate reductions in the immediate future. This implies that rates should be held in January. Beyond that the only viable policy seems to be ‘wait and see’, while noting that US rate reductions, for example, stimulate the British economy through the trade account and are a substitute for rate cuts at home

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

The UK banking sector lent £89bn in sterling in the third quarter of 2007, equivalent to 25% of GDP at current prices (strictly speaking, lending was only £76.2bn, because loans of £12.8bn secured on dwellings were transferred out of the sector due to net disposals and securitisations). Where did this £89bn go? A quarter, £22.3bn, was mortgages and other lending secured on residential property; £23.6bn was to financial intermediaries other than insurance and pension funds, credit companies, fund management groups, collective investment vehicles and securities dealers; fund managers borrowed £7.2bn; another £10.3bn was borrowed by “activities auxiliary to financial intermediation” and £10.9bn went to the development, buying, selling and renting of real estate. The rest of the economy borrowed £14.7bn.

If we were ever in any doubt that borrowing has been the principal driver of asset market activity, then this analysis should surely settle the matter. The UK economy sits atop a gigantic peak in transactions activity – in household and commercial property, in large businesses and in equities. The Treasury expects to collect £15bn in stamp duty in the current fiscal year. Frenetic trading of business, property and financial assets has been fuelled by massive amounts of bank and capital market credit. An unavoidable consequence of the global credit downturn, or crunch, is that finance is becoming harder to obtain. Net secured lending to individuals slumped from £9.5bn in September to £7.3bn in October. The value of gross mortgage approvals fell from £29.3bn in September to £25bn in October. Property transaction volumes in England, Wales and Northern Ireland fell in November to stand 29.5% below a year earlier.

These sharp declines illustrate the significant potential that exists for transactions activity to contract. The scope for a co-ordinated slump in turnover values is real and imminent. Some transaction volumes have already fallen back, despite the surge in bank credit in 2007 Q3. The second quarter was a phenomenal period for mergers and acquisitions activity and the likely peak of private equity deals in the UK. The further in time we move away from this frenzied quarter, the starker the comparisons are likely to become.

Third quarter national accounts data revealed the extent of the imbalances that have developed. A current account balance of payments deficit of 5.7% of GDP and a large inventory accumulation, equivalent to 70% of the gain in real GDP, are examples. It is reasonable to expect a significant deceleration in quarterly growth during 2008, with an increasing likelihood of negative real growth. M4 growth has plunged from 1.3% in August and 0.9% in September to 0.2% in October and 0.1% in November.

In the light of these dramatic developments, the obstacles to a reduction in Bank Rate have been swept aside. It is now a question of how far and how soon to cut. On the basis that the additional liquidity injection by the Bank of England cannot be guaranteed to have a permanent effect on LIBOR spreads, there is a strong case for a double-cut in January. Interest rates should fall, not only to forestall a sharp deceleration in economic activity but also to counteract the unintended tightening implied by unusually wide LIBOR spreads.

The November ONS retail price First Release continues the recent pattern of slowing private sector inflation balanced by rising inflation of administered and exogenous prices, such as oil prices and indirect taxes. With annual private sector inflation back to around 1.5%, Bank Rate has scope to fall to around 4.5% during 2008.

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

The official data published up to now has shown a limited impact so far on the UK labour market from the credit crisis. The number of people claiming jobless benefits fell by 11,100 in November, the fourteenth consecutive monthly fall, taking the unemployment rate down to 2.5% - matching a thirty two year low. The more comprehensive Labour Force Survey (LFS) data showed the unemployment rate fell by 0.1% to 5.3% in the three months to October, the lowest since 2006 Q1. The unemployment level was 1.64m, down by 15,000 over the previous quarter. The employment rate rose to 74.5% in the quarter to October, with total employment at 29.29m, up 114,000 on the previous quarter and 226,000 on the year. Despite the tighter labour market, however, whole economy average earnings growth eased by 0.1% on both the including and excluding bonuses measures, at 4% and 3.6%, respectively, in the three months to October compared to the same period last year. But this cannot continue if economic growth remains above trend and price inflation accelerates further, as is expected.

This suggests that, in order to cut interest rates further, there must be a lot of confidence that UK economic growth will ease sufficiently to deliver enough spare capacity to ensure that a negative output gap begins to exert downward pressure on inflation. Otherwise, the tightness of the labour market, elevated inflation expectations, and high retail price inflation (RPI was 4.3% year-on-year in November), suggest that annual consumer price inflation could accelerate up to, and perhaps top, 3% quite quickly during the course of this year.

UK rates though can be cut further but only on the basis that the economy does slow to a 2% to 2.5% range in 2008. If not, any cuts should be quickly reversed. New methods of dealing with the logjam in the credit markets, which is being reflected in high inter-bank rates, should help to separate the two issues. The central Bank Rate should be set for the real economy. The issue of credit spreads should then be dealt with separately, especially as there appears to have been little adverse impact so far onto the real economy from the credit crisis. The chance of a policy mistake caused by cutting rates – in an attempt to solve a problem that is not due to the level of Bank Rate - is high. I would leave rates on hold in January at 5.5%, but with a bias to ease.

What is the SMPC?

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

SMPC membership

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

The outcome of the latest Shadow Monetary Policy Committee (SMPC) monthly E-Mail Poll (in conjunction with the Sunday Times) is set out below. The rate recommendations are made with respect to the Monetary Policy Committee’s (MPC’s) Bank Rate decision to be announced on Thursday 6 December.

On this occasion, four SMPC members voted to leave Bank Rate unchanged on 6 December, while five members voted for a reduction. Somewhat unusually, the rate cutters were split, however, with three wanting a reduction of ½%, but one wanting a cut of ¼%, and another a more aggressive cut of ¾%. It could be argued therefore that the SMPC had voted for a ½% reduction with a five/four majority, on average, although this oversimplifies the more nuanced debate set out below.

All of the SMPC members concerned were aware of the uncertainties created by the global credit crunch and the associated danger that this could lead to a sudden cracking of the robust UK economic conditions reported for the third quarter of this year, when much of the official data expires.

Comment by Tim Congdon
(London School of Economics)
Vote: Cut by ½%
Bias: Wait and see

Long-run money/income relationships are difficult to interpret given the current short-run uncertainties. The November 2007 Financial Statistics came in the post this morning and I thought I would check how much the crisis had affected the size of the sterling inter-bank market. The answer is that UK banks’ sterling inter-bank assets fell from £639.7bn at the end of August to £248.6bn at the end of September. No doubt much of this was the cancellation of off-setting lines, but banks that have traditionally been net recipients of inter-bank funding are being squeezed savagely. There is so much to say, but the restoration of banking ‘normality’ is essential.

My verdict is that – at current interest rates – the stock of UK bank lending to non-banks, and hence the level of bank deposits and the M4 money measures, might even fall for a month or two at some point in the next six months. The Bank of England and the Financial Services Authority (FSA) plainly don’t know what has hit them. I am in favour of a ½% cut in base rates. (Incidentally, my forecasts that this cycle would end with rates of 6% or above has been correct, in terms of inter-bank rates, although I could never have dreamt the precise circumstances. For those who are interested, UK banks’ balances with the Bank of England jumped from £16.8bn at end-August to £24.1bn, which would imply a surge in M0 if it were still being calculated. To me that simply shows the irrelevance of M0, but no doubt there are other views.)

The main reservation here is that a ½% cut in base rates might trigger a 5% or so fall in sterling. That is why it would be better for the Bank of England to restore the normal working of the inter-bank market by supportive money market operations, but my verdict is that the relevant officials are reluctant for the Bank of England to appear particularly active in the money markets. Major improvements to the 1998 Bank of England Act are needed.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Cut by ¼%
Bias: Cut more if economic conditions deteriorate further

The credit crunch of the past few months has dramatically changed the economic outlook. With house prices now clearly falling, CPI inflation close to target at 2.1% in October (and recently below target), retail sales declining by 0.1% in October, real GDP growth slowing to 0.7% quarter-on-quarter in 2007 Q3, and business investment flat in the same quarter (albeit up 4.6% on the year), the economy is much closer to a tipping point than in any period in the last few years. These data on activity and inflation are supplemented by weakening money and credit data. In October, sterling M4 broad money rose only 0.1% over the month, and slowed to 11.8% on the year, while total lending also slowed sharply.

Meantime, in November short-term money market rates have risen again to new peaks with three-month sterling London Inter-Bank Offer Rate (LIBOR) above 6.5% and 2-year credit swap spreads (the difference between inter-bank lending rates and equivalent maturity Treasuries – a measure of risk aversion) rising above 110 basis points compared with normal levels of 30 basis points. These signs of stress in the money and credit markets imply further weakness ahead both for economic activity and inflation. As yet there is room for doubt as to the certainty of economic weakening because symptoms of the preceding euphoria still persist – for example in some of the commodity markets. Nevertheless the Bank of England needs to move now to get ahead of the markets by lowering rates. I would cut rates by 25 basis points, with a bias to cut more if economic conditions deteriorate further.

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

Much was made in the media about the recent marginal downward revision to the GDP data for the third quarter. Instead of a 0.8% quarterly increase, as originally estimated, GDP growth was estimated to be “only” 0.7%. But this number was still strong and hardly suggested that the economy was suffering from any serious effects of the credit squeeze, which developed in August, during that period. The increase in domestic demand was over 1.0%.

The recent economic news has, however, been much less comforting. Most survey evidence, including that from the Bank of England’s regional agents, has been negative. The housing market is beginning to look very ugly. The British Bankers’ Asociation (BBA) mortgage approvals data for October slumped. But the progressive introduction of the excessively bureaucratic Home Information Packs (HIPs) has probably had a negative impact on the market, though at this stage it is impossible to judge just how significant the impact has been.

In addition, the equity markets have been extremely volatile and look expensive in the current economic climate. It can fairly safely be said that the bull market is over. The inter-bank market remains far from normal and, given the Bank of England’s apparent reluctance to “normalise” it, there will surely be further turns in the credit squeeze on households and businesses – especially on high risk households and on smaller and riskier businesses. These domestic developments, along with the undoubted slowdown in the US (the UK’s most important individual trading partner), clearly threaten Britain’s growth prospects. But the speed and the extent of these negative impacts on economic growth are unusually uncertain.

There are, however, not just growth risks. There are also inflation risks, which present the Bank of England with a dilemma. Producer prices inflation has recently picked up, not least of all reflecting the rapid increase in oil prices. CPI inflation has also risen. Under these circumstances, I vote, on balance, for no change in December – but with a strong bias towards easing.

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

I believe that this is a moment for masterful inaction. I can understand the temptation to cut in the face of a building second hump in three-month interbank rates indicating a second phase to the credit squeeze, and other data indicating broad money growth slowing very rapidly. But the MPC's mandate is to meet its inflation target - all other matters are secondary. Perhaps they should not be, but that is a policy matter for another time. And inflation is currently above target, is projected to go further above target over the next few months and to stay there for a whole year, and presents a risk of going above the 3% threshold early next year. It would be potentially disastrous to combine a significant squeeze with further lost credibility from going above 3% and to face a scenario of raising rates materially at the same time as broad money growth collapsed, house prices fell, and GDP slowed.

Further, although the credit squeeze is clearly having an effect on financial markets, and may well feed through into lending for investment as well as private consumption, it is still far from clear what negative real impact this reduced willingness to lend will have. It has been thought for some time that consumers had over-borrowed, and some degree of retrenchment may well be economically positive. That is not to say that one should let matters run out of hand - I'm not proposing an Andrew Mellon strategy. But I think that a panicky response is as likely to damage confidence as to underpin it. For now, as far as we know, all there is is retrenchment and a temporary stalling in credit, and at the same time we must have a concern about above-target inflation for the near- to medium-term. Unless matters go spectacularly badly - say, large stock market falls, or a large fall in oil prices - I would urge that rates be held at least until February, when we can think again with clearer heads and more data.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Cut by ¾%
Bias: Cut by a further ¾% in early 2008

It is difficult to understand why the Bank is proving so slow to respond to a situation that has been eminently predictable since September at least. It is obvious that the interest rate the Bank should be trying to fix under their 'interest-rate policy' is the market rate for the private sector, roughly speaking the inter-bank rate. (It can hardly wish to target the government borrowing rate!) Well, this rate has gone up since August from 5.75% to around 6.5%, equivalent to a 75 basis point rise in Bank Rate. Yet the Bank which never intended this to happen in August has sat idly by.

It is true that third quarter growth was strong; but that reflected history before the banking crisis and this accompanying rise in rates. The rumblings and gnashing of the credit crunch have been loudly audible since then. For Mervyn King to tell us suddenly, in the week of the Inflation Report, that growth looks 'threatened', with strong consequent downward pressure on inflation makes the Bank look like fools. It had been obvious weeks ago.

I regard the Bank's behaviour as highly irresponsible, just as I regard its behaviour during August and September as both irresponsible and neglectful of a century of monetary teaching from Bagehot on. It is time for some sense to prevail. Rates need to be cut by 75 basis points at once to stabilise a fast-deteriorating situation. This, by the way, would just get us to where the Fed has already moved, in offset to the unintended rise in market rates. From then on rates will need to be cut further; I would like to see market rates at 5% quite soon in 2008. That implies, with the interbank risk premium at present levels, another 75 basis point of cuts early next year.

Comment by Peter Spencer
(University of York)
Vote: Cut by ½%
Bias: To cut

The credit crisis - which seemed to be resolving itself a month ago - is intensifying. UK inter-bank market rates have moved back up to a premium of 75 basis over base rate in the three-month area. This premium acts as a lightning rod, revealing the stress the banking system is under and transmitting this to other sectors. It reflects both counterparty risk and the pressure on bank regulatory capital posed by loan losses and the need to take Structured Investment Vehicles (SIVs) and other off-balance sheet vehicles back on board.

The bank reporting season could help to solve the problem of counterparty risk in the banking system, but will do little to resolve the problem in the hedge fund and SIV sectors, which remain completely opaque. It will do nothing to ease the pressure on regulatory capital. This pressure might be eased by by halting share buy-back programmes and floating subordinated debt. However, it will probably take large rights issues to solve this problem quickly – and it is hard to envisage banks engaging in these in the current environment. Short term, it seems they have little alternative to slowing the growth of the balance sheet by cutting back on inter-bank and other lending. The authorities may have to relax the regulatory regime just as they did for life insurance companies in early 2002.

As long as these pressures remain, banks will restrict the flow of credit to other sectors and make it more expensive. It is hard to estimate the effect this will have on the economy, since it is hard to find any recent precedent. The closest is perhaps the Savings and Loan (S&L) crisis that hit the US banking system in the early 1990s – when it took two years of low interest rates to recapitalise the banks. However, many companies borrow at LIBOR and other rates that move automatically with inter-bank rates, so their interest charges have already gone up. Average corporate borrowing rates are already 2 percentage points up on the year. The last time we saw this kind of increase (in late 2004) business investment growth fell back from 9% to below zero within six months.

My main concern is for small and medium-sized enterprises (SMEs) that tend to rely on their banks for medium-term finance. They are probably safe at the moment, but what happens when this is due for refinancing in say six months time? Many of these are in household goods and other sectors that have done well on the back of the cheap and plentiful flow of credit, areas that will surely be sensitive to a consumer slowdown. My worry is that the bank will take one quick look at this and simply say sorry.

The UK economy went into the crisis with a strong momentum, but is now decelerating sharply. Business confidence surveys fell back right across the board in October. Advance indicators of the housing market – notably mortgage approvals and the Royal Institution of Chartered Surveyors survey balances – also point to a sharp slowdown. If effective interest rates remain at these artificially high levels for much longer it is hard to say what will happen. I would cut base rates by ½% immediately to offset the inter-bank premium and bring three month LIBOR back towards 6%. I would then monitor lending conditions very carefully with a view to further reductions.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold
Bias: Wait and see but tightening remains a possibility for 2008

It is possible to almost pity the MPC at present – if institutions can be pitied - because there is an extremely high probability that any decision they make will be the wrong one. In addition, the potential costs of errors of judgement have risen sharply, with the possibility of a credit implosion and serious recession on the one side being counterbalanced by the dangers of a run on sterling and an upwards ‘gear shift’ in inflation expectations on the other. The big picture is that Britain’s small open economy is heavily dependent on the wider global background. Many people have excessive faith in the ability of the MPC to control events and grossly overestimate the power of modest tweaks in the official REPO rate to influence the real economy.

The lax fiscal background revealed by the October 2007 Public Sector Finances data exacerbates the pressures on the monetary authorities, because of the resulting policy inconsistency. The widespread perception, following the Northern Rock and the missing Revenue and Customs computer disks affairs, that the late Mr Oliver Hardy is now in No. 10 Downing Street, and the late Mr Stanley Laurel in No. 11, also does nothing for the credibility of the wider policy framework or the attractions of sterling for global investors.

With the benefit of hindsight, it is apparent that the ‘Great Moderation’ of recent years was underpinned by a sensible and steady pace of broad money creation at the level of the mature industrial economies as a whole. However, the excessively low real interest rates from 2001 onwards led to an upwards creep in OECD broad monetary growth, an over stimulation of financial markets, and accelerating inflationary pressures in the prices of commodities and fixed assets such as property.

Recent pressures in the international financial markets can be regarded as the inevitable re-entry costs that had to be paid if monetary growth was to be brought to heel and international inflation to be kept tethered at around 2.0% to 2½% or so. Between 1996 and 2005 annual average broad money growth in the ‘core’ OECD area as a whole fluctuated in a remarkably narrow 4¾% to 5½% band, while CPI inflation only varied between just over 1½% and 2½%, despite an oil price which gyrated between US$13.4 for a barrel of Brent Crude in 1998 to a probable average of over US$73 this year (it was US$92.5 on 27 November).

However, OECD broad money growth picked up to average 6¼% in 2006 and a part-projected 7¾% this year (it was 8.1% in the third quarter alone). Such numbers are not consistent with the maintenance of slow and steady inflation in the long run. However, the high level of credibility achieved by Central Banks by the mid 2000’s meant that the longer-term inflation implications of this monetary acceleration have not been anticipated by economic agents, at least so far. This is why accelerating OECD monetary growth had stimulatory effects on economic activity and the price of fixed assets in recent years that, in turn, led to further speculative activity and credit demand.

The hard-line implication that follows from this analysis is that people who go on a credit binge will ultimately suffer a hangover, and that ‘hair of the dog’ treatment by central banks exacerbates this addiction in the long-run, and may ultimately destroy the credibility of their counter-inflationary commitment. However, this does not mean that broad money and credit growth should be allowed to collapse, which is the mistake made by the Bank of Japan’s ‘sado-monetarists in the early 1990’s.

An outbreak of credit rationing can also lead to sudden and powerful adverse effects on economic activity that are simply not incorporated in conventional forecasting models, particularly those employed by most central banks (indeed, one suspects that the downwards adjustments to the Bank of England’s Inflation Report growth forecasts between May and November were largely the result of applying negative residual adjustments to the forecasts generated by the Bank’s model – it would be nice to know). This is an important point where the UK is specifically concerned because the economy appears to have been glowing red hot in the third quarter, when most of the official data expires, with non-oil market sector Gross Value Added (GVA) rising by 0.9% quarter-on-quarter (or 3.9% annualised), to stand 4% higher than in 2006 Q3, and the deficit on net exports of goods and services equalling some 4¼% of the basic-price measure of GDP. The recent easing of the sterling index to 100.9 (January 2005=100) might also be considered as a warning shot across the bows where future inflation prospects are concerned.

There is a widespread assumption in the current interest-rate debate that the present level of three-month interest rates is somehow ‘wrong’ and that the generally noticeably lower official REPO rates are more appropriate to the underlying economic situation. This view may not be entirely correct, however. In particular, if one assumes that the normal three-month real rate of interest in the world as a whole is around 2%, when the OECD output gap is at neutral, and adds on the latest ‘headline’ CPI figures, then this suggests that: the three month rate in the US should be around 5.5%, compared with its present 5.0%; the Euro-zone three month rate should be 4.6%, which is broadly where it is; and Japan’s three month rate should be 1.8%, compared with the observed 1.0%, although this is a somewhat artificial calculation because of Japan’s mildly negative annual inflation rate.

A similar calculation for the UK using my preferred ‘double-core’ retail price measure, which rose 2.8% in the year to October, would suggest an equilibrium three-month rate of 4.8%. However, a freely estimated statistical relationship using data for the past four decades suggests that one might also want to add on the ratio of the balance of payments deficit to GDP, which is presently around 3½%. This suggests that Bank Rate could rise to 8¼% in a worst case scenario, in which overseas investors refused to plug the payments gap with the cheap capital inflows that have been engendered by the attempts of leading economies in Asia and elsewhere to hold down their exchange rates. This 8¼% is most definitely not intended as a forecast in any shape or form. However, it is noteworthy that in the mid 1990’s, when core inflation was around its present level for several years, but the payment’s deficit was much smaller, Britain’s official REPO rate fluctuated around 6% to 6¾%, which is reasonably close to where three month inter-bank rate is today (6.5% on 27 November).

Overall, while recognising that there are serious downside risks to the credit creation process and economic activity, I do not believe that the evidence as yet supports the case for a cut in Bank Rate, and suspect that more damage will be done if inflationary expectations take off, or there is a run on the pound, than will be averted by aggressive rate reductions in the immediate future. Beyond that the only viable policy seems to be ‘wait and see’, while noting that rate reductions overseas stimulate the British economy through the trade account and are to some extent a substitute for rate cuts at home.

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

During the past month or so, global credit conditions have tightened demonstrably. US credit impairments that were obvious months ago were formalised by a flood of rating downgrades in mid-October. These have forced commercial and investment banks and other non-bank financial institutions around the world to acknowledge further asset write-downs and realised losses. A downward spiral in US house prices, feeding on the escalation in foreclosures, continues to undermine asset quality. Financial losses emanating from the US mortgage market and structured finance are now expected to reach US$500bn with multiplier effects on other segments of the credit system. In short, a profoundly deflationary credit downturn has taken hold.

The implications for the UK economy of this global credit event are becoming apparent, week by week. A small subset of private sector services, including computer services, other business services (legal, accounting, recruitment etc.) and financial intermediating is contributing over 60% of quarterly GDP growth in 2007 Q3. This subset of activities is particularly vulnerable to a setback in global capital market activity and a loss of momentum in credit growth. Declining activity rates in UK residential and commercial property markets add another dimension of concern. Consequently, the UK must be considered one of the most exposed economies to the global credit downturn.

Over the past week, credit traumas have spilled over into the interbank markets in a reprise of the August debacle. Hence, the premiums of interbank rates to base rates in the major currencies have widened again, penalising borrowers in the wholesale financial markets and the swaps market. In the case of LIBOR, it would require an immediate cut in base rate of about 50 basis points to offset this inadvertent tightening. The d