Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 16th April, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 9th May. Five SMPC members wanting an increase of ½%, another voted for a ¼% increase, and three voted to hold Bank Rate.

This vote distribution implies a ½% increase on normal Bank of England voting procedures. The recommendation of a rate rise in May represented the fourth consecutive month that a majority of the SMPC had voted in favour of higher interest rates. However, it was the first time for several years that a majority of the shadow committee had recommended an increase of ½% rather than ¼%.

While the SMPC has recommended a more hawkish stance than the official rate setters recently, there has always been a SMPC minority who wished to freeze rates until there were clear signs of recovery. The SMPC was also more hawkish than the official rate setters during the credit bubble that preceded the 2007 and 2008 financial crash. It is hard to argue, with hindsight, that the Bank of England was justified in ignoring the signs that the Heath-Barber and Lawson credit booms were being repeated in the earlier 2000s.

There appear to be three main intellectual differences between the majority view on the SMPC and the official one. These are: 1) the extent to which weak growth is a supply-side phenomenon, rather than a demand-side one; 2) how far misguided financial regulation has led to a damaging restriction in the supplies of money and credit, and 3) whether Quantitative Easing (QE) has been exhausted as a stimulus or, alternatively, should be re-directed towards private sector debt.

Minutes of the meeting of 16th April 2013

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

The Chairman began the meeting by stating that he had been overseas at the time of the March Budget. However, he was not surprised that the official borrowing projections had been revised up yet again or that the official growth projections had had to be revised down. This is exactly what one would expect from the extensive international literature on fiscal consolidation. The Chancellor had consistently pursued what were known as ‘timid’ Type 2 fiscal consolidation policies – in which taxes were raised and the volume of government consumption increased, albeit through poor control rather than overt intent – and the result had been exactly what one would expect from the fiscal stabilisation literature; i.e., persistent deficit overshoots and growth way below official expectations. The interesting questions were: who on earth the Chancellor was looking to for advice, and why the Conservatives had spent their thirteen years in opposition without ever getting to grips with the intellectual issues involved? The Chairman then invited Trevor Williams to give his assessment of the global and domestic monetary situation.

Economic situation

Trevor Williams began his presentation by stating that he would start with an examination of the global monetary statistics and then work down to the Euro area and finally to the UK. He started with money supply growth in the leading three (G3) international economies and the emerging economies, which showed continued stagnation in the former and a slowing in the latter. Within the developed economies, the USA had seen some acceleration but was still below recent highs, whereas monetary growth in the UK had picked up but was still running at a very low rate. Monetary growth in Japan and the Eurozone remained flat. In Asia, monetary growth was dominated by China but here there was a slowing. Monetary growth was robust in Latin America but this looked to be an excessive growth rate if continued for too long. Brazil was, perhaps, an example of where there has been too much focus on excessive credit creation rather than supply-side reforms.

Credit growth in the developed economies was also slow and flat, with the UK still in negative territory. Surveys of bank lending conditions in the emerging markets revealed a tightening of credit standards. Furthermore, the price of credit had been rising in the USA, UK and Eurozone with adverse consequences for economic recovery. Policy rates remained low in the advanced economies and had remained stable in the emerging economies.

Global inflation had remained under control and it was also contained and falling in the developed economies. Global GDP was still heading up. However, the gap between the growth of the emerging economies and the sluggishness of the mature economies remained as large as ever. Elsewhere in the real sector, manufacturing output in Asia had risen sharply but had fallen back in the mature economies. The bottom line was that there was insufficient strength in the world economy for an inflationary danger to emerge. Inflation was not a major problem. A plot of output gap and core inflation for the major economies revealed no discernible pattern and little in the way of inflation risk. This meant that policy rates could remain low.

Trevor Williams went on to examine the statistics for the Euro area starting with ten year government bond yields. Euro area risks had reduced on the surface, owing to policy action, but underlying problems remained. While the European Central Bank (ECB) balance sheet was set to stabilise along with that of the US Federal Reserve, the Bank of Japan balance sheet was set to take-off. Despite the increase in ECB liquidity to the markets, corporate lending rates in Italy and Spain had widened against Germany and France. Euro area divergence continued with differences in manufacturing growth between Germany and the rest. In Germany, house prices had been rising gently, while those in Spain and Ireland had been declining.

In the UK, inflation was likely to remain above target but wage inflation would be weak and the economy was likely to slow in March after a good start to the year. The indicators were signalling a worsening of output, following some signs of growth at the end of 2012. The British economy had seen some improvement in money and credit conditions. However, these were insufficient to spark a strong revival in growth. Nevertheless, the latest figures for 2013 Q1 (Editorial Note: this refers to the figures released on 25th April) showed that the economy expanded by 0.3%, based on the 44% of output data available in that quarter.

This offsets the fall of 0.3% in 2012 Q4, if left unrevised. The good news was that world inflation trends remained benign. With commodity prices off lower in recent months, as the world economy slowed, inflation was set to stay low, recently in line with the weakening of global growth. The Bank of Japan had joined the QE party, and seemed prepared to go for higher inflation to revive their economy, with attendant risk for government debt.

Discussion

The Chairman then thanked Trevor Williams for his excellent presentation. He said that, in keeping with tradition, he would ask the IEA Observer, Philip Booth, to make a vote as the meeting had been inquorate. He then kicked off the discussion by expressing some unease about the manner in which the Retail Price Index (RPI) had recently become an ‘un-statistic’ as far as the Office for National Statistics (ONS) was concerned. The figures were still being published under the banner “NOT NATIONAL STATISTICS”. However, the ONS could not have it both ways. If the RPI was not a useful variable, why had the ONS persisted with its publication every month since the late 1940s? If it was worthwhile then, why had it now ceased to be useful, given that it was widely employed in private-sector contracts as well as for Index-Linked Gilts?

David B Smith’s fundamental concern was that, having failed to achieve a meaningful fiscal consolidation, the Chancellor was now planning to go even further in unleashing the inflation tax – perhaps, with the hoped-for acquiescence of Mr Carney and the Bank’s proposed more flexible inflation mandate – and was trying to disguise that decision by downgrading the RPI and its constituents. David B Smith added that some of the new measures of the price level (such as CPIH, which added housing costs to the established Consumer Price Index or CPI) were potentially useful. Unfortunately, only a relatively short back run from February 1998 onwards was available for the new measures. This was too limited a period to permit of any serious econometric modelling, something that represented a serious impediment to a forward-looking inflation targeting framework. David B Smith then added that it was not clear that the new RPI ‘Jevons’ (RPIJ) – which was named after a Victorian economist – was superior to the old RPI from a conceptual viewpoint.

That depended on the assumption that there was no loss of consumer utility when one switched from, say, apples to pears because the price of apples had gone up, even if one disliked pears. All that one could say was that retail-price inflation fell somewhere between the 2.7% shown by RPIJ and the 3.3% shown by the RPI, and not that any one measure was superior. There followed a short discussion about the proposed statistics.

The Chairman then asked Patrick Minford and Roger Bootle to make their respective comments immediately, as he knew that they both had to leave before the adjournment of the meeting. In addition, he said that he would need to call for two further votes in absentia in order to complete the magic nine. These votes were subsequently supplied by Jamie Dannhauser and Andrew Lilico. Having taken the votes of Roger Bootle and Patrick Minford, the Chairman stated that it was time to go round the table and record everybody else’s views. He said that, on this occasion, he would allow the discussion to continue into the voting round and that other people’s comments on the votes would be recorded for once. This reflected the relatively small size of the group remaining and the fact that there was still a reasonable amount of time left. The votes concerned are listed in alphabetical order below, including the two votes cast in absentia.

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

Philip Booth said that he was nervous about the mortgage guarantee scheme. He said that there was an inconsistency between the government encouraging the banks to build up capital, so that they would not fail and be a burden on the taxpayer, and at the same time for the government to guarantee loans directly. The logical policy was for the government to create a legal framework to allow banks to fail and to deal with the ‘too big to fail’ problem. In response, Kent Matthews said that he did not see an inconsistency in the government having a too-big-to-fail policy and the government absorbing the risk of bad assets of the banks through an asset guarantee scheme. It was a logical extension of a too-big-to-fail policy.

Philip Booth said that the underlying problems were on the supply-side. He said that the productivity problem could not be solved by monetary policy and that Bank Rate should be raised by ½%, given the forecast for inflation, and that there should be no further QE.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Hold Bank Rate.
Bias: To cut to 0.1%.

Roger Bootle said that for once he agreed with Patrick Minford (see below) in his assessment but not in his conclusion. He said that the banking system was broken. In the 1930s, the banking system had supported the recovery, as it had also done by-and-large in former recessions. He agreed that there had been regulatory overkill. Roger Bootle added that it was not clear why there was a need to tighten regulation now rather than later. He said that the popular culture of putting bankers in the stocks did not help the recovery process. This was because active bankers were needed to get the economy out of its current mess.

Roger Bootle added that the Treasury attitude of fattening up the publicly owned banks for sale was not the right structure for recovery and that the government was not addressing the problem of the banks. The economy was flat but there remained potential for improvement. The fall in commodity prices had been significant. Oil at around $100 a barrel (Brent crude) was an important milestone. He said that inflation would probably come in better than expected. If inflation fell by the end of the year, the portents for recovery were good. He said that he was only a lukewarm supporter of QE. Sterling had depreciated sufficiently already, so there was no need for further QE. He added that there should be no change to interest rates immediately. However, it may be necessary to cut rates further to 0.1%, and have negative rates imposed on bank reserves held at the Bank of England, if the economy remained moribund.

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

In his vote in absentia, Jamie Dannhauser stated that CPI inflation remained stubbornly above the 2% target. It could go to 3% in the months ahead, in his view. However, around 1 percentage point of this could be explained by higher administered prices, suggesting a more subdued rate of underlying inflation. Absent the effect of higher university tuition fees, ‘core’ UK inflation had been below 2% since November. Indicators of price pressures in the more recent past, for instance the three-month annualised change in ‘core’ inflation, painted a picture of benign inflation. Other series, such as average wage growth or the annual change in the gross value added deflator, support the contention that the current inflation overshoot was not generalised.

Output growth continued to disappoint. The first quarter data might well show a small expansion in real GDP, but there was little momentum in the economy. External risks to growth remained sizeable given the fragility of the underlying economic position of the Euro area, even if complacent financial markets suggested otherwise. Monetary growth had picked up somewhat. There were signs that the Funding for Lending Scheme (FLS) had led to an easing of credit conditions, especially in the mortgage market. The increased availability of higher-risk loans to first-time buyers in particular could have a marked impact on house prices in the short-term and UK households’ propensity to save. Prospects for consumption had improved since the autumn.

Following news that the FLS was to be extended, there was no need to alter policy this month; it seemed advisable to wait-and-see what additional support to credit supply and broad money growth might be forthcoming. Nevertheless, with slack in the economy, particularly in the labour market, and good reasons to fear that persistently sluggish demand growth would feed through into damage to Britain’s supply capacity, monetary policy should be biased towards additional ease until such a time that there was a clear, self-sustaining momentum in broad money growth. The demands from regulators for UK banks to increase their capital buffers – by between £25bn and £50bn – by year end would be an important headwind to monetary creation in the short-run that monetary policy could attempt to offset.

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

In his vote in absentia submitted following the SMPC gathering, Andrew Lilico expressed the view that, with GDP growth somewhere between slightly negative and slightly positive for two years, it was understandable that policymakers were scrabbling around for some new magic bullet to boost the economy once more. Such initiatives included the FLS, the ‘help to buy’ scheme and flexible inflation targeting. What policy makers did not want to accept was that there are no painless fixes here. This was not a crossword puzzle to solve with a moment's inspiration.

On the other side, were a few defeatists who said that we must learn to live in a growth-free world. Andrew Lilico claimed that we should not accept that either. The government could do some positive things to boost medium-term growth. For example, it could: cut the size of the state; raise public sector productivity; raise the workforce size through higher retirement ages, and privatise or liquidate the nationalised banks.

Macroeconomic policy, per se, could not boost medium-term growth – as Mark Carney had acknowledged recently. Done to excess, though, macroeconomic looseness could damage growth, and had arguably been doing so for some time. Those that argued for yet more stimuli should ask themselves this question: "What would persuade me the path of stimulus was not working, if not the past three years' experience?" If the answer is: "Nothing", what you have in place is a habit, not an economic policy.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate; additional QE to be used only if the Euro crisis re-emerged.

Kent Matthews said that nothing had changed in the economy since the last physical meeting of the SMPC, held on 15th January, to make him change his mind on policy. Monetary policy had run its course and there was no sign that the economy was going to respond the low interest rates or the past policy of QE. He agreed with Phillip Booth that the problem of the economy was a supply-side one. QE and low interest rate policy had distorted the capital markets making inefficient the natural process of financial intermediation. Low interest rates were keeping enterprises that should have died in a state of ‘un-death’. This was starving new enterprises of much needed funds. Bank policy was hampering the efficient working of the capital market. While there was a need to regulate banks, he agreed that this was something for the future. Even announcing tighter regulation in the near future would influence commercial banks’ expectations and create perverse effects. Tighter regulation should be suspended until it was clear that the economy was on the road to recovery. He voted to raise Bank Rate by ½% and to hold QE which could be deployed if the Euro crisis were to flare up as it would inevitably.

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

Patrick Minford said that the credit channel was blocked. America had managed to unblock its own credit supply through the US Federal Reserve buying sub-standard assets. However, the Bank of England had refused to buy anything other than gilts. The conservative attitude of the British Central Bank towards policy and towards the regulation of the commercial banks had blocked the credit channel. QE had distorted the capital market, which had made it cheap for the government to borrow but not companies. Distortionary monetary policy had resulted in firms being kept artificially alive while starving credit elsewhere. Funding for lending was an attempt to unblock the credit channel but with little success. He said that the capital regulations for the banks should be suspended in order to unblock the credit channel. QE should be stopped and interest rates should be pushed up. The problem was that the Treasury was focussed on fattening up the Royal Bank of Scotland group and Lloyds for sale so that the taxpayer did not incur a loss. It meant that the banks were more engaged in building up capital than in lending and reviving the economy. He said that interest rates should be raised to 1%.

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

David B Smith said that the economy had experienced a major – and predictable – supply withdrawal. There was a mass of empirical evidence that a rising government share in national income reduced capacity in the long term, even though there might be a short run boost from fiscal policy. His own statistical research suggested that roughly one-third of the output shortfall in the OECD area as a whole since 2008 had occurred because of the increased socialisation of the international economy since 2000, although the rest does seem to have been associated with the financial crash. In the UK, there were three things going on simultaneously. First, the increased socialisation of the economy had contributed to slightly over one half of the output shortfall since 2008, although the rest was statistically associated with the crash, if these were assumed to be independent events. Second, monetary policy had provided some transitory stimulus. However, monetary ease could not stimulate output in the long run – when the supply side was the crucial influence – and it had probably exhausted its effectiveness by now. Third, incentives and regulation had had perverse effects, especially in the case of the commercial banks.

With macro-policy exhausted, there was an overwhelming need to implement bold micro reform of the economy generally and financial institutions, specifically. For competitive reasons, as well as the too-big-to-fail issue, we needed to go back to smaller banks with regional head offices in some cases. This could be quickly brought about by breaking up the big state-owned banking groups into their historic constituents and flogging off the bits at the best price that could be achieved. He accepted that this might leave the government with a rump ‘bad bank’. However, competition and manageability should be the goals, not trying to get the taxpayers’ money back. Policy needed to address three issues. These were: first, deregulation; second, government spending, and third, the structure of the banking market. He voted to raise Bank Rate by ½% to restore monetary discipline to refocus on inflation. There was nothing further to be gained from additional QE.

Philip Booth cautioned the committee not to advocate a top-down bank restructuring because markets were not being allowed to come to a natural solution. In response, David B Smith said that he accepted Philip Booth’s argument as a general rule, when the starting point was a competitive system. However, that was not the case with the British banks, which were heavily cartelised, often as a result of officially encouraged mergers, such as those of the early 1920s and the late 1960s, which had reduced the number of clearing banks from eleven to five.

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

Peter Warburton agreed with the diagnosis that blockages in private sector credit transmission were the greatest impediment to UK economic recovery. Policy innovations, such as the extended FLS and the help-to-buy initiatives were designed to “fly under the radar” of an overbearing financial regulatory regime. FLS has demonstrated beyond all reasonable doubt that it is market interest rates that matter to economic behaviour rather than the largely irrelevant Bank Rate. Paradoxically, to regain relevance, Bank Rate needs to increase in order to reconnect with the market structure of rates. With the Budget announcement of a new Bank of England remit and the invitation to further policy experimentation, it is imperative that Bank Rate is not committed to remain at ½% for an extended period. Were this to be done, its irrelevance would be ever more apparent.

However, with the addition of the massive dose of Japanese quantitative and qualitative easing, the force of global reflationary policy has increased materially. Japan has an urgent agenda for economic expansion and for policies to affirm the credibility of the 2% inflation target. It would be a surprise if the global economy did not strengthen, and also display more of an inflationary bias, in the remainder of 2013. UK’s distinctive susceptibility to imported inflation, aggravated by early-year Sterling weakness, reinforces the argument for beginning the process of Bank Rate normalisation.

There are compelling reasons to diversify some of the £375bn of existing QE into a portfolio of other assets, including securitised property, infrastructure and possibly even SME (small and medium-sized enterprises) assets as a means of lowering the regulatory burden of the banks that relates to these loans. The fact that the ‘Bad Bank’ debate has revived in recent weeks is a reminder of how little structural progress has been made to restore health to the UK banking system.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold; no further QE.
Bias: Neutral.

Trevor Williams said that Bank Rate should be held and that QE should also be on hold. In the UK, household savings had risen and government savings were not as negative as they once were. However, significant further adjustment was required before they were stable. Corporate balance sheets were robust but adjusting lower as household savings rose. In other words, corporate profit growth seemed to have slowed sharply. The wider current account balance of payments deficit last year, at 3.7% of GDP, was a sign that the savings/investment balance in the UK was still misaligned. A troubling economic environment in Europe was making it very difficult for the UK to grow through exports, although the situation was not helped by the domestic fall in productivity and the subsequent rise in unit labour costs. Nevertheless, raising interest rates was not the answer, despite the legitimate worries about the negative effects of keeping them too low for too long. Keeping rates on hold did not preclude the need for supply-side reforms to help kick start confidence and recovery. Indeed, it bought time for this to happen. An immediate increase in rates would most likely lead to higher default rates and hit already fragile consumer and business confidence, further delaying recovery rather than speeding it up. He voted to hold Bank Rates and hold QE. However, the Bank should buy non-gilts if further QE was to be exercised.

Policy response

1. On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in May. The other three members wished to hold.
2. There was only modest disagreement amongst the rate hikers as to the precise extent to which rates should rise. Six voted for an immediate rise of ½% but one member wanted a more modest rate rise of ¼%.
3. All those who voted to raise rates expressed a bias to raise rates further. There was also a common view that QE would be more effective if it was directed towards the purchase of private-sector liabilities, rather than government bonds.

Date of next meeting
Tuesday 9th July 2013.

What is the SMPC?

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

Current SMPC membership

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

In its most recent e-mail poll, which was finalised on 27th March, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 4th April. Two SMPC members wanted an immediate increase of ½%, while three wanted a rise of ¼%, implying a rise of ¼% on normal Bank of England (BoE) voting procedures.

This represented the third consecutive month that a majority of shadow committee members had decided that a rate increase was justified on economic grounds, and the second month in a row that it was five to four in favour. Of the four that voted against a rise, none voted for more QE though it was held in reserve by one.

The verdict on the Budget was that it was neutral and so will do little to stimulate the economy. More broadly, some believed it was a missed opportunity: to go further in stimulating the economy via capital projects to kick start growth and more on the BoE’s remit. On the latter, the worry was generally that the changes announced and Mark Carney’s arrival suggests a period where monetary policy would be loose and could be seen to endorse inflation.

Fears about the public sector's debt position were felt by some to have been vindicated in the Budget. With more debt, for longer in the future, with not enough effort in the view of some to rein it in, prospects for recovery were damaged.

For one, lack of control of fiscal policy is as responsible for the lack of recovery as the supply side issue that the UK faces. For another, that the rating agencies were too slow to recognise the UK’s debt problem, not too fast. One worried that the focus on both fiscal and monetary policy is wrong and self defeating, their failure actively contributing to the weakness of the economy. Structural reform is key to recovery.

Comment by Tim Congdon
(International Monetary Research Ltd)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: To achieve low and stable growth of the quantity of money (broadly-defined).

Disappointment about the UK economy’s performance is widespread today. The government is under pressure ‘to do something’. However, its macroeconomic options are limited. Some Keynesian critics say that the government should boost its own spending, in order to stimulate aggregate demand as a whole. But the large budget deficit and associated increases in public debt prohibit such so-called ‘fiscal reflation’, while experience over many decades shows that fiscal policy does not work in the manner discussed in the textbooks. The Budget documents therefore endorse ‘monetary activism’, with the Bank of England (BoE) reported to have been given new powers to influence the economy in a positive way.

I would say that the central problem in monetary policy at present, as over all of the last five years, is that banks cannot readily grow their balance sheets while they are struggling to meet officialdom’s demands for more capital and liquidity relative to risk assets. Since equilibrium national income is a function of the quantity of money broadly-defined (i.e., of the total of bank deposits, more or less), officialdom’s demands remain a powerful deflationary force. Monetary activism in the form of ‘quantitative easing’ (QE) (i.e., the creation of new bank deposits [money] by the state) has been tried and has been vital in mitigating the officially-imposed deflation. However, various initiatives ‘to ease credit conditions’ – such as the Funding for Lending Scheme (FLS) and the granting of powers to the BoE to purchase corporate bonds (i.e., to engage in the ‘credit easing’ advocated by Ben Bernanke) – are of little importance relative to the clamp on money growth implied by the official pressure for safer bank balance sheets.

The Budget announced that public sector net borrowing is expected to be about £120 billion in the coming 2013/14 fiscal year, much as it was in 2012/13. The Office for Budget Responsibility (OBR) has correctly said that Mr Osborne’s campaign to reduce the budget deficit has ‘stalled’. As a result, public debt will rise faster than national income this year and next. Even more worrying are the medium- and long-term prospects for the UK’s public finances. In documents published with the Budget the OBR sets out a plan with assurances that, on present policies, the debt/GDP will peak in 2017. However, it had previously given assurances that the debt/GDP would peak two or three years earlier, and it was wrong. The remainder of this note discusses why the government has failed to bring the budget deficit down to lower and more sustainable levels.

The economy’s weaker-than-expected growth performance is often mentioned as the main cause of the disappointing fiscal arithmetic. Since the start of the Conservative-LibDem coalition government in 2010, growth of national output has been lower than envisaged. As tax revenues are a proportion of national output, they also have been lower than forecast. On this basis the blame for the above-target deficit outturns lies with the ‘supply side’ of the economy, which is understood as having less dynamism than in the 1980s and 1990s for all sorts of reasons that cannot be immediately remedied. Osborne has not yet been criticised because of unsatisfactory control of public expenditure. Indeed, the standard badmouthing he receives from ‘the left’ in British politics is that he has been too austere (or even ‘too austerian’, to quote Paul Krugman’s neologism in his 2011 book, End this Depression Now!). The left seems to think that Osborne has been dogmatic and uncaring in his commitment to lowering public expenditure. My argument here is that some important evidence does not support this view. On the contrary, Osborne has not reduced general government consumption at all.

As is well-known, Gordon Brown reacted to the Great Recession by so-called ‘Keynesian fiscal reflation’, so that government consumption continued to grow even as private spending and the government’s tax revenues fell. That led to the sharp widening in the budget deficit recorded between 2007 and 2010. After the change of government in 2010, the first few quarters of data appeared to suggest a move to austerity. The annual change in general government consumption was negative in each of the four quarters to the second quarter of 2011. Meanwhile, the rebound in the economy in 2010 and early 2011 boosted tax revenues, causing the budget deficit to drop significantly from 11% of GDP in 2009/10 to 8% of GDP in 2011/12. Osborne’s Plan A seemed to be in place and the UK retained its triple-A credit rating.

In the last few quarters for which data are available (i.e., up to the third quarter of 2012), general government consumption was rising faster than total expenditure in the economy. On this basis the claims of tight expenditure control under the coalition governments, and the polemics about an unjustified move to austerity, are invalid. Total expenditure in the economy is predominantly expenditure by the private sector. Whereas it has been barely growing since 2011, general government consumption has been increasing at about 2% - 3% a year.

It is therefore not true that the setbacks on the budget deficit are entirely to be attributed to weak tax revenues and the inability of the economy to expand because of supply-side constraints. The setbacks on the budget deficit are also to be explained by rising public expenditure. Osborne and his team have a more definite responsibility to control government consumption than the government’s transfer payments, the levels of which are set partly by statute and the economy’s performance (as with welfare benefits) and partly by conditions in the government debt market (as with debt interest). But an obvious link holds between control of government consumption expenditure and the budget deficit, and then between the budget deficit and the burden of debt interest. Further, the higher is the budget deficit, the greater is the increase in the national debt and – for any given average interest rate on the debt – in the debt interest that has to be paid on the debt.

The analysis in this suggests that so far Osborne’s record in curbing the budget deficit has been at best mediocre. In the last few quarters he has allowed government consumption to increase noticeably in real terms. That is one reason why the budget deficit will remain well above 5% of GDP when the present Conservative-LibDem coalition government comes to an end.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%. No change to QE.
Bias: Neutral but liquidity support available if Eurozone situation deteriorates.

Several important things came out of the March 20th budget. One is the continued implausibility of the OBR’s growth forecasts. Although the 0.6% growth forecast for 2013 is disappointing, the subsequent rates of 1.8% (for 2014), 2.3% (for 2015) and 2.7% (for 2016) are hard to believe. The OBR appear oblivious to the fact that there has been a negative supply shock, and even if potential GDP remains >2% there is little rationale for believing that the output gap will be closed. As I argued in a policy report for the Mercatus Center, the forecast reduction in government spending as a proportion of GDP can in large part be attributed to over optimistic growth forecasts. Attempting to stimulate aggregate demand in a world where potential GDP has fallen will lead to frustratingly sluggish growth and rising inflation expectations (having almost fallen to 3% in 2012, they are now approaching 4%) – exactly what we see today.

The Chancellor’s attempts to reignite a UK boom in subprime lending appear to be a muddled attempt to kick life into the housing market. It is not clear whether it will help the intended target of those priced out of the housing market, as opposed to existing homeowners using public money to cash in on another housing bubble. However, the combination of low interest rates and reduced lending standards generates adverse selection (in terms of enticing people to take on debt that they cannot afford to service) and moral hazard (incentivising mortgage holders to take on more risk). Lending standards provide an important market test and “Help to Buy” backfires if it’s help to buy an asset that you cannot ultimately afford. In a 2012 report the Financial Services Authority (FSA) pointed out that although sales of fixed-rate mortgages were increasing relative to variable rate ones, there has been a sizable shift of people already on mortgages from the former to the latter – 55% of new mortgages were fixed rate, but less than 30% of outstanding mortgages were fixed. Although it is incredibly difficult to use monetary policy to deflate specific asset bubbles, the BoE should not facilitate government efforts to maintain them. The release of data regarding the FLS should generate scepticism about the Chancellor’s efforts to widen the scope. There’s no doubt that such schemes can help at the margin but it is unlikely that they will drive banks’ decisions to extend credit.

In terms of the monetary policy remit, the announcements were underwhelming. Moving towards forward guidance ties the hands a little of those who attempt to simulate the MPC’s decisions, and inevitably turns attention away from speculating about policy decisions and towards the remit itself. Delaying the date in which the letter to the Chancellor is due constitutes an acknowledgement that inflation will continue to remain above target, without changing that target. Adding the objectives of “growth and employment” constitutes a slightly more flexible target, but is merely making a vague de facto remit, a vague de jure one. It formalises the discretion with which the MPC have already been utilising, but fails to offer a clear replacement. It is this leeway that is stymieing recovery, because it generates uncertainty. It would have been preferable to combine a nominal growth target with unambiguous expectations about its future path. Nominal GDP grew by 6.6% in Q3 2012 (relative to the previous quarter), but only 0.4% in Q4. Most would agree that going forward the optimal rate is somewhere between the two, but the stability of expectations are more important than the actual rate. In a similar way, it is the permanence of QE that determines its impact, and uncertainty about how the stock of QE will be maintained over time has limited its potential impact. Forward guidance is a fairly meek way to manage expectations relative to the types of commitment central bankers should be making.

Over the past few months, I have argued that the overriding goal of the MPC should be to get back to a neutral monetary policy, and I would still argue that rates are artificially low. Even though there is a danger of raising them too soon, the events in Cyprus also remind us that there’s a limited window of opportunity. With such disappointing growth figures it would be dangerous to raise interest rates without also have a clear communication strategy to explain why, but for the purposes of debate I vote for a moderate rate rise even without this. If events in the Eurozone begin to pose a serious risk to the UK banking system, it would be unwise to wait until an MPC meeting to act. Therefore the BoE should be prepared to offer liquidity provisions as and when needed.

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

Monetary growth, the housing market and survey evidence point towards a muted recovery in 2013. The Budget was fiscally neutral and won't change the short-term economic outlook. Nor should it. Fiscal policy should concentrate on deficit reduction and long-term growth, by improving the incentives to work, save and invest. The underlying budget deficit is stuck. Over the 2011-12, 2012-13 and 2013-14 period the underlying deficit is flat at close to £120 billion. Yes, it is projected to fall thereafter, but these are forecasts and the error factors are huge ¬¬- around 1 percentage point of GDP per annum for every year ahead i.e. £15 billion 1 year ahead, £30 billion 2 years, £45 billion 3 years etc. It wouldn't take much for the budget deficit to get stuck at £100 billion for as far as the eye can see.

I differ with the consensus about the short (stronger) and long term (weaker) economic outlook. Basically, I think the short-term outlook, driven by the recent pick-up in broad money growth, could be a little stronger than expected. With regard to the long-term outlook, the potential growth rate of the UK economy is probably below 2 per cent. If so, and in the absence of radical supply-side reform, fiscal policy will be under pressure throughout the current decade and as a result monetary policy could remain loose for the entire period.

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

Rationale: British policymaking is stuck in a rut. The Fixed Term Parliaments Act has condemned us to no General Election until 2015, when in a healthy political system we might have had two General Elections by now, since 2010. Policymakers are therefore trapped by foolish promises they made in 2008 and 2009, or even earlier, regarding their approach to fiscal and monetary control. That has meant that any concerted effort to raise the UK’s sustainable growth rate by cutting government consumption spending early or seriously increasing the efficiency of government consumption spending has been impossible. The government, having in 2011 abandoned its target of eliminating the structural deficit over a Parliament, has in the latest Budget abandoned any attempt to cut the deficit at all, being content to allow the deficit to sit at £120bn in 2011/12, 2012/13 and 2013/14. With no deficit reduction scheduled in the deficit for three years, the government’s economic policy can no longer even pretend to be a “deficit reduction programme”.

Having abandoned efforts to cut the deficit or raise the sustainable growth rate, and with events in Cyprus reminding us – if the experiences of Iceland, Ireland and Spain were not already lesson enough – that countries with as large banking sectors relative to GDP as the UK’s cannot save their major banks without bankrupting the state, the government is now clearly switching to a policy of “financial repression” to make its obligations manageable. Public service spending, benefits, tax allowances, and the deficit are all to be held in nominal terms, then inflation encouraged to accelerate fiscal drag, devalue benefits, and ease the burden of debts, whilst easing the balance sheets of bust banks by eroding the real value of their liabilities to depositors. Understandable though such a policy is, the choice of such a route constitutes surrender to events.

In the Budget a change to the monetary policy remit was announced, with George Osborne effectively informing the BoE that from now on it was fine for inflation to be as far above target as the Bank likes, for as long as it likes. That such a change in the remit was greeted with a shrug and remarks along the lines of “But that’s what policy has been for years anyway” just indicates how totally the BoE’s credibility has been eviscerated in recent years.

The new BoE framework can best be described as “not avoiding inflation”. Policymakers around the world, through the long and sad history of the monetary system of exchange, have found not avoiding inflation a tempting route. It often seems as if letting inflation go just a little higher would make everything just that little bit easier. But once inflation goes much above 5% it becomes volatile as well as difficult to keep down. The consequence will be that employers and workers will be forced to anticipate inflation in wage-setting. However, they will find it difficult always to predict inflation accurately. A number of consequences spring from this: some years employers may pay far too much, and either go bankrupt or cannot hire workers; in other years employees may be paid far too little, and therefore find themselves unable to service their own debts. High and volatile inflation thus causes unemployment and personal and corporate insolvency. Policymakers appear so set on attempting (but failing) not to repeat what they regard as the failures of the 1930s that they have forgotten the key lessons of the 1970s and 1980s and set aside the core insights of the macroeconomic theory of the past forty years.

This is the most fundamental lesson of the past few decades of macroeconomic theory and practice: neither fiscal nor monetary policy can raise the medium-term growth rate of economies, but can lower it if pursued to excess. Debates about “fiscal stimulus” and “flexible inflation targeting” thus miss the point. We do not have a short-term problem susceptible to short-term solutions. We have a deep-seated structural problem that only structural solutions can address. Monetary and fiscal stimulus measures have had their go, and achieved what they could. They have now passed the point at which they do good and reached the point at which they do harm, and the longer they are kept in place the more harm they will do.

Comment by Kent Matthews
(Cardiff Business School)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: To raise rates further.

In case anyone thought that the euro crisis looked to be coasting towards some sort of resolution based on the politician’s hope that something ‘good’ will happen if we could just hold on, the whole thing flares up again. Indeed this crisis will run and run with periodic lulls until something ‘good’ really happens as the politicians hope or the whole experiment be declared a failure with the breakup of the single currency. Whatever happens in the future, the Bank needs to have enough ammunition in its arsenal to use against the fallout from a likely breakup and the inevitable contagion of the ensuing bank crisis. QE worked to arrest a fall in the financial markets from developing into a disastrous collapse. It can be used again if the euro crisis threatens to turn into a survival phase with all the negative implications for the UK.

With this backdrop it has certainly not been a good time for Cameron’s fourth budget. Earlier, Moody had downgraded UK debt from its AAA rating and now Fitch has placed it on negative watch. The budget itself was unadventurous with only weak signals of a future supply side policy that might have positively influenced growth expectations and provided a boost to domestic investment spending. What is left of policy is a dependence on the continuation of a supposed loose monetary policy that has demonstrably failed to stimulate a moribund economy. More of the same does not sound like a good policy.

There are three reasons why the Bank should start the process of raising interest rates – two good ones, and one weak one. If the euro crisis reaches a terminal phase with the knock on effects for the UK economy, at near zero interest rates, monetary policy has no traction. A phased rise can be reversed sharply if needed to provide comfort to financial markets. The second good reason is that the current policy has led to the survival of zombie corporates (bank credit insiders) while companies that need to grow (bank credit outsiders) are faced with a credit famine and relatively high borrowing rates and tough conditions. The result is that the current policy of QE and low official bank rate has denied the economy of a Schumpeterian process of ‘creative destruction’. The third reason is that the Bank, even belatedly can try and restore some credibility to its inflation target policy. It is a weak reason because the credibility of its anti-inflation policy may well have been irreparably damaged and any rise in interest rates may fail to influence inflation expectations. However, it is worth a try!

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

While there has been criticism of the Chancellor’s decision to subsidise mortgages, for me this is a most significant step for monetary policy. As I have argued in previous SMPC submissions, excessively harsh regulation of the banks – and especially the heavy new capital requirements which are expensive to meet now when banks are unattractive to investors – have raised the costs of credit to SMEs and personal borrowers, the two sets of clients who have no effective alternative to banking. So the credit channel is blocked by regulation.

By subsidising mortgages which are widely used by both these client sets, the Treasury is directly offsetting this distortion. It remains to be seen how effective the subsidy is in practice; as so often with these bureaucratic interventions one cannot know until the detail is laid out of how it is all accessed, what side-conditions and so on. However, what is becoming clear is that the Treasury and the Bank may at last be taking action to relieve the effects of their other, regulative, actions on monetary conditions; the FLS is another one of this type that may be having a modest effect. QE, as I have argued and shown in the data, is not doing the job; it is merely reducing returns to savers; cheapening the cost of credit to government, and possibly preserving ‘zombie’ clients.

It would be better to reverse the regulations and allow the market to work freely. But with the great and the good determined to regulate, as seen in the Parliamentary Committee and the Vickers Report, the only avenue left is this sort of offset.

My view therefore is that this latest mortgage offset, together with the FLS, should be consolidated and strengthened as necessary to eradicate the distortion and get the cost of credit down to these two sets of clients. QE should be stopped and steadily reversed. Interest rates should be raised towards normal levels, starting with 0.5% this month, with a bias to continue upwards. The object should be to return general rates to normal, while eradicating the abnormal premium on SME/personal lending.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

As expected, the Treasury has revised the remit for the BoE’s MPC to allow even greater flexibility in the interpretation of the inflation objective. Although the inflation target remains unchanged at 2% “at all times”, there are three concessions to flexibility that are potentially significant in combination.

First, the MPC has been given permission “to deploy forward guidance including intermediate thresholds in order to influence expectations and thereby meet its objectives more effectively. The Government considers any use of intermediate thresholds to be a matter subject to the Committee’s operational independence in setting policy, to be considered in exceptional circumstances. The Committee is requested to provide an assessment of such approaches to setting policy alongside its August 2013 Inflation Report.”

Second, in forming and communicating its judgments the Committee should promote understanding of “the trade-offs inherent in setting monetary policy to meet a forward-looking inflation target. It should set out in its communication … the horizon over which the Committee judges it is appropriate to return inflation to the target.”

Third, when actual inflation departs from the target, in conjunction with the publication of the MPC minutes, the Committee should “communicate its strategy towards returning inflation to the target after consideration of the trade-offs.”

The disturbing aspect of these remit changes is the acquiescence of the Treasury to the Bank’s judgment and economic model. The terms of the remit allow for two distinct circumstances in which departures of inflation from target will be tolerated. The first takes for granted that there is a clearly identified short-run, and perhaps medium-run, trade-off between inflation and real economic activity. The second concerns situations where “attempts to keep inflation at the inflation target could exacerbate the development of imbalances that the Financial Policy Committee may judge to represent a potential risk to financial stability.”

Hence, the MPC is given the flexibility to “look through” inflation deviations when to tighten monetary policy would be judged to create additional output volatility and/or to jeopardise financial stability. In essence, the Bank has been given carte blanche to disregard the inflation target over an indefinite horizon.

There is an underlying premise in the Treasury document “Review of the monetary policy framework” that the sources of above-target inflation are temporary and irrelevant to the operation of monetary policy. However, since QE plays a well-documented role in driving up primary product prices, then energy and commodity price impulses cannot be considered exogenous or temporary. Similarly, the side-effects of fiscal tightening such as higher excise duties, VAT or air passenger duty, reflect the reality of ongoing fiscal normalisation. These are not exogenous or temporary, either.

The remit is crafted as if the inflation rate were drawn, as if by a gravitational force, back to 2% per annum. It does not consider the alternative: that the UK inflation rate may be in transition to a new and higher equilibrium. Our decomposition of the Retail Price Index into semi-exogenous factors (e.g., administered prices, excise duties, oil and commodity prices) and prices mainly determined in the domestic private sector is revealing. The series for private sector inflation has a clear upward drift in its inflation rate that has been in place since 2005. The Treasury makes no attempt to explain the persistence of this trend, nor its implications for the task of anchoring inflation expectations. This upward drift in private sector inflation, mirrored in consumers’ inflation expectations, is unlikely to be arrested by the adoption of a more flexible inflation mandate.

Finally, the revised remit rules out the replacement of inflation targeting with nominal GDP targeting, but holds open the door for the level of nominal GDP to play a role as an intermediate threshold, should Mark Carney wish to exercise this freedom. For further illumination on this issue we must wait until August.

However, neither the scope for larger and longer inflation departures from target nor the freedom to adopt US-style forward guidance on the level of Bank Rate addresses the fundamental blockage in the credit system. Until the Bank of England relaxes the overbearing capital and liquidity requirements on UK banks and considers the purchase of private sector assets within its asset purchase programme, then the effective growth-inflation trade-offs will remain hostile. Mark Carney’s most pressing task as incoming Bank governor is to unblock the credit transmission not to construct an elaborate set of conditions under which Bank Rate may one day be raised. Indeed, if there is a role for ‘forward guidance’, it is to reassure markets of the Bank’s determination to take rates back to the region of 2% to 2½% over the next two years. An immediate move to ¾% is my preference.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold interest rate and no increase in QE.
Bias: Hold interest rate for now.

After a broadly neutral budget that allows the debt-GDP ratio to rise to levels not seen for fifty years, the weakening of the inflation remit of the BoE, the appointment of Mark Carney and the negative-watch warning from the credit rating agency Fitch, the question that is being asked increasingly is whether the UK is positioning itself to partly inflate away its debt. Although this would be officially denied, it is becoming increasingly likely and may even shortly come to be seen by many as the only politically acceptable solution. I think that this would be the wrong way out of our debt and growth problems.

There is no convincing evidence to show that increasing government expenditure would raise private consumption expenditures, even in the short term, as assumed in Keynesian economics. If it did so in the long run, this would imply, most implausibly, that the larger the government sector, the better off would people be. Increased government investment expenditures, if well targeted, would lead to an increase in GDP and consumption. It was probably a mistake by the government to cut these, but increasing them now would only bring longer term benefits to growth. I would have preferred a budget that put more money into the hands of those most likely to spend it immediately and paid for this by cutting further wasteful government expenditures.

The changes to the BoE’s remit are still vague but strongly suggest allowing more inflation in order to increase growth, especially over the cycle. This makes sense if higher inflation is due to a negative supply shock, but not if it is due to a positive demand shock. In fact, the BoE has already adopted this policy but, perhaps due to its remit, has not formally admitted it. It is clear, however, that such a change in its responsibilities are unlikely to have made much difference to the conduct of monetary policy in the current recession, or to have increased the ability of monetary policy via interest rates to affect the real economy. The zero lower bound to interest rates has caused this. Only outright money financing of the deficit might raise GDP in the short term. Even QE and bailing out the banks is fiscal policy. In short, whatever the , monetary policy is much less effective in dealing with a recession caused by a negative supply shock as now.

In my own recent research on the UK’s credit rating (CEPR Discussion Paper 9378, March 2013) I found that the UK’s credit rating should rather have been downgraded in the second quarter of 2008. From 2010, when the government came to power, the UK’s credit rating would have started to rise, and at the present time it is even healthier. In other words, the credit rating agencies appear to have got their timing of the UK’s credit rating completely wrong. The news in Moody’s and Fitch’s down-ratings is that they are too late.

In my view the Chancellor is correct to say that one of the main reasons why the UK economy has not performed better is its export performance to the Eurozone. I would add to this the rise in the UK’s saving rate as households and banks tried to rebuild their balance sheets. Although higher inflation would probably lead to a further depreciation of sterling – as well as reduce the real value of debt – I do not recommend this as the right solution for the UK because UK imports are not that price sensitive and exports to non-euro markets are already competitive, are growing and are higher than those to the euro area. The main problem with higher inflation that lasts too long or is too high, even temporarily, is that it risks raising longer-term inflation expectations. In short, I think that we just need to stick to plan A, be patient and not adopt policies for the short term that worsen things later. It was short-termism that got us into this mess in the first place.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold Bank Rate and hold QE in reserve.
Bias: Neutral.

As the UK Chancellor said in the opening of his Budget speech, 'this is a fiscally neutral Budget'. So it proved, with spending increases offset by spending cuts and tax increases in future years. However, as the starting point in 2013/14 was worse than forecast in the Autumn Statement in December - a PSNB of £86.5bn rather than the £80bn expected then, some £6bn higher. The cumulative effect of higher deficits in coming years means that net debt peaks at 85.6% of GDP in 2016/17 rather than the earlier 79.9% in 2015/16. That represents an increase of roughly £100bn more at the end of the five-year projection period. Gross debt peaks at 100% of GDP.

It would have been worse but for an under-spend by government departments in this financial year that has been carried forward and used to increase spending in some areas. In addition, economic growth has been revised lower by the OBR for 2013, to 0.6% from 1.2%, and next year to 1.8% from 2.0% previously. Unemployment is expected to peak at 8% by the OBR and stay there for at least two years, and CPI inflation has been raised modestly higher for this year and next. The result of these revisions is lower tax revenues relative to the previous projection in the December 2012 Autumn Statement. But these figures did not surprise financial markets and so have had little impact. Gilt yields have actually fallen back somewhat and the currency has barely moved (though likely partly down to events in Cyprus). Essentially, fiscal austerity has been maintained in the medium term with little increased borrowing in the short term.

As for the monetary policy stance, once again there was actually little change in practice. The remit has been maintained, and a study of the UK's monetary policy framework published by the Treasury concluded that the mandate should continue to focus on the primacy of price stability and the inflation target. But the BoE has been asked to look at how it could refine its operational activities - by perhaps providing conditional forward guidance and by explaining in more detail the trade offs between greater inflation flexibility and the impact on growth. Although clearly influenced by the Federal Reserve’s current practise, the changes announced were close to the bare minimum that markets expected.

The main announcements from a corporate perspective were to boost infrastructure investment, to cut the main rate of corporation tax to 20% by 2015/16, and to boost housing market activity through various measures. All in all, this was a business-like Budget that enshrined the government's tight fiscal policy stance and the loose monetary stance of that has been in place over the last few years.

What is the SMPC?

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

Current SMPC membership

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

In its most recent e-mail poll, which was finalised on 26th February, the Shadow Monetary Policy Committee (SMPC) decided by five votes to four that Bank Rate should be raised on Thursday 7th March. Three SMPC members wanted an immediate increase of ½%, while two advocated a rise of ¼%, implying a rise of ¼% on normal Bank of England voting procedures.

This represented the second consecutive month that a majority of shadow committee members had decided that a rate increase was justified on economic grounds. However, no one expected to see an actual rate change this close to Mr Osborne’s 20th March Budget. In addition, four SMPC members believed the British economy was so weak that Bank Rate should be held, while one believed that additional Quantitative Easing (QE) would be required before the economy could recover.

The majority view was that the stock of QE should be held at its present £375bn, however. Both the SMPC’s ‘hawks’ and ‘doves’ included people who believed that QE would be more effective if the Bank bought more private-sector assets and relied less on government debt purchases. There was also disquiet about the extent of the structural fiscal weakness that might be revealed in the 20th March Budget.

This might exacerbate the downwards pressure on Sterling that was initially triggered by Sir Mervyn King’s comments at the 13th February Inflation Report launch and subsequently exacerbated by the removal of Britain’s AAA rating by Moody’s on 22nd February. The rapidly diminishing credibility of other aspects of UK policymaking made it difficult for the Bank of England to carry conviction, especially given its history of inflation overshoots, in the view of several SMPC members.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Additional QE and a rebalancing towards non-gilt assets.

Over the last month, the trade-weighted value of the pound has fallen by another 3½%. Its total decline so far in 2013 has been roughly twice as large. The implied fall in Britain’s real effective exchange rate (REER) represents an important stimulus to growth, given the economy’s need to rebalance away from domestic spending towards net exports. The extent to which this nominal depreciation translates into a sustained real depreciation is unclear; there is a possibility that it could be dissipated in a higher price level. However, given recent experience and the considerable slack in the labour market, upward pressure on unit labour costs should remain limited and a lower REER is likely to persist.

This removes some of the urgency for additional Bank of England asset purchases. Nevertheless, the case for continuing monetary aggression remains strong. Indeed, a major driver of recent sterling weakness has been the Monetary Policy Committee (MPC) itself. Its recent pronouncements suggest a greater willingness to look through above-target inflation, an expectation of additional gilt purchases – three MPC members voted for another £25bn at February’s meeting – and a desire to expand the authorities’ monetary arsenal. The minutes of the latest meeting point to a wide-ranging discussion of other tools to boost activity in the UK. While the Bank remains reluctant to undertake these unilaterally, there does appear to be some support for co-ordinated action. Importantly, there seems to be greater consensus on the MPC of the dangers for long-term supply capacity of allowing demand growth to be persistently weak. In technical jargon, the MPC’s ‘reaction function’ may include not just the output gap and the deviation of inflation from its target, but also the growth rate of output.

This is sensible monetary policy-making in today’s highly unusual environment. Even though Consumer Price Index (CPI) inflation is set to be above 2% into next year, the risks to inflation over the medium-term are limited. Powerful deflationary forces persist, including the on-going Euro crisis, the persistent failure to resolve global imbalances and widespread fiscal consolidation in the advanced world. A central bank concerned about wider financial stability and hysteresis effects on long-run supply capacity has a strong incentive to err on the side of doing too much. At the current juncture, this gives the green light for continuing monetary aggression.

However, there is also an argument for more targeted interventions. A general expansion of the stock of broad money via gilt purchases remains a powerful tool, and should continue to be used where necessary to maintain adequate bank deposit growth; but there are good reasons to consider other types of action, including co-ordinated steps with the government, that would involve the purchase of non-gilt assets. The obvious parts of the economy that could be helped via such a mechanism are: the commercial property sector, the home building industry and the energy and transport infrastructure sector.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%.
Bias: Raise Bank Rate further.

Two things suggest that the present situation of Bank Rate at ½% and a £375bn stock of QE may be about to end. On the one hand, growth remains sluggish at best, and three members of the MPC wanted to increase QE last month. On the other hand, CPI inflation continues to remain above target, and the Bank of England seems increasingly likely to publicly admit that they are happy for it to remain so. Both sides of the debate are finding compelling evidence to support their positions. One might think that the so-called ‘doves’ are the pessimists, because they’re still haunted by the (thus far, absent) threat of deflation. And the inflationary fears of the ‘hawks’ mark them as optimists, in the sense that they anticipate that past monetary easing will finally start kicking in. However, another way to view this is that by wanting to keep interest rates low indefinitely, the doves are implicitly assuming that once the present storm has passed it will be plain sailing. In other words, once the waters are calm again we can start to worry about exit policy. By contrast, the hawks may reject the idea that we are in the process of leaving the storm. Indeed, if one anticipates that there may be a deterioration in the health of the economy – whether it’s through another US fiscal cliff, a Euro-zone crisis, double digit inflation, etc. – then we might view the present as an opportunity to repair our defence mechanisms before the real storm actually arrives. In this sense, we need to fully consider the opportunity costs of keeping interest rates unchanged, and the trade-off between prompting a crisis as against having the monetary policy tools in place to respond to a future one.

As we prepare for the arrival of a new Governor, there seems to be greater attention being given to finding ways to loosen monetary policy. One of the problems with QE though is that the more successful it is the more it prevents markets from adjusting. The supposed positive impact of the Funding for Lending (FLS) scheme comes at the cost of propping up a housing market that is artificially high. In addition, interest rate guidance can backfire if the market interprets it as the central bank accepting that the recovery will be long and slow. Furthermore, it impedes the Bank of England’s desire to have a clear communication policy about their target.

Given that Nominal GDP is growing at a moderate rate, and growth in M4ex continues to rise – in December it hit 5.2% which is higher than it’s been for more than two years – the economy is in reasonable shape. One can always find reasons to wait but there’s even been good news on the fiscal front with a higher than anticipated surplus in January. The change in Governor also presents a window of opportunity to act. A moderate action would be to begin the process of raising interest rates back to their natural rate. This would make growth quicker and more sustainable, and also provide ammunition should external events cause a future deterioration. There is no reason to believe that raising rates would send a positive signal about the economy and boost confidence, but there’s also no reason not to believe that. A more ambitious action would be to get serious about replacing the regime of inflation targeting.

A Nominal GDP level target would help the Bank of England deliver monetary stability, and avoid the present challenges of trying to boost growth when inflation is above target. Most importantly, it would make future crises (caused by the central bank) less likely, because Nominal GDP is a better indicator of the monetary stance than CPI. Nominal GDP targets do not rely on timely and accurate estimates of GDP, because you can target market expectations instead. Mark Carney has indicated that a debate about monetary policy would be a good thing. One has to agree.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Maintain asset purchases at £375bn; only increase the total to offset declines in M4ex.

Why has economic growth been so much weaker in Britain than in the United States? This is not something that can be explained by a superficial comparison of the components of GDP. Keynesian economists tend to focus on the role of fiscal stimulus, yet this does not provide a satisfactory explanation of the different performance of the two economies. There has been much blame heaped on the coalition government for its strategy of austerity. However, the UK’s fiscal strategy has been less restrictive than that of the US when measured by the rate of narrowing of the budget deficit. In short, the US budget deficit has narrowed more, yet real GDP growth has been clearly superior to that in the UK. The explanation must lie elsewhere.

The evidence suggests several more fundamental factors that differentiate US and UK performance – namely the vastly greater leveraging up of Britain’s banks during the bubble, the relative failure of the British government’s measures to restore the health of the banks, and the more adverse consequences for the economy of British bank deleveraging. Ironically, the British government led the way in recapitalising the banks in the wake of the Lehman crisis, only to lose its lead to the US after the US Treasury’s Troubled Assets Relief Programme (TARP) was adjusted to focus primarily on repairing the balance sheets of the banks.

In the United States, the total debt of all domestic sectors (household, non-financial corporations, financial corporations and government) has declined from 311% of GDP in 2009 Q1 to 255% in 2012 Q3, a decline of 56 percentage points. In Britain, by contrast, total debt of all corresponding sectors has declined only about half as much. From a higher absolute peak of 561% of GDP in 2010 Q1, UK total debt has declined to 529% of GDP in 2012 Q3, a decline of 31 percentage points. Basically, this means British households and institutions are having more difficulty repairing balance sheets than their American counterparts. Is it possible to pin-point the differences?

Drilling down into the debt ratios for individual sectors shows that both the household and the non-financial corporate sectors in Britain are lagging in their balance sheet repair. However, the major problem is in the UK financial sector. This is partly on account of its larger size relative to GDP, partly on account of British banks’ high dependence on non-deposit financing (such as inter-bank borrowing and debt issues) during the credit bubble of 2003 to 2008, but also due to the adverse impact of financial sector deleveraging on the economy. Given the amount of balance sheet contraction that has been required of the banks, partly from regulatory pressure, and partly stemming from their own shareholders, creditors and customers, it was inevitable that banks should pass on the effects of deleveraging in the form of reduced lending and the imposition of tighter credit conditions to households and businesses.

Just as there was a positive feedback loop in the financial sector during the bubble which meant that rising asset prices created more collateral for banks to lend against, so in the current de-leveraging phase a negative feedback loop has operated whereby lower asset prices and tighter credit standards have reduced the amount that banks are willing to lend. Above and beyond all of this, the British government’s early measures to restore the health of the banking system were far less effective than the measures taken by the US authorities.

The process of US bank rehabilitation consisted essentially of four main elements. First there was greater attention to restoring capital levels: the US Treasury and the Federal Deposit Insurance Corporation (FDIC) required immediate recapitalisation by all banks, much of it directly from the government in the form of preference shares, but some of it from market sources. Second, this was quickly followed by a series of demanding stress tests and further rounds of capital-raising where necessary. Third, the FDIC required the banks to take substantial write-downs against toxic loans, and to take back ‘on balance sheet’ at least $400 billion of securitised loans, cleaning up their balance sheets by late 2010. Finally, the US Federal Reserve provided large amounts of additional liquidity by means of its QE operations, pushing banks’ excess reserves to $1.2 trillion by February 2010. In short, capital levels were greatly increased, loans were reduced, balance sheets were cleaned up, and liquidity enhanced. The net result was that US banks were able to embark on new lending by March 2011. Indeed, US bank lending has been growing at roughly 4% per annum since then – in marked contrast to the UK or the Eurozone where bank lending is still declining.

An additional factor that operated in the US but was not present in the UK was that the US banks were able to rely on the guarantees of the two giant nationalised housing agencies, Fannie Mae and Freddie Mac, which have served as an additional shock absorber for the mortgage portfolios of the US banking system.

In Britain, the successive shock failures of Northern Rock, then RBS and HBOS seemed to paralyse the government and the Financial Services Authority (FSA). Instead of forcefully taking them over in their entirety or insisting on some minimum level of systemic recapitalisation for all the banks, things were handled on a non-systemic, case-by-case basis. A systemic approach seemed beyond reach, either because the government had already shot its bolt with its very large current spending at the onset of the crisis, or because the amounts of capital required would have threatened the government’s AAA credit rating. In any event some banks, such as Barclays, were permitted to seek external sources of capital, while others like HSBC did not have to raise capital at all. The stress tests conducted by the European Banking Authority (EBA) in Europe and the UK were widely regarded as noticeably more lenient than those conducted in the US, and the extent of loan losses imposed was much less damaging to banks’ balance sheets. Consequently UK banks remained more leveraged and with less robust balance sheets than their US counterparts.

As an example of the consequences of this different treatment of the banks in the UK, consider the results of their reliance on non-deposit funding. At the peak of the bubble in early 2009, banks were funding an astonishing £760 billion or 55% of GDP from non-deposit sources. The subsequent withdrawal of these non-deposit sources by wholesale, domestic or foreign, lenders is inevitably forcing banks to deleverage – either by reducing their lending, or by selling their subsidiaries, whether core or non-core businesses. Based on the latest data, bank lending that is funded from non-deposit sources was still £184 billion in December, or 10.8% of GDP in 2012 Q3. This means that the British economy and the British banks, in particular, still have further to deleverage before they can start to expand again without relying on leverage.

In view of this challenging backdrop, it is appropriate for the Bank of England to keep Bank Rate at ½% and for it to continue to provide additional liquidity as necessary in the form of QE operations if, and when, money and credit threaten to become too tight in quantitative terms.

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

Monetary growth, the housing market and survey evidence point towards a muted recovery in 2013. Consequently, there is probably no need currently to adjust QE or interest rates. Any tightening in interest rates risks a further weakness in Britain’s broad money supply at present. The argument for a tightening based on the misallocation of resources under QE is a tempting one. However, an immediate rate rise could prove counterproductive. This is because a higher Bank Rate could reduce the broad money supply, which would hasten the need for an offsetting, and economically distorting, expansion in QE in turn.

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

The British economy has, as expected, been downgraded from AAA status – first by Moody’s. Moody’s key driver for this decision – the poor medium-term growth outlook for the UK – is entirely correct. Most discussion of growth policy in the UK is highly confused. Monetary and fiscal policy can move growth around in time, so as to achieve the country-wide equivalent of household consumption smoothing, limiting recessions in exchange for lesser booms.

However, we need to recall the old truth that it is only supply-side and structural reforms that can increase medium-term growth rates, not government borrowing or loose monetary policy. That is the central lesson of macroeconomics of the past forty years, and yet people forget it so easily: if we have a medium-term growth problem we cannot solve it with fiscal or monetary stimulus, since neither fiscal nor monetary policy can increase medium-term growth; they can only reduce it if they are done to excess.

Monetary policy has passed that point of excess. Remarkably, at the last MPC meeting three members voted to increase QE even though the Bank itself forecast inflation to be far above target for years – illustrating how little the inflation target constrains policy any more. MPC members have stopped even pretending that their decisions to print extra money are driven by the need to avoid inflation falling below target several years hence in some model that systematically under-predicts actual inflation. Now they are content to vote for even more inflationary measures when they themselves say inflation will be above target.

Monetary policy is a powerful short-term tool. It can limit damage during the first eighteen months of a severe recession. It can limit the peaks and troughs of more normal and gentle cycles. It can prevent inflation running away. What it cannot do is to create medium-term growth.

Interest rates were cut to near-zero in late 2008 and early 2009. Good. We started printing money from early 2009. Excellent! But at some point any serious economist should accept that monetary looseness has had its go and must make way for longer-term policies. Six years into the financial crisis, and four years into zero rates and quantitative easing, it is surely reasonable to ask whether the short term has now turned into the medium term.

To put the point the other way around: almost everyone is agreed that current policy is not working, and many say it’s time to try something else. We have tried the path of ‘über’-looseness and it did not work. Might we not, whilst there is yet time to try something else, try the path of merely extreme-looseness, tightening a little to see if it helps?

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

It should be reasonably clear by now that the UK has slow growth for ‘fundamental’ or ‘supply-side’ reasons. First, the huge rise in raw material prices has impoverished us. Since the Bank of England has done little to stop this raw material inflation passing through into consumer prices, a rough measure of how much living standards have been driven down as a result is provided by the cumulated excess of inflation over the 2% target since 2006. This will be 7% up to the end of this year on the assumption that inflation averages 2.8% in 2013. The hike in raw material costs is probably the biggest element in causing the drop in real income; an adverse movement of this size in the terms of trade is just like a fall in productivity. Essentially, it means that, for the economy not to spend permanently more than its income, spending must drop by this amount. Notice that this cannot be offset by higher demand from government, say, because it is permanent; any attempt to do so would lead to excess international borrowing and hence solvency problems.

Along with this, there is a consequent fall in output, as permanently lower demand deprives various home-focused industries of their market: housing is the most obvious but other industries particularly affected by high material costs are also hit, notably transportation and travel. Hence we notice that certain sectors, such as volume cars and house building, have great excess capacity. However, since demand cannot be stimulated in a general way, this excess is ‘structural’ and has to be disposed of by accelerated depreciation. This is no doubt why measures of relevant ‘excess capacity’ (i.e., in sectors where there has not been the same structural collapse) are small.

Then, we come to the collapse of the UK’s two most productive sectors, North Sea oil and banking. This collapse appears to account for the bulk of the fall in labour productivity since the crisis. Both collapses were partly due to circumstances – with the North Sea, it was the exhaustion of extractable reserves and with banking, the crisis itself – and were partly due to government actions. With the North Sea our governments have been ‘time-inconsistent’, constantly changing the rules to squeeze extra income out of the industry; the extractive oil and gas industry no longer has much confidence that any further exploration/extraction efforts will not be milked by HM Treasury. With banking, the Coalition government has, as I have argued repeatedly, over-reacted in its new regulative agenda while also failing to restore bank competition; hence the industry is contracting sharply. This was an avoidable disaster.

Finally, we come to the main side-effect of the banking collapse – the fatal blocking of the credit channel. This is another ‘structural’ element in our economic situation which is turning out to be non-remediable by monetary means; no amount of QE and bureaucratic schemes like FLS has loosened this constraint because the regulations create massive incentives for bank contraction.

So, like it or not, our situation is one of weak growth forced on us by fundamental constraints. Only supply-side action can change this situation. Apologists for ‘demand stimulus’ argue that the government could spend more on infrastructure, which is true as borrowing against good long-term projects is not difficult and does not undermine solvency. However infrastructure projects are held up by planning and political hurdles, not particularly by lack of funds. Other apologists point to the effect of the Second World War in stimulating output. Of course, a war changes an economy’s structure towards the production of armaments and military consumption, and a one-industry state can commandeer the means of production and force them to operate at high capacity; but in peacetime the economy is diverse and structural/supply-side issues have to be solved by peacetime policies to get the resources into the right places and permit growth based on market forces.

Where does this leave monetary policy? The answer is in a difficult place. QE and ultra-low interest rates are doing nothing to change growth, as one would expect. They are in fact massively distorting the market for savings by creating a privileged borrower, HM Treasury, at the expense of those committed to lending to it (e.g., for pension reasons). They are also subsidising bank profits on their existing balance sheet by giving banks a large arbitrage profit on the bank reserves produced by QE. Through this subsidy the present policy is distorting credit supply in favour of large existing firms, which seem like ‘zombies’ to be on bank life-support. It is time to put an end to these distortions and return to a realistic monetary policy that understands its limited capability.

If the government wants to stimulate money and credit, then it should look to the serious loosening of the new regulative framework and also a renewed push for bank competition, perhaps by break-ups of the large Treasury bank holdings into several smaller banks. In my view, the ring-fencing debate is an irrelevancy and an intrusion into industrial structure – the banks have argued persuasively that they need to be able to fulfil multiple functions. What matters is the number of banks and the competition they engender, which has been curbed sharply by the new cartelised set-up. Of course if the government did succeed in this loosening up, the huge overhang of QE would be an inflationary threat as existing bank reserves would be rapidly converted into credit expansion. Far better therefore to unwind this programme while there is still no threat, because the banks are immobilised by regulation. In summary, I recommend a rise in interest rates by ½%, no further QE, and a programme to unwind QE, while raising rates to normal levels, over the next two years.

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

With the UK Budget scheduled for 20th March and something of an inter-regnum in place at the Bank of England until Mark Carney takes over on 1st July, it is most unlikely that Bank Rate will be altered when the MPC meets on 7th March. In addition, it is improbable – albeit, possible – that any substantial new QE initiative will be announced, either. This does not mean that a rate rise might not be desirable on economic grounds simply that it is unlikely to happen. An interesting aspect of the MPC minutes, published on 20th February, was the sign that officials were already anticipating the more activist monetary stance believed to be preferred by the incoming Governor. This clearly helps to smooth the transition. It is possible that Sir Mervyn King’s unexpected vote for an extra £25bn of QE in February reflected the discussions that he had been having with his successor. Given that a well-run monetary policy should minimise the shocks it delivers to the real economy, this would all be very reasonable and civilised if that is what actually transpired.

Such civilised niceties should not be allowed to disguise the fact that UK fiscal policy is now massively – and, humiliatingly for Mr Osborne – off course and that British policy makers are losing their credibility in the financial markets, as can be seen from the decision by the Moody’s rating agency to withdraw Britain’s AAA rating. One result is that a 1976 style stabilisation crisis can no longer be ruled out, particularly as we draw closer to the 2015 general election date and the prospect of a Labour government or a Labour/Lib-Dem Coalition. For anyone who remembers that period, there are aspects of the current UK economic conjuncture that are reminiscent of the policy errors of the mid 1960s and early 1970s that culminated in the December 1976 International Monetary Fund (IMF) bail out of the British economy. First, the groundwork for the mid 1970s crisis was laid because the supply performance of the economy was severely damaged by the more than 10 percentage point increase in the share of government expenditure in GDP under the 1964 to 1970 Labour government, just as it has been by the broadly similar rise between 2000 and 2010. Second, in both cases, the growth of potential real GDP collapsed to some 1% to 1½% per annum because of the ‘crowding out’ – particularly, of private investment – that resulted. However, the authorities failed to adjust their policies accordingly, ran an unduly lax monetary policy and created stagflation, not growth. Third, between 1970 and early 1974 an ineffectual Conservative administration then tried to use a Keynesian demand stimulus to boost the economy, in which they were aided and abetted by a central bank which was politically subservient and intellectually soft on inflation. Finally, and following the humiliating collapse of the Conservative Heath administration in February 1974, the new Labour government let public spending rip, ignored rising inflation and the deteriorating trade deficit, aggressively raised taxes, and piled populist intervention upon intervention, until the markets finally lost patience.

One important difference with this earlier period is that the recent growth of broad money and credit has tended to be too low because of a misguided and pro-cyclical regulatory tightening, whereas the mid-1970s still suffered from the monetary overhang build up in the earlier Heath-Barber credit boom. However, accelerating inflation can result from a collapse in the exchange rate in a small, open and trade-dependent economy such as Britain’s. Furthermore, higher inflation does not have to be validated by a faster monetary expansion if the real exchange rate falls. The real exchange rate can tumble out of bed because the perceived post-tax rate return on human, physical and financial capital is reduced – perhaps as a result of higher taxes or populist anti-business rhetoric – or if the markets lose faith in the competence with which the economy is managed. The present Governor seems to believe that a weaker pound is necessary to re-balance the economy and to stimulate private demand. However, it is by no means certain that a weaker pound is indeed stimulatory. Whether or not currency depreciation boosts activity is essentially a quantitative question that depends on the deeper structure of the economy and the precise values of certain key parameters. A lower exchange rate will increases activity if: 1) the price elasticities of demand for exports and imports are high; 2) the pass through from the exchange rate to domestic prices is partial and slow; 3) higher inflation does not provoke adverse feedbacks, such as a rise in the savings ratio, and 4) there is ample spare capacity in the sector of the economy that engages in international trade. The Bank has published remarkably little research as to whether these conditions are currently satisfied. Instead, official rhetoric sometimes appears to be re-cycling a warmed up version of 1960s Cambridge Keynesianism, which implicitly assumed that these conditions held.

Unfortunately, it is no longer possible to examine the properties of a wide range of UK macroeconomic forecasting models to see how far these conditions are satisfied, as one could have done twenty or thirty years ago. Indeed, we are still waiting for details of the Bank’s new forecasting model COMPASS to be published, although that is promised to happen in the next few months. For what they are worth, the properties of the current version of the Beacon Economic Forecasting (BEF) macroeconomic model suggest that: 1) competiveness elasticities have fallen sharply and consistently in recent decades and may now be zero in the case of imports; 2) the pass through from the exchange rate to domestic prices is eventually 100%, and 3) higher inflation reduces activity through a range of mechanisms. That high and variable inflation reduces growth has also been found in international panel data studies, which try to explain the long run growth performance of a set of countries, and also in much of the empirical work published in the 1970s and early 1980s. The Bank’s apparent belief that higher inflation is positively associated with stronger activity appears to have forgotten this earlier research, which generally indicated the opposite. Finally, one must have reservations as to whether an economy with some 5½ million government employees and some 2½ million working in manufacturing – which is the current British situation – has the same capacity to increase output in response to a lower exchange rate as one with 3¾ million government employees and 7¾ million in manufacturing, which was the UK situation in the mid-1960s, for example.

As far as the forthcoming 20th March Budget is concerned, “sufficient unto the day is the evil thereof” applies. However, it needs emphasising that, in terms of the fiscal stabilisation literature, all that Mr Osborne has attempted has been a ‘timorous Type 2’ fiscal consolidation programme, in which tax increases have been front-end loaded, public investment has been cut, and current government expenditure and welfare costs allowed to rise. There exist countless international studies showing that Type 2 packages lead to unexpected output weakness and a worsened fiscal position. One can only despair at either the quality of the advice that the Chancellor has been receiving, or his willingness to listen to it. In contrast, a ‘bold Type 1’ package of tax cuts, public consumption reductions, tight control of welfare bills and no public investment cuts – which the Conservatives should have prepared while in opposition and then implemented immediately – is normally associated with positive output surprises, reduced joblessness and an improved fiscal position.

However, before giving up in despair it is worth noting four chinks of light penetrating the gloom. The first is the recent strength of world equity markets, which might be regarded as a longer-leading indicator of the economy. Some central bankers have expressed concern that this development represents a return to bubble conditions. However, the normal monetary transmission mechanism is for financial markets to respond first to monetary stimulus, and then commodity prices, before activity picks up and eventually inflation at the end of the process. The second has been the consistent acceleration in the growth of the M4ex broad money measure from 1.5% in December 2011 to 5.2% in December 2012. This development could be derailed easily by ill-considered regulatory interventions. However, if the acceleration continued much further, there could be concern about its longer-term inflationary consequences. Third, there has been the parallel and linked turn round in the housing market, with the Office for National Statistics (ONS) house price index declining by 0.4% in the year to December 2011 but rising by 3.3% in the year to December 2012. Finally, there has been the continued decline in both official measures of joblessness. This development may encourage consumer confidence, even if it is hard to reconcile with the ONS growth figures.

As far as the March Bank Rate decision is concerned, the breakdown of fiscal discipline, the recent weakness of sterling, the faltering market confidence in UK policy making, and the likelihood that higher inflation reduces activity, suggest that it is time to introduce a ½% hike in Bank Rate. This is not because of any economic effects that it might have, which would be small, but in order to demonstrate that the Bank of England has not just become a supine underwriter of fiscal profligacy. A second reason to raise Bank Rate is to head off the possibility of a major run on the pound developing because speculators would no longer face a one-way bet after a rate rise if they short sold sterling. The stock of QE should be left where it is for the time being and only added to if broad monetary growth threatened to nosedive, perhaps as a result of renewed problems in the Euro-zone. Because recent UK inflation overshoots have probably reduced economic activity, it is now time to say enough is enough. The Bank of England should act with the same counter-inflationary resolve as the pre-EMU Bundesbank would have done under current circumstances and not as it did itself in the 1960s and 1970s when Britain was reduced to the ‘sick man of Europe’.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

UK monetary policy has been thrown into even greater disarray, if that were possible, by speculation over impending changes in HM Treasury’s remit to the Bank of England, hints that incoming governor Mark Carney will alter the substance and style of policy and the news that the present Governor voted with a minority to raise the amount of QE to £400bn. The side effects of these developments, especially their impact on overseas holders of Sterling, are unequivocally bad for inflation outcomes. The latest Bank of England Inflation Report contains a notably downbeat inflation assessment and Martin Weale’s balance of payments speech spells out the risks of external inflation.

While there may be some glimmers of hope regarding UK output and export volumes for the year ahead, these remain vulnerable to the resumption of debt hostilities in the Euro area and the potential for disappointment regarding the FLS. Nevertheless, with a more stable demand outlook than seemed possible a few months ago, the time to begin the normalisation of Bank Rate is now. It would serve the added purpose of rebutting the charge that the Bank of England has forsaken its responsibility to preserve sound money. There remain four months before Mark Carney arrives. This is far too long an interval to allow the weak Sterling trend to go unanswered.

The Bank of England must not lose sight of its goal of normalising short-term interest rates. Running policy on the basis of a permanent emergency is sending a depressing message to the entrepreneurial sector. If there is a role for ‘forward guidance’, it is to reassure of the Bank’s determination to take rates back to the region of 2% to 2½% over the next two years, beginning with a move to ¾% immediately.

The suggestion that the Bank should consider the purchase of other assets besides gilts is worth pursuing. The Bank of England could learn from the experience of the Bank of Japan, that relatively small purchases of private sector assets – for example commercial property, exchange-traded equity funds and commercial paper – could have potentially more powerful effects on the real economy and business confidence than further huge purchases of government debt. At the same time, the gradual withdrawal of Bank funding of the budget deficit would help to discipline fiscal policy.

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

So far this year, the economic data in the UK have continued to be broadly flat: some indicators have pointed to faster growth others to slower. There is as yet no decisive trend suggesting a sustained recovery is underway. That said the economy will probably grow this year compared with last but only a lacklustre recovery, with growth close to 1%, seems on the cards at present. It is not a recovery that leaves the MPC comfortable that enough has been done, if the minutes of the February meeting are anything to go by. Clearly, it has also left the rating service Moody’s uncomfortable as it cited weaker growth than expected at this stage of the recovery as the principal reason for the decision to downgrade the UK’s credit rating from AAA to AA1. That having been said, the downgrade was not a huge surprise and probably means very little for the UK’s cost of borrowing. After all, official borrowing costs have remained low in the US and France – which is, probably, the better example for the UK – even after they were downgraded.

However, the MPC still appears comfortable with the prospect of inflation remaining above the 2% target until 2015. We know this because they said so. The voting at the February meeting showed that Governor King and Paul Fisher joined with David Miles in wanting more QE but these three were outvoted by the six other members of the Committee. This suggests that the biggest concern for the three is economic growth (is there more bad news in the forthcoming data that they are aware of?) and that even above target inflation would be accepted. Actually, the minutes showed that the whole MPC accepted above-target inflation, but the three dissenters wanted further easing now, implying a greater willingness to risk inflation for growth. Of course, their view is that inflation will eventually fall below target, if no action is taken now to boost the economy. In other words, that there can ultimately be no long lasting inflation threat if growth stays weak. For now, the financial markets have accepted this, although inflation expectations are creeping up.

To some extent this is borne out by the latest labour market data, which showed wage inflation of just 1.4% in the year to December. With consumer price inflation running at 2.7% this implies a drop in real pay of 1.3%. If there is sustained consumer price inflation, it certainly seems unlikely that it will be of the cost-push variety. However, producer price inflation did come in higher than expected, with the usual suspects of higher food prices and utility charges to blame. Meanwhile, manufacturing shows only a modest recovery and retail sales continue to struggle, though UK automobile sales remain remarkably resilient.

Claimant count unemployment fell by 12,500 in January (with December’s fall revised to 15,800 from 12,100). The Labour Force Survey (LFS) measure of employment surged again, and was up by 154 thousand in the fourth quarter of last year. With GDP contracting again in 2012 Q4 this suggests that the UK productivity puzzle – i.e., why it has remained so sluggish – continues. The softening in annual earnings growth to 1.4% on a headline basis in the three months ending in December is consistent with weak productivity gains. The problem is that weak productivity is consistent with weak growth, so how to break the link? Perhaps the Budget on 20th March may have something to say on that score.

My vote is for keeping interest rate at ½% and QE at £375bn for now, but with a bias to ease via more QE but with more variety in the assets being purchased. If economic activity weakens further - or shows no signs of recovering - economic growth in the first quarter of this year looks like it will be around plus ¼% or so, based on data from the latest Lloyds Bank Commercial banking's business survey. If this growth projection still holds as more data for 2013 Q1 are released, it may not be enough for the MPC. After the action from Moody’s, they may be even more willing to try to boost the economy than before. 

What is the SMPC?

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

Current SMPC membership

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

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 15th January, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be raised on Thursday 7th February.

Four SMPC members wanting an increase of ¼%, while two advocated a rise of ½%, implying a rise of ¼% on normal Bank of England voting procedures. The recommendation of a rate rise in February was the first time since September 2011 that a majority of the SMPC had voted in favour of higher interest rates.

One reason was that fiscal policy seemed even further off course than was previously believed, and risked damaging the credibility of all UK policy making. Another was that the lull in the storms engulfing the Euro-zone provided an opportunity to raise Bank Rate while the markets were still reasonably calm.

However, there were also some noticeable intellectual differences between the SMPC majority, who wanted a rate rise, and the approach more commonly favoured by UK policy makers and the financial media. In particular, it was believed that the almost unprecedented degree of government intervention in the UK economy in recent years was leading to major problems with aggregate supply and preventing the re-allocation of resources from Zombie sectors to those with genuine growth potential. It was also feared that sustained artificially low interest rates were leading to a growth-destroying misallocation of capital.

However, three SMPC members believed that there was a genuine demand shortfall, which would be alleviated by additional monetary stimulus. Most SMPC members thought that there should be no additional Quantitative Easing (QE) for the time being, however.

Minutes of the meeting of 15th January 2013Attendance: Phillip Booth (IEA Observer), Roger Bootle, Jamie Dannhauser, Anthony J Evans, Graeme Leach, Andrew Lilico, Kent Matthews (Secretary), Patrick Minford, David B Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.
Apologies: Tim Congdon, John Greenwood, David H Smith (Sunday Times Observer), Mike Wickens.
Chairman’s introductory comments

The Chairman commenced the gathering by recording the thanks of the Committee for the contribution made by the retiring SMPC member, Ruth Lea, over many years. He then welcomed the newest recruit Graeme Leach, Chief Economist of the Institute of Directors, to his first physical meeting of the Committee. As there were eleven members in attendance, the Chairman announced that the comments of members that arrived after the first nine turned up would be recorded but not counted for the final rate recommendation. This followed the precedent of the rare previous meetings when the gathering had been super-quorate. The ’extra’ pair of comments and votes have not been ‘lost’, however, but are recorded in full in the Appendix to the main vote. The Chairman then invited Andrew Lilico to give his assessment of the global and domestic monetary situation.

Economic Situation

Andrew Lilico started his presentation by listing the risks faced by the different economic blocks that made up the world economy, beginning with the USA. The risk facing the USA was that the present activist stimulus policy could generate only a temporary expansionary effect, followed by inflation. The risks confronting the British economy included a small likelihood of a gilts crisis and the loss of its AAA rating. The Euro-zone crisis remained in the wings. Looking further afield, the risks of higher inflation in China, and of an oil crisis arising from geo-political tensions, were ever present. Last year had been a poor one for the Euro area and the outlook remained flat. Furthermore, the developing and emerging economies had not been unaffected by the weakness of the developed economies. The leading indicators compiled by the Organisation for Economic Co-operation and Development (OECD) had signalled positive for the UK and USA but less so for China and the Euro-zone.

There followed a short discussion about the fiscal situation. This had been initiated by Phillip Booth asking about the projections for the US economy. David B Smith said that the rise in the share of the general government sector in US GDP to over 40% – i.e., what used to be considered European social-democratic levels – would almost certainly have impaired America’s long term growth. He added that the ‘big government’ policies of George W Bush and President Obama may have had a qualitatively similar – but smaller – impact on America’s supply side to Gordon Brown’s policies in Britain. However, Graeme Leach, Trevor Williams and Andrew Lilico were more sanguine about US long-term growth prospects citing: the political deal with the Republicans, who will be looking for spending cuts; the utilisation of shale gas, and the resurgence in US manufacturing productivity.

Resuming his presentation, Andrew Lilico stated that broad money growth had weakened in the USA and China but had picked up in the Euro area and Britain. UK GDP grew in 2012 Q3 but may have contracted in the final quarter of last year (Editorial Note: the ‘flash’ output based measure of fourth quarter real GDP, released on 25th January showed a quarter-on-quarter decline of 0.3% but no change on the year-on-year comparison). The Bank of England’s central projection for GDP was that it would not regain its 2007 peak until 2014/15.

Since the first violation of the inflation target in March 2007, the price level had risen 8.4% above the level that would have prevailed if the 2% target had been continuously met. Nevertheless, the Bank of England continued to project easing inflationary pressure based on current interest rates and £375bn of QE.

Andrew Lilico went on to present his analysis of the economy in the context of the Wicksellian theme of the natural rate of interest (Editorial Note: Knut Wicksell, 1851 to 1926, was a pioneering Swedish monetary economist).

Interest rates below the natural rate were good for growth in the short run but bad for growth in the long run because of the misallocation of capital that resulted (i.e., so-called ‘mal-investment’). Interest rates had been near zero for almost four years now and there had been further stimulus from QE. At some point, the long-run negatives would outweigh the short-run positives arising from the current ultra-lax monetary stance where the world economy was concerned. QE had boosted the demand for bank reserves. However, this had not been translated into an increase in bank lending. Commercial banks were prepared to lend at low rates to existing business customers – in effect, this was a strategy of ‘gambling for resurrection’ where Zombie companies were concerned – while new and viable businesses had to bear higher rates. This lending priority: first, created a competitive distortion; and, second, led to a misallocation of capital towards areas where its productivity was lowest.

In summary, the policy challenge was to raise the long-term growth rate, not just to recover from a temporary recession. Monetary policy had run its course. This meant that the objective had to be to normalise interest rates in periods of market calm, in Andrew Lilico’s opinion. While recent Euro-zone developments had led to a calming of markets, a rise in Bank Rate of ½% immediately, followed by later rises would not be inappropriate.

Discussion

The Chairman thanked Andrew Lilico for his thorough and thought-provoking presentation. He then asked Roger Bootle and Patrick Minford to make their respective comments there and then as he was aware that they both had to leave early. Roger Bootle then said that he had not heard a cogent argument as to how supply-side policies would get translated into consumer demand. Andrew Lilico and others said that an increase in aggregate supply would work through expected future income, which was a standard transmission mechanism in New Keynesian models. Patrick Minford added that, after four years, it was hard to continue to label the state of the economy as a lack of demand.

Roger Bootle said that four years needed to be compared with the length of the Great Depression of the 1930s which lasted nearly a decade. As to the fall in potential GDP, he agreed that this may have occurred but it was a question of degree. To argue that it was all a matter of the supply-side was a mistake. He said that he had never believed that QE would create growth. The alternatives he mentioned were that that the exchange rate should be lower but not a precipitous decline that would endanger a collapse. The Funding for Lending Scheme (FLS) may yet have some effect.

Akos Valentinyi said that the interventionist policy of the Roosevelt government delayed the recovery in the USA in the 1930s. Recovery may well have come sooner in the absence of the New Deal. Jamie Dannhauser disagreed and said that he had a lot of sympathy for Roger Bootle’s position. He added that the micro evidence did not support a supply side interpretation. Both supply and demand were interrelated. Demand could come from corporate investment and exports. Roger Bootle said that, if the 1930s was not a situation of weak demand, he asked why the Second World War created demand. Philip Booth said that the comparison of a wartime economy with a functioning market economy was inappropriate.

Kent Matthews added that a study of the Roosevelt Works Progress Administration programme in the 1930s by Dan Benjamin and himself, published by the Institute of Economic Affairs (IEA) as a Hobart pamphlet in 1992, reported research that showed that for every ten jobs created by government intervention in the New Deal, nine jobs were destroyed in the private sector. In a similar way, Bank intervention in keeping rates so low for so long was probably creating more harm than good. David B Smith added that it was worth bearing in mind that the British experience in the 1930s had been very different to that of the US. Since he had recently published an article on the subject (Britain in the 1930s: Lessons for Today, in B & O, The Quarterly Journal of the Economic Research Council, Summer 2012, Volume 42 No. 2, www.ercouncil.org) he would not comment further, apart from noting that the draconian fiscal discipline of the time, which saw a rise in the constant employment budget surplus to a peak of some 4.2% of GDP in 1933, was quite consistent with an average growth in real GDP of 4¼% per annum between 1933 and 1937. If only we were so fortunate today.

Kent Matthews next proposed that Andrew Lilico’s analysis of the relative ease with which insiders and outsiders had access to bank credit fitted the facts. A recent report by Deloitte suggested that the number of Zombie companies being kept alive by low interest rates and available credit could be as high as one-in-ten. These insider borrowers were kept alive by banks that were afraid to ‘pull the plug’ for fear of the negative outcome of accepting the resultant write offs on their balance sheets. The other side of the coin was that new credit was not being granted to viable companies, except at high interest rates and tough collateral conditions. In the case of insiders, risk was being ‘under-priced’ whereas it was ‘overpriced’ for outsiders. Recessions normally lead to a clear-out of unprofitable companies through the Schumpeterian process of ‘creative destruction’. However, this can only work if credit markets were well functioning. Exceptionally low interest rates for this length of time work against the process of efficient credit allocation and acted as a hindrance to a natural recovery.

Having already taken the votes of Roger Bootle and Patrick Minford, the Chairman stated that it was now time to go round the table and record everybody else’s votes. These are listed in their customary alphabetical order below. As Kent Matthews and Roger Bootle were the last to arrive the Chairman ruled, in line with established SMPC practice, that these two would have their views recorded but their vote discounted. To avoid confusion, these two comments are set out in an Appendix.

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

Jamie Dannhauser said that he had no disagreement with the supply-side arguments that called for greater deregulation. These arguments had merit. Nevertheless, it was a question of balance. The danger was that the economy sleep walked into a Japanese state of long-run minimal growth. Jamie Dannhauser added that it would be better to err on the side of a more aggressive monetary stance and, possibly, ease further, employing more and wider QE beyond gilt purchases. He said that the dominant risk was the Euro-zone crisis. QE would have worked if it had not been for the uncertainty created by the events in Continental Europe. What was needed now was wider, and marginally more, QE.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%.
Bias: No further QE; raise Bank Rate further as the opportunity arises.

Anthony J Evans said that he did not believe central banks were out of ammunition and there was more that they could do to loosen the monetary stance. Nevertheless, the risk was that additional intervention would be more likely to make things worse rather than better. The existing low interest rate policy was causing damage and rates should not be kept low indefinitely. Central bank activism had failed because policymakers had failed to lift expectations – it was better to threaten a loose policy but actually keep it neutral, than it was to forecast low growth and keep it loose. In his opinion, the Bank of England should not do any more QE. Anthony J Evans concluded that interest rates should be moved towards the natural rate and that the current situation presented a window of opportunity to do so. He voted to raise Bank Rate and had a bias towards further increases.

Comment by Graeme Leach
(Institute of Directors)
Vote: Hold Bank Rate and hold QE.
Bias: Neutral on Bank Rate but maintain additional QE available as a contingency measure if Euro crisis worsens.

Graeme Leach said that the economy seemed to be condemned to a low growth scenario due to supply-side influences and in particular the size of the state, which was undermining potential GDP growth. Whilst there was scope to support demand through further QE, he argued that any decision to further boost QE should await clearer numbers as to the sustainability of the slight improvement in broad money growth on the M4eX measure seen towards the end of 2012. He also stated that a significant expansion in QE was almost inevitable at some stage over the next twelve months, in view of the high probability of a further flare up in the Euro crisis.

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

Andrew Lilico said that the Bank of England could generate a temporary expansion through an easy monetary stance but that this would be followed by higher inflation. Monetary policy had to be rebalanced and the interest rate should be allowed to revert to a higher Wicksellian norm. The rate of interest could not stay at the current level forever. The calm in the markets provided this window of opportunity for rates to rise.

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

Patrick Minford stated that he agreed with Andrew Lilico’s assessment. Money could not be used to systematically stimulate growth. The forthcoming Bank of England Governor, Mark Carney, had implied that more QE would be deployed and that the inflation target would be abandoned. Patrick Minford said that any abandonment of the inflation target would represent the worst kind of time inconsistency. He said that it was time to signal that monetary policy could not be used indefinitely to stimulate growth. He said that he was getting used to being a lone voice. He voted to raise Bank Rate to 1% immediately, followed by further rises in future months.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate by ¼%.
Bias: To raise Bank Rate further and hold QE.

David B Smith said that the economy was facing a macro supply-side contraction – fundamentally, this was caused by the massive increase in the public spending and regulatory burdens since 2000 – but also the culmination of a whole series of microeconomic problems. The recent spate of changes to the international environment, and the marked rise in energy costs since 2005, meant that many individual sectors of the economy, as well as specific companies, were now technically obsolescent. This was something that some household name retailers had recently found to their cost. However, the same argument applied to wider swathes of the UK economy. The implication was that resources needed to be reallocated rapidly from the Zombie economy to the sectors that had a future. This required a background of low regulation and frugal tax costs if the necessary flexibility was to be achieved. Unfortunately, the political process – as well as the commercial banks’ wish to keep bad debts off balance sheet – militated against the required re-allocation of productive resources to socially more useful ends.

In this situation, monetary policy was not a workable source of stimulus and neither was a conventional fiscal demand boost. The more he had examined the details of the December 2012 Autumn Statement, the worse things appeared. Despite his rhetoric to the contrary, Mr Osborne appeared to be acting in practice as the ‘son of Gordon Brown’, rather than the ‘anti-Brown’ that the economy needed. The Bank of England had lost all credibility and the yield on 2½% Consols – where yields had probably been less distorted by QE – had already broken upwards through 4% at the start of the year. Policy-induced nervousness was likely to see gilt yields rising further (and sterling weakening) and not necessarily in a controlled manner. A shakeout of the British government bond market looked particularly likely if the financial markets suspected that one reason for Mr Carney’s appointment was Mr Osborne’s desire to whip up an unsustainable credit boom before the 2015 general election. He said that a modest rise in Bank Rate was needed to signal a change in monetary stance to the market and that the monetary authorities were not simply supine accomplices to the breakdown of fiscal integrity. David B Smith voted to raise rates and to hold QE (subject to events in the Euro-zone) with a bias for further rises in Bank Rate until it was somewhere in the 2% to 3% range.

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

Akos Valentinyi said there were three sources of uncertainty that impinged on UK interest rate policy. The first was the Euro crisis; the second was domestic regulatory policy, and the third was US fiscal policy. He said that he believed monetary policy had run its course and keeping interest rates at the current level worsened the misallocation of capital. QE had distorted bond yields. He voted to raise rates with a bias to further increases.

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

With reference to the earlier discussion regarding the competing diagnoses of aggregate demand deficiency or supply-side bottlenecks, Peter Warburton argued that the UK economy suffered from a combination of both. Excessive credit growth in the global economy over a number of years had been accompanied by physical over-investment in some sectors, under-investment in others and mal-investment in yet others. Some industries faced structural over-capacity and were deliberately running down the capital stock, resulting in a lengthening of the median asset life. There was a suspicion that additional labour resources were being deployed to keep aging assets in operation. In other sectors, including energy, transport and food, there had been under-investment in the infrastructure and supply constraints were evident. A shortfall of demand in relation to productive capacity could just as well be read as a signal for supply to contract as for demand to expand. Certainly, with public expenditure representing such a large proportion of GDP, there could be no presumption that government should act to remedy a supposed demand deficiency. The size of the government sector lay beyond the range of effective counter-cyclical fiscal policy. It was highly probable that further additions to public current spending would have a negative impact on GDP.

Peter Warburton then added that QE, in terms of government bond purchases, should be thought of in global terms and not just nationally. The aggregation of QE in different countries had a pooled effect in the global bond market, rather than a ring-fenced effect in the national bond market. Peter Warburton said that he agreed with Jamie Dannhauser that there was a need to widen the scope of QE by extending it to other assets. However, this should not be through additional QE but by reallocating the existing stock of QE, perhaps up to £50bn, over a wider range of assets. The overall stock of QE should be increased only as a contingency. The Bank of England needed to learn from the experience of the Bank of Japan, that relatively small purchases of private sector assets – for example commercial property, exchange-traded equity funds and commercial paper – could have potentially more powerful effects on the real economy than huge purchases of gilts. At the same time, the removal of Bank funding of the budget deficit would help to discipline fiscal policy. On the basis that more could be done to leverage the Bank’s existing balance sheet size, he believed that it was time to revisit the normalisation of Bank Rate. He voted to raise Bank Rate with a bias towards further increases.

Comment by Trevor Williams
(Lloyds Bank Commercial Banking)
Vote: Hold. No further QE.
Bias: Neutral.

Trevor Williams said that a rise in the Bank Rate at this juncture would be a disaster. Households would be less likely to spend and corporations less likely to invest. In some sense, they had a ‘desired’ target in mind. So, if rates rose and debt payments went up, they would have to save more to make up the gap between desired saving and the actual. There were both demand and supply issues and ‘Minsky moments’ that were unfolding, according to Trevor Williams. The Bank of England could not do anything about Europe except to react. UK economic growth over the past five years had just been a smidgen better on average than that of Spain, despite the latter’s well documented problems. It was difficult to resolve all the problems that the British economy faced with interest rate policy alone, since many of these were structural and long term in nature. Public spending needed to be cut and the need for a rebalancing of policy remained an important issue in the medium term. While Trevor Williams felt that there should not be any further QE, for now, he believed that the Bank should continue with its efforts to reduce the cost of credit to small businesses. He said the Bank of England needed to think more creatively about monetary policy. He voted to keep interest rates on hold.

Policy response

1. On a vote of six to three, the IEA Shadow Monetary Policy Committee recommended a rise in Bank Rate in February.
2. There was disagreement as to the extent at which rates should rise. Two members wanted rates to rise by ½% – which would have been the traditional policy response in the past, when rates came down in quarters but rose in halves – while four said that rates should rise by ¼%. One reason for limiting the recommended rise to a ¼% was so as to avoid an undue shock to the financial markets after such a long period of stasis.
3. All those who voted to raise rates expressed a bias to raise rates further.
4. There was a general agreement that the delay in implementing Basle III was welcome because it allowed commercial banks more time to rearrange their balance sheets and made it less likely that there would be a damaging and internationally-synchronised reduction in the supplies of money and credit to the private sector.

Date of next meeting
16th April 2013.

Appendix to Main Vote

This appendix sets out the views of the two SMPC members who attended the gathering but did not have their views recorded in the main vote, because nine members had already arrived.

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

Roger Bootle said that monetary policy may have reached its limit however that was no argument for raising interest rates. UK demand was weak because of weak consumption. Therefore, he would have voted to maintain the rate of interest.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%. (Vote discounted)
Bias: To raise Bank Rate; additional QE to be used only if the Euro crisis re-emerged.

Kent Matthews said that QE was always available as a contingency if the Euro crisis flared up again, as it certainly would in due time. However, QE should not be used to bolster domestic monetary policy until then. A rise in the rate of interest would certainly cause pain in the short term but it was a necessary action for two reasons. First, it was necessary to signal to the market that monetary policy was being rebalanced towards some normal position that would create the conditions for the efficient allocation of credit and a natural recovery. Second, monetary policy would have no traction at interest rates already at near zero in the event of a terminal Euro-zone crisis. Correspondingly, Kent Matthews would have voted to raise rates and to hold QE as a contingency.

What is the SMPC?

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

Current SMPC membership

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

In its most recent e-mail poll, finalised on 31st December, the Shadow Monetary Policy Committee (SMPC) decided by seven votes to two that Bank Rate should be held at ½% on Thursday 10th January. One dissenter wanted to raise Bank Rate by ½%, while another desired an increase of ¼%. Most SMPC members thought that there should be no additional Quantitative Easing (QE), given that annual broad money growth had recently picked up to 4% to 4¼%.

However, additional QE might still be needed if this monetary acceleration went into reverse. More generally, unduly heavy handed financial regulation was seen as a major cause of the UK’s weak money and credit growth. Using QE to offset regulatory shocks was a roundabout and undesirable way of stabilising the monetary aggregates. Less intrusive regulation, and reduced QE, was a simpler and better course.

Several SMPC members expressed their disquiet about the fiscal weakness revealed in the 5th December Autumn Statement. This made an unpropitious background to the conduct of monetary policy. In addition, the rapidly diminishing credibility of the official fiscal projections made it difficult for the Bank of England to carry conviction, especially given its history of inflation overshoots.

With the volume of general government current expenditure in the third quarter of 2012 already 4.5% higher than the Chancellor had intended in 2010, it was also felt that Mr Osborne was already on ‘Plan G’ or ‘Plan H’, let alone the ‘Plan B’ advocated by Labour. Some SMPC members expressed reservations about the idea that nominal GDP targets should replace those for inflation. Nominal GDP targeting was a theoretically appealing concept but was likely to prove a nightmare to implement in practice.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate and pause QE.
Bias: Adjust Bank Rate and QE to achieve appropriate growth in broad money.

The UK’s M4ex broad money definition rose by 0.4% in October, the last month for which official money data are available at the time of writing (28th December). Over the six months to October, the annualized rate of growth of M4ex was 6.2%, clearly above the norm over the last five years of the Great Recession and its sequel. The relative strength of money growth in the recent past has owed much to QE, which might be regarded as artificial. All the same, the numbers are consistent with a marked easing of balance-sheet strains throughout the British economy. Late 2012 has not been an exciting time for the British economy but cyclical excitements are to be avoided. Share prices have moved ahead, the housing market has improved, London commercial real estate is quite active and companies’ expansion plans are not cash-constrained.

Retailers have reported a satisfactory Christmas, albeit with a continuing shift from the High Street to web-based suppliers. Even unemployment has been falling. Given a mildly favourable international background, the UK macroeconomic outlook for early 2013 is also mildly favourable.

The persistence of the budget deficit at extremely high levels is a sign of weak government, not of fundamental economic weakness. Nevertheless, it may lead to the loss of the UK’s triple-A credit rating. According to the Autumn Statement, ‘public sector net borrowing’ is to be £99bn in 2013/14, compared with £80bn in 2012/13. The rise in the deficit may be justified in Keynesian circles by the argument that aggregate demand will be stronger because of the rise in the budget deficit. However, there is no evidence whatsoever that – in recent decades in any major economy – the growth of demand has been positively correlated with changes in the cyclically-adjusted budget deficit, as the Keynesian argument requires.

It is now appropriate to make two brief comments on the international background. First, a great media hullabaloo about the USA’s ‘fiscal cliff’ seems to have persuaded some participants in financial markets that the US economy and, hence, a large part of the world economy may fall into another recession in 2013. May I simply repeat my observation in the last paragraph, that ‘there is no evidence whatsoever that – in recent decades in any major economy – the growth of demand has been positively correlated with changes in the cyclically-adjusted budget deficit, as the Keynesian argument requires’? Far more important to the US cyclical prospect are recent and imminent movements in key asset prices – i.e., the prices of real estate and quoted equity – and critical to these movements are the quantity of money, broadly-defined, and hence the behaviour of the banking system. Although the US banking system, like others in the G20 nations, is unfortunately subject to the misguided Basle III rules, US broad money is growing at present, if only slowly.

Moreover, the Conference Board’s leading indicator index is rising gently. In my opinion, US economic activity would be little affected in 2013 by a large fall in the Federal deficit. Furthermore, the USA’s financial image would be greatly enhanced by a big move back towards a balanced budget over the medium term.

Secondly, fears of a Eurozone rupture have abated since spring 2012, largely because Germany, in particular, has shown increased willingness to underwrite debt issuance in the Club Med countries. However, Eurozone break-up fears will probably return at about the time of the German elections in September 2013, when German taxpayers realize the scale of the contingent liabilities now being incurred to their potential cost and have the opportunity to pass judgement on the subject. More fundamentally, the trend rate of economic growth in the Eurozone (i.e., Western Europe without the UK, more or less) is now pitifully low, perhaps even indistinguishable from zero. This low or negligible trend growth rate will constrain the demand for the UK’s exports in 2013, but growth outside the EU – particularly in Asia – should revive after a rather mediocre 2012. Overall, the global outlook for UK companies, which are increasingly refocusing away from the EU, is fine.

My view on monetary policy is the same as at the end of November. There is no hurry to move to a higher level of short-term interest rates for the present, although I find it possible that I will be advocating a rise in interest rates in 2013. As ever, the overriding objective should be stable growth of the quantity of money at a low non-inflationary rate. QE has been paused, partly because of the slight upturn in broad money growth. However, the ‘monetary authorities’ (i.e., the Bank of England, the Treasury and the Debt Management Office as a Treasury agency) need at all times to coordinate the management of the public debt, so that the state’s transactions in public debt help in maintaining a low and stable rate of money growth.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Expansion of QE, including purchase of non-gilt assets.

The decision regarding additional monetary ease was a close call this month. UK output growth remains sluggish. Although the recent volatility in monthly data series makes it tricky to ascertain the underlying strength of demand and economic activity, there is scant evidence that the economy is doing anything other than bumping along the bottom. Certainly, output growth appears currently to be weaker than had been anticipated a few months ago.

Particularly discouraging were the latest revisions to UK GDP, which revealed a much larger contribution to third quarter output growth from inventory accumulation than was indicated previously. In addition, the level of nominal spending, which is a potentially more relevant variable for monetary policymakers, was revised down by 0.7%.

Looking ahead, puzzlingly strong construction output in October could imply a stronger (or more likely a less weak) headline reading for fourth-quarter GDP than many have recently been forecasting; but there was disappointing news from the much larger service sector (77% of UK gross value added) which saw activity in October no higher than it had been on average in 2012 Q3. Similarly poor figures have recently emerged from the retail sector, where the volume of spending appears to have declined in the final three months of the year.

Outside of the UK, the economic environment is mixed. The trough in Chinese growth appears to be behind us, but emerging world growth more generally does not look set for a strong revival. If anything, the persistent slowdown in broad money growth in emerging markets (EMs) over the last six months suggest that sub-par rates of economic expansion in EMs should continue for a while yet. At the time of writing, there was no agreement amongst US politicians on how to deal with the ‘fiscal cliff’. A messy compromise is ultimately likely to be reached, which prevents a retrenchment worth 5% of GDP impacting the economy in 2013; but US economic activity will still be restrained by relatively sizeable fiscal tightening over the coming quarters. Improving US monetary conditions suggest private domestic demand should continue to grow at a reasonable clip in the face of this tightening, albeit we may still be some way from consistently above-trend output growth. The main external threat to the UK economy comes from the Eurozone, which is a long way from safety despite appearances to the contrary. Activity is still declining, and investor confidence could easily be shattered, as Europe’s politicians approach one of the many hurdles they still have to clear.

Given the dangers to Britain’s long-term supply potential from persistently sluggish demand growth, there is a strong case for erring on the side of doing too much at this stage with monetary policy. The on-going regulatory barrage faced by UK banks, despite the potential benefits it may bring in terms of long-term financial stability, is undoubtedly constraining private sector spending, and more importantly the rebalancing of capital and labour resources within the UK economy. Since politicians of all stripes are swinging behind a ‘punish the banks and bankers’ agenda, monetary policy has to do the heavy lifting. The FLS appears to be having some effect at the margin in easing credit supply, particularly in the mortgage market. However, additional Bank of England asset purchases would seem warranted. Despite the recent increase in UK broad money growth, it is not yet at a rate consistent with the pace of nominal demand growth that seems desirable. With such uncertainty hovering over macroeconomic policy in the world’s major economy, there would seem to be a strong argument for postponing a final decision until next month. But barring any major surprises, another round of QE is likely to be necessary very soon.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Maintain asset purchases at £375bn; only increase the total to offset declines in M4ex.

Why is the British economy refusing to respond to a supposedly very stimulatory monetary policy after failing to react to a very large dose of fiscal stimulus? On the monetary side, the answer is that policy is not what it appears. Macro-economic textbooks take it for granted that lower interest rates – or a near-zero Bank Rate – will lead to easier monetary or credit conditions, but this is not always true. If the demand for credit falls (or the credit demand curve shifts to the left) more than the increase in supply (typically a rightward shift in the supply curve), then it is entirely possible to have very low interest rates and a negligible increase in bank credit. Broadly this summarises the situation in Britain today. First, households have drastically cut their willingness to borrow because: with house prices down 24% in real terms since their peak in 2007 Q3, new full-time jobs scarce, and income growth weak, their ability to repay mortgages or other debt has fallen sharply. Second, larger companies are able to borrow more cheaply and for longer terms in the bond market than directly from banks. Third, the banks are hardly growing their balance sheets at all due to their need to reduce their dependence on borrowed (i.e. non-deposit) funds and to improve their capital ratios. In fact, official data show total sterling assets and liabilities have declined from £4.066 trillion in January 2010 to £3.644 trillion in October 2012, a fall of 10.4%, with most of that decline occurring in the first half of 2010. Since then bank assets and liabilities have remained essentially unchanged, exactly replicating the experience of Japanese banks in the 1990s. In short, Britain has low interest rates but tight credit.

Given the size of the private sector (the gross liabilities of households, non-financial and financial firms together amount to about fifteen times GDP), it would require an immense injection of money via QE to offset the tendency of all these private entities to contract their balance sheets. In effect, private sector de-leveraging is overwhelming public sector attempts to re-leverage the economy. The clear implication is that the economic recovery may continue to disappoint until the point at which private sector balance sheets are well on the way to repair. Assumptions by the Office for Budget Responsibility (OBR), the Bank of England and others, of a fairly prompt return to 3% growth, are wildly at odds with this analysis. More fundamentally, the lesson for policy-makers is that monetary stimulus can only work effectively in an economy where leverage is not already excessive.

On the fiscal side, the OBR is projecting that underlying Public Sector Net Borrowing (PSNB) defined to exclude special factors will be £120.3 billion, or 5.1% of GDP in fiscal 2012-13. This might appear to be very large and supportive of private spending. However, it is not the absolute or relative size of the deficit that matters, but the increment in the budget deficit that is the key measure of stimulus. On this basis the years of greatest stimulus were in 2008-09 (when the PSNB increased by 4.3% of GDP) and in 2009-10 (4.3%). Since then the Coalition has deliberately attempted to narrow the deficit: 2010-11 (minus 1.6%), 2011-12 (minus 1.7%), and an OBR-projected minus 2.8% in 2012-13. In other words, the maximum PSNB increases served to prevent the economy suffering an even more catastrophic decline in output in 2008-10, but no such stimulus can now be expected.

Like monetary policy, fiscal stimulus also can only work under certain conditions. Typically fiscal stimulus will only be effective up to some indeterminate point where either the level of government debt becomes too large to attract buyers – hence, driving up interest rates as in the peripheral Eurozone economies – or where the scale of government spending and transfers as a share of the GDP becomes counterproductive and inhibits the growth of the private, wealth-generating part of the economy. The judgement of the markets as expressed in the yield on UK government gilts may be unclear. However, the preference of the Coalition for reducing the deficit as a fraction of GDP in the shortest reasonable timeframe is well known, even if the timetable may be slipping a little.

If the core problem is damaged household and financial sector balance sheets, then central bank and government policy should be directed to helping the private sector to repair their balance sheets as soon as possible. However, both the traditional policy tools have been maxed out. Monetary policy, which works by expanding the loans and deposits available to the private sector, is blocked because the banks do not want to lend and households do not want to borrow. Of course, low interest rates minimise debt repayment problems, but this is secondary. It still takes households far longer to repair balance sheets than either the corporate or banking sector. Fiscal policy, which works by expanding the liabilities of the government, is blocked because at some indeterminate level of government debt there is a serious risk of driving up interest rates for all borrowers.

An alternative approach would be to adopt some form of debt forgiveness, for example by government stepping in to take over (say) half the outstanding mortgage debt of households, and replacing those mortgages on the books of the banks with government debt. However, this creates huge problems of moral hazard. In addition, the distributional effects would be very unfair because it would mean reducing the debt of new mortgagees by much more than those whose mortgages are almost fully repaid. Another problem in modern financial markets is that the mortgage is often no longer on the books of the originator, having been securitised and sold on, possibly several times. Variations of these debt forgiveness or foreclosure forbearance strategies have been attempted in some countries, but without much success. Against this background the Bank of England must learn to pay far more attention than it did in the past decade to the state of balance sheets across the economy. For the present, it should hold Bank Rate stable at ½%, thereby helping borrowers to repair their balance sheets, but be prepared to undertake additional asset purchases if M4ex growth registers absolute declines.

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

This time of year is notoriously difficult for interpreting the economic tea leaves, particularly as there have been highly mixed reports from individual retailers in the run-up to Christmas and the subsequent New Year sales. January is not the time to jump the gun with a change in interest rates or QE, in the absence of a very clear message from elsewhere in the economy.

The signal from the performance of M4ex broad money performance over recent months is that the UK economy can avoid a triple-dip recession but that GDP growth at a rate above 1% to 1.5% is unlikely during the first half of 2013. If the December and January M4ex figures show a weakening in broad monetary growth, then a further expansion in QE will probably be required.

However, and whilst accepting that QE can be employed to support the demand side of the economy, too little attention is being paid to the underlying supply-side weakness as a result of the total government intervention index – this can be defined as the combined impact of public spending, taxation and the regulatory state. Consequently, any increase in money GDP as a result of QE, continues to risk being led more by inflation than real growth. The UK outlook continues to be constrained by the absence of a genuine supply side policy, capable of boosting private capital formation and total factor productivity growth.

On the international front there are three clear threats to the global economy in 2013. The first is the US fiscal cliff. Second, there is the risk of an intensification of the Euro crisis. The third such threat is the possibility of pre-emptive military activity by Israel or the US against Iran. At the time of writing, the US appeared to be heading over the fiscal cliff, without any agreement between the White House, the Senate and the House of Representatives. Anyone who followed the deficit reduction negotiations during the first Obama administration will know just how far apart the House of Representatives is from the Senate and the White House on this issue. A deal based on substantial tax simplification, which takes an axe to deductions and in so doing permits lower marginal rates and higher overall tax revenues, (plus sharp reductions in entitlement spending) might be attainable in the long-term. However, it seems impossible to bring this about in a matter of days before the New Year. The political standoff between higher taxes and lower spending seems set to continue. At best, only a short-term politician’s fudge is likely to prove achievable as a consequence.

The Draghi Plan has provided a temporary respite to the Euro crisis. However, it is very unlikely to prevent a Greek exit from the Eurozone at some point over the coming year (Editorial Note: the reasons are set out in Still Going Down? in the Institute of Directors Big Picture, Winter 2012, which can be downloaded from www.iod.com). Consequently, precautionary behaviour towards business investment will remain a source of weakness. The final economic threat is a real and present danger. The level of uranium enrichment by Iran is no longer the key issue because the pursuit of weapons grade enrichment has been obvious for years. However, the threat that this enriched uranium will be incorporated in a deliverable weapon is a red line for the US Government, and not just for the Israelis. Consequently, a significant geo-political risk will hang over the world economy in 2013.

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

One of the strange things about the current debate about monetary policy and inflation targeting is how many of the protagonists, from finance ministers through central bank governors to the International Monetary Fund (IMF) and the Bank for International Settlements (BIS), have forgotten all they were taught about macroeconomics. They seem to believe that monetary policy, now to do with fresh injections of central bank money (QE), can create growth when everyone can fully see the injections from well in advance of the act and long after the original banking crisis has given way to a weak, ‘new normal’, recovery. Yet even the most ‘New Keynesian’ model, with long-duration price/wage rigidity, does not predict that money can boost output much in these conditions. A model, on the other hand, with a fair degree of price/wage flexibility is definite that no effect at all on output will result.

The main channel through which New Keynesian models see effects on output occurring is through future interest rates being kept low and so stimulating investment, perhaps also consumption. The argument is that the central bank sets interest rates and can influence expectations of where it will set them in future by a special monetary intervention addressed to the future. Nowadays, these models are usually supplemented with a banking sector which charges a premium on its loans that varies with the strength of lending demand. As we have seen, the lending premium has remained stubbornly high in spite of the monetary stimulus applied.

What we have observed here and in the US – and, indeed, in most western economies including the northern Eurozone – is weak growth in spite of massive monetary stimulus. Businesses can see little need to invest, consumer spending is growing slightly, government spending is of course restrained; monetary policy is having little effect on any of these sources of demand. Ironically, the area where it might be having most effect is government where QE, allied to general fear, has brought down the cost of government borrowing to the point that real interest rates have become negative. Even so, governments are in no mood to commit to new spending levels when they are rightly concerned about long-run solvency.

Accounting for all this weakness is a challenge to our understanding. Some say it is due to ‘deleveraging’; in a literal sense this is true as people and firms are not spending and so running down debt. However, this is purely a description not a causal explanation. The question is why they are de-leveraging so relentlessly in the face of low interest rates. To this, the most plausible answer is that prospective returns on capital are low and expected real incomes growing little because productivity growth is slow and promises to remain so.

The deep reasons for this appear to lie first in the massive shift in the terms of trade for oil and raw materials against western consuming countries. Indeed, producing countries of the West, such as Canada and Australia, and of the developing world – such as Africa – are in much better shape.

The second reason is the regulative backlash against the banking system in the West. This has most effectively blocked the banking channel of monetary policy. It is a commonplace of recent surveys, such as those carried out by the Bank of England through its agents, that Small and Medium-sized Enterprises (SMEs), which account for some 50% of employment and a slightly smaller share of GDP, cannot get loans from the banks on reasonable terms or in some cases on any terms at all. One symptom of this banking channel blockage is the exceptional weakness of broad money growth and the non-existent growth of credit. Governments and regulators are convinced this regulative tightening is both necessary and will make the economy ‘safe from crises’ in the future. In this they are likely to be quite wrong. This is because capitalism is naturally crisis-prone, since productivity growth is inherently unpredictable and subject to potentially large swings in both directions. Recent Cardiff Business School research suggests that, simply due to these swings, crises of some depth can occur quite regularly and will generally trigger banking problems as well. While our elite classes get to grips with this reality, their heavy-handed regulative intervention is worsening the economic ‘supply-side’ on top of the weakness induced by the raw material terms of trade shift. Printing money to get over such real supply-side weaknesses will not have much if any effect, as indeed we are observing in practice.

There is increasing talk of raising the inflation target both here and in the US. No less a man than the Bank of England Governor to be, Mark Carney, has made a high profile speech arguing for some ‘temporary’ raising of the inflation target. He is a bit late in this since the Bank has been indulging in this sport for a few years now, having overshot its target substantially. His reason for suggesting this is that it will boost growth. But, surely, everyone knows the theory of ‘time-inconsistency’ in monetary policy under which the desire of policy-makers to boost growth by creating extra inflation generates inflation without succeeding in boosting growth? The reason for this is that once people begin to think inflation is being used as a tool for boosting growth they will expect the ‘inflation target’ to be regularly breached whenever growth is disappointing. They will then calculate how much inflation will seem worthwhile as the price of getting more growth; this rate will then become the ‘inflation expectation’. Wage inflation will then rise in line with these expectations and fuel this very inflation rate. Growth in employment and output will not increase as the channel of higher competitiveness (lower real wages) will be frustrated.

One might add that interest rates too will rise as inflation expectations rise. This will not aid recovery and could harm it. It will indeed mean that the value of government debt falls so that the public debt ratio will fall. This can be thought of as the effect of the ‘inflation tax’. However, the whole idea of inflation targeting was to make sure governments did not use this tax rather than orthodox taxation; voters disliked the random redistribution generated by high inflation and that underlay the legislative move to the target. So far, inflation expectations have remained moderately anchored in spite of such loose talk. However, authors such as Bennett McCallum have warned that time-inconsistent behaviour is a deep problem of political economy. Those of us involved in the public debate have to be constantly on the watch for its recurrence in ever-plausible guises. It seems that the Carney speech is particularly dangerous as it has been welcomed by George Osborne as the ‘start of a debate’. It is a dangerous one. This is because it is one thing to print money when you are committed to reversing it, whenever that may be appropriate, and quite another to have no commitment to reversing it because you are aiming for higher inflation.

In sum, present monetary policy is badly adrift. It needs to be recognised that monetary policy is only a tool of stabilisation in response to shocks. Once the situation has become one of persistently weak growth, monetary policy can no longer have much, if any, effect; it will only drive inflation higher. The only reason the massive loosening of money has had little effect so far on inflation is that: first, the inflation target is still there; and, second, that the banking system has largely killed off money creation as fast as it has occurred because of regulative overkill. Regulative overkill will be with us for some time because of current government fashion. It is undermining growth but we just have to live with that.

Monetary policy so far is not causing much inflation. However, it is also not helping growth. All it is really doing is redistributing income from savers to the general taxpayer; this is politically unsustainable even if economically it is just a transfer and so has no clear welfare implication. Nevertheless, if the UK monetary authorities were to move to a commitment to generate growth by printing as ‘much money as it takes’ and abandoning the inflation target by also by ‘as much as it takes’, then matters would be alarming indeed. Accordingly, it is really time to get back to normality in the demands on monetary policy and in its behaviour. QE should stop and be reversed over the next year or so. Bank Rate should be raised towards normal levels, starting with a ½% increase forthwith.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: Avoid regulatory shocks; break up state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

In line with its now-customary pre-Christmas sadism towards the economic forecasting community, the Office for National Statistics (ONS) released a mass of new economic figures on 21st December, which have not yet had time to be incorporated into the wider macroeconomic debate. The new data included not only a revised and more detailed set of GDP accounts for 2012 Q3 but also new third quarter statistics for the balance of payments current account and the general government accounts broken down by sub-sector and economic category. In addition to the new third quarter data, there have been back revisions to previously published official statistics. These have generally extended back to the first quarter of 2011. The new ONS figures supersede the national accounts data, published on 27th November, which were employed to generate the 5th December OBR forecasts released with the Autumn Statement (see: OBR Tables 1.1 and 1.2, which are rounded to the nearest £bn., however).

The volume of general government consumption in 2012 Q3, which was the base date for the OBR forecasts, has been revised up from £84.5bn in chained 2009 prices to £84.685bn, for example, while the volume of general government fixed capital formation has been revised up from £7.0bn to £7.384bn. However, there have also been noticeable downwards revisions to the current price figure for general government current expenditure in the third quarter – from £88.3bn to £85.956bn – and for general government fixed capital formation, from £7.8bn to £7.634bn, as the result of revisions to the implied costs of these items. Taking 2012 Q2 and Q3 together, which corresponds to the first half of the 2012-13 fiscal year, the value of general government consumption expenditure has been revised down from £175.9bn to £170.1bn (minus 3.3%) and current price fixed capital formation by general government has been revised from £15.7bn to £15.1bn (minus 3.5%). These two items make up not quite 54% of total government spending; the rest is mainly transfer payments such as welfare benefits and debt interest. It is conceivable that overshoots elsewhere are offsetting these gains. However, there also remains a chance that the Autumn Statement forecasts are slightly too pessimistic on the spending side, even if one suspects that they may also be too optimistic where receipts are concerned.

At present, it is almost impossible to discuss the UK fiscal situation without getting sucked into the ‘Plan B’ debate. Plan B advocates have been given more credibility than they deserve. This is largely because of the Chancellor’s failure to mount his soapbox and explain why fiscal retrenchment is so desperately required. In practice, there are at least four sources of economic evidence that are relevant to this debate: the fiscal stabilisation literature; international cross-section/panel data studies; simulations on macroeconomic forecasting models, and direct reduced form statistical relationships between, say, private investment and the budget deficit. None of this massive literature, which has been built up over the past three or four decades, supports the ‘Plan B’ approach, nor has it had a look-in in the UK fiscal debate. In terms of the fiscal stabilisation literature, what Mr Osborne has attempted has been a ‘timorous’ Type 2’ fiscal consolidation programme, in which tax increases were front-end loaded, public investment was cut, and current government expenditure and welfare costs were allowed to rise. There exist countless international studies showing that Type 2 packages lead to unexpected output weakness and a worsened fiscal position, as has happened in the UK. In contrast, a Type 1 package of tax cuts, public consumption reductions, tight control of welfare bills and no public investment cuts – which should have been implemented but was not – is normally associated with positive output surprises, reduced joblessness and an improved fiscal position, particularly if it is done ‘boldly’.

Furthermore, it is apparent that the volume of general government consumption is running well ahead of Mr Osborne’s original intentions, even if it is difficult to be precise because of the constant re-basing of the national accounts. The first volume projections for the level of general government expenditure were released by the OBR with the November 2010 Autumn Statement. At that point, it was believed that the volume of general government current expenditure would have contracted by 2% between 2010 Q2 and 2012 Q3. In the event, it rose by 2.5%, representing a cumulative Keynesian ‘boost’ of 4.5% of government consumption – the equivalent of 1% of real GDP. The implication is that we have already more than received the alleged Keynesian stimulus that Mr Balls has been asking for, but as a consequence of grossly inadequate spending discipline rather than by design. In other words, Mr Osborne is already on ‘Plan G’ or ‘Plan H’. One can only apprehend the day that the financial markets wake up to this reality.

In the light of the various 21st December ONS releases, it now looks as if the ‘headline’ measure of UK real GDP measured at market prices was largely unchanged on average in 2012, while the arguably more informative basic-price measure of non-oil GDP increased by an annual average of 0.2%. After so many ‘false dawns’, most macroeconomic forecasters are probably too shell shocked to predict a strong recovery in 2013 and subsequent years, even if experience suggests that, once an upswing commences, it tends to be far stronger than anticipated. Furthermore, it is normally several quarters into the new cyclical phase before most commentators realise that the business cycle has turned. For what they are worth, the latest forecasts generated on the Beacon Economic Forecasting (BEF) macroeconomic model suggest that ‘headline’ GDP will increase by 1.3% on average in 2013, 2.8% in 2014 and 2.5% in 2015. Two reasons for this modest optimism are that UK broad money growth has picked up and that the 2013 prospects for Continental Europe and the US look slightly better than they were in 2012¬ – despite the likelihood that some peripheral members will leave the Eurozone and that the US will indeed plunge off the fiscal cliff. While on the subject, and as an aside, the mandatory spending cuts that would result from a failure to resolve the US fiscal crisis would almost certainly be economically beneficial in the medium term. It is the prospect of higher taxes that should really scare people because of their adverse effects on aggregate supply. However, damaging tax hikes are likely to occur under President Obama, regardless of whether or not there is an agreement with the Republican majority in Congress.

The latest UK inflation figures show that the target CPI increased by an unchanged 2.7% in the year to November, while the all-items RPI and the old RPIX target measure increased by 3.0% and 2.9%, respectively. The ‘double-core’ retail price index – which excludes mortgage rates and housing depreciation and is the most historically consistent inflation measure – rose by 3.0% over this period, compared with the 3.2% recorded in October. The latest BEF forecasts suggest that CPI inflation will ease slightly to 2.4% in the final quarter of 2013 but then accelerate to 3.2% in late 2014 and 4.4% by the closing three months of 2015. There are two proximate reasons for this acceleration. The first is that inflation in the Organisation for Economic Co-operation and Development (OECD) area is expected to accelerate from 2% in 2013 Q4 to 3.5% in late 2014 and 4% by the end of 2015, compared with 1.9% in 2012 Q4. The second is that the sterling exchange rate index is expected to weaken by a cumulated 17% or so between 2012 Q4 and 2015 Q4, amplifying the effects of increased inflation overseas. At a more fundamental level, both developments reflect the long-lagged effects of the long period of ultra-loose monetary policy and supply-damaging fiscal and regulatory actions, internationally and domestically, since 2008.

Higher inflation could be averted by a pre-emptive rise in Bank Rate during the course of this year – our forecasts have assumed that Bank Rate will be held at ½% until 2013 Q3 - and robust measures to improve supply-side performance; by which, one means genuine public spending reductions, reduced marginal tax rates and a bonfire of regulatory controls, including those on the banking sector. However, it is unlikely that the politicians or the monetary authorities have the stomach for such measures in most Western democracies. Instead, any official response is likely to be too little and too late, unless the international bond markets get the bit between their teeth and enforce the adoption of the more conventionally orthodox fiscal and monetary policies required for the achievement of economic stability in the longer term.

Moving on, it has recently been suggested that inflation targeting should be replaced by the targeting of nominal GDP and both the next Bank of England Governor, Mark Carney, and the Chancellor have flirted with the idea ¬ – the latter, possibly, because he sees whipping up a pre-election, money-supply led boom as his last political hope for a 2015 general election. However, nominal GDP targeting is an example of an appealing theoretical idea that could prove a nightmare in practice. The facts that government spending is around one half of GDP and that imports are a negative item in the GDP identity means that nominal GDP targets can easily give perverse policy signals, even if one ignores the significant practical measurement problems involved. Targeting private sector domestic expenditure, which is all that monetary policy can influence, would make more sense. However, it remains difficult to disentangle this concept from public sector transactions, given the way in which the national accounts are put together. This is a weakness that could be fairly easily rectified by appropriate action on the part of the ONS, however.

As far as the January Bank Rate decision is concerned, the temporarily reduced uncertainties in Continental Europe suggest that there is a window of opportunity to raise rates and that it is now time to introduce a modest ¼% hike in Bank Rate. This is not because of any economic effects that it might have, which would be trivial, but in order to demonstrate that the Bank of England has not just become a supine underwriter of the surreptitious fiscal profligacy contained in the Autumn Statement. The medium-term aim should be to get Bank Rate into the 2% to 3% range at which it re-engages with the money market rates that determine borrowing costs. A prompt move to such a Bank Rate during the course of 2013 would help forestall the pickup in inflation seen in the BEF forecasts for 2014 and 2015. International growth studies indicate that both the mean rate of inflation and its standard deviation have a negative impact on the level and the growth of real GDP per head. Recent inflation overshoots have reduced economic activity, not boosted it as some Bank officials appear to wrongly believe.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

We begin 2013 with diminished expectations of UK economic improvement. Three new pieces of information have become available over the past month: the contents of the Autumn Statement, the first quarterly report on the Funding for Lending Scheme (FLS) and the detailed national accounts for 2012 Q3. None of these has provided comfort on the UK economic situation.

The principal objective of the Autumn Statement appears to have been to make the Shadow Chancellor look foolish. By crook, more than hook, the fiscal deficit projection for the current year retains a downward bias. However, it is surprising, to say the least, that the OBR saw fit to endorse the assumptions that allowed Mr Osborne to avoid the embarrassment of reporting a rising deficit for 2012-13. This is still the most likely outcome, particularly in the light of the December public finances release. One of the few remaining planks of supply-side transformation, the reduction in the absorption of resources by the public sector, has run aground.

The overall stance of the coalition’s economic policy, as commonly understood, was to combine fiscal tightening, monetary ease and currency flexibility. Fiscal tightening fizzled out in 2012; monetary ease has been overruled by undesirably tight credit conditions, and our currency has drifted higher in the light of more aggressive monetary policy measures taken elsewhere. Policy implementation rates are poor.

The FLS is beginning to have a favourable impact on mortgage accessibility, but mainly at the upper end of the income distribution. Unfortunately, it is also having the unintended effect of depressing interest rates on savings accounts as banks substitute cheaper FLS funds for retail deposits. FLS is counteracting the market-driven interest rate increases attributable to Eurozone risk, but does not seem close to the degree of impact hoped for by its architects.

The third quarter national accounts confirmed the slump in construction output, weighted towards residential housing (down 14% in the latest quarter) and the bloated contribution of government expenditure and income transfers to the GDP total. Inventories are accumulating while net exports are weakening, not aided by Sterling appreciation. If it had not been for the disbursement of Payment Protection Insurance (PPI) mis-selling compensation, household consumption might not have edged to a 1.3% year-on-year gain in the third quarter of 2012.

Ultimately, the restoration of a confident expectation of even a modest pace of economic growth requires the private sector credit system to operate much more efficiently than at present. All policy energies should be directed to this end, since no schemes will succeed on their own merits in the absence of affordable credit and a positive framing of policy. Replacing the governor of the Bank of England should make some difference to the latter, but probably not to the former. Ironically, had Mr Osborne aired the dirty linen of the UK public finances he may well have repelled some of Sterling’s fair weather friends. As it is, the UK has the pretence of fiscal rectitude (and has preserved its AAA sovereign rating) but not the reality.

Finally, rather than Japan taking a leaf out of the UK’s policy playbook (in its emulation of FLS), the UK should consider copying the Bank of Japan’s purchases of Exchange Trade Funds (ETFs), Japan Real Estate Investment Trusts (J-REITs) and corporate bonds. The leverage obtained from small purchases of beaten-up private sector assets makes far more sense than the massive purchases of (over-priced) government bonds. The Bank of England should be looking to raise Bank Rate through 2013, but it does not seem like now is a good time to start.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate for now.

The most interesting development in the last month has been the announcement that Mark Carney is to be the new Governor of the Bank of England and his reported statement that he favours a change in the way that monetary policy is conducted in the UK from inflation to nominal growth targeting. Would this be a good idea? It has received much support in the media. It would also crown Sir Samuel Brittan’s advocacy for this, which has been conducted in his Financial Times column for the last forty-five years. The reason why this old proposal has been resurrected is the recent poor real growth performance of the UK, the US and the Eurozone. The apparent implication is that by targeting real growth instead of inflation, monetary policy would have been different and growth would have been higher. The intellectual underpinnings for the use of monetary policy to target economic growth may be attributed in modern times to Milton Friedman’s claim that monetary policy is more effective than fiscal policy in stimulating output in the short run. The stylized statistic is that the stimulatory effect of an increase in the money supply lasts for about eighteen months. In contrast, estimates of the fiscal multiplier have steadily fallen: it was assumed to be between 1 and 2 during the high days of Keynesianism in the 1960s when the UK had a fixed exchange rate, it is now estimated to be much less than 1.

A serious analysis of the relative effectiveness of monetary policy and fiscal policy as implements to increase economic growth would need to take into account the particular policy instruments being considered (e.g., interest rates or one of the many measures of the money supply; current or capital government expenditures), methods of financing deficits (tax, debt or money), whether the exchange rate is fixed or floating and the state of the economy (full or under employment). There is also the issue of how much risk should be transferred from the private to the public sector in order to increase investment spending. Until the financial crisis, the monetary history of the UK under a floating exchange rate had pointed to the efficacy of inflation targeting compared with trying to control the money supply or targeting a nominal exchange rate such as the former Deutschemark. Moreover, the academic literature favoured focusing solely on inflation (strict inflation targeting) over also taking into account economic growth (flexible inflation targeting) because this was thought to minimise the welfare loss to the economy from fluctuations in both inflation and output. This implies a rejection of targeting nominal growth as this would give an equal weight to inflation and output growth.

Nonetheless, strict inflation targeting is not without its problems. It is, for example, much better suited to dealing with a positive demand shock (which raises both inflation and output) than a negative supply shock (which raises inflation but reduces output). Raising interest rates following a positive demand shock would, as required, reduce output and inflation but, following a negative supply shock, not only would it reduce inflation but output too. A second problem is the zero lower bound on interest rates. Both constrain the ability of interest rate policy to stimulate the economy. These limitations have been evident in the current recession and have undermined the effectiveness of monetary policy. For example, real GDP in the UK has fallen by 2.9% since the end of 2007, while nominal GDP has grown by 8% and CPI inflation has averaged 3.5% per annum. This appears to be evidence of a classic negative supply shock. Other examples of a negative supply shock in the UK were in 1974/5 following the oil price hike, when inflation rose to over 26% and output fell by 1.5% and in 1980/1 when inflation rose above 17% and output fell by 3.2%.

The implication of this discussion is that the case for switching to nominal income targeting must rest largely on its ability to raise output following a negative supply shock as this is when strict inflation targeting is least effective. It is clear, however, that the monetary policies pursued during the current recession by the Bank of England, the US Federal Reserve and, to a lesser extent, the ECB, have had little to do with strict inflation targeting. The Bank has not responded to inflation by raising interest rates (as strict inflation targeting would require) even though inflation has been double its target value. Rather, it has kept interest rates at an historic low, and has accompanied this with a large expansion of the money supply via QE - in effect, open market operations. It is difficult to think of how a monetary policy geared to nominal growth targeting could have done more. The Bank of England has never even claimed to be a strict inflation targeter. It has always taken a close interest in output, if only because it took the view that interest rates affected inflation through their effect on output. It is also able to choose how fast to bring down inflation, and hence how much to curtail output in the process.

To sum up, there seems to be no advantage to switching to nominal growth targeting. Indeed, it could make matters worse if taken too seriously because inflation takes time to adjust and, if the aggregate rate of price increase is high, it may be necessary to engineer a deep recession to achieve the nominal growth target. In my view, it is better to give priority to controlling inflation with the aim of maintaining longer-term inflation expectations – but to permit inflation to exceed its target in a recession. In short, the Bank should continue to do what it does now. This is not, however, all that can be said about the operation of monetary policy. Perhaps the most important feature of the Bank of England Act of 1997 was that it sought to make monetary policy independent of fiscal policy and of political interference. Optimal macroeconomic policy aims to control inflation and stabilise economic growth, though not by targeting nominal growth. A combination of monetary and fiscal policy is therefore required. Consequently, given the Act, fiscal policy should take on a large part of the burden of stabilising output particularly when, as now, the Bank has run out of monetary policy options and appears to be impotent to raise output further. For example, the possibility remains of injecting a further monetary stimulus via fiscal policy by temporarily money financing part of the deficit – in effect a ‘helicopter drop of money’. In this way the continuing expansion of debt could be halted and, if clearly understood to be a temporary expedient, inflation expectations may not be greatly affected. Perhaps this is what Friedman had in mind.

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

The evidence so far suggests that the UK economy seems to have ended 2012 with little or no growth impetus. The Purchasing Managers’ Indices (PMIs), for construction and manufacturing remain below 50, whilst the services PMI remains only a little above, suggesting that output contracted in the final quarter of 2012. Output remains about 4% below the peak level seen in 2008. Taking the five years to 2012, the economy has been flat. This represents easily the worst recovery from recession since World War II and a grim reminder that the issues facing the economy are more structural than cyclical. For comparison, the UK economy has barely performed better than Spain since 2008 and worse than France, even though the UK is not in the Eurozone. Indeed, the UK has the poorest growth record of any of the G-7 leading economies, relative to its trend rate of growth prior to the economic crisis. On even optimistic growth scenarios, the UK economy is unlikely to regain its pre-recession level of output until 2015 at the earliest. It is clear that the UK has entered a low-growth, low-wage inflation trajectory since 2007. The former could be described as pay back for the roughly decade long debt fuelled growth that now has its apotheosis in the deleveraging that companies and households are now undertaking, which means they are not spending.

With consumer spending constrained by a lack of desire to borrow, and companies sitting on cash rather than investing, low growth seems the only outcome since fiscal policy cannot offset this loss of consumption. The government now has to deleverage too – or, at the least, promise to do so in the medium term – if it is not to face a rise in borrowing costs. Furthermore, low interest rates will not ‘solve’ the problem either, since this is a problem of excessive debt that only debt reduction can resolve. It does help to mitigate its effects, however, as it allows the repayment amounts to be low and keeps down defaults, thus preventing an even greater desire to save and a worse retrenchment.

However, the problem is deeper than demand, as the fall in the exchange rate has not prevented a rise in the UK’s current account deficit to some £55bn in 2012 after a narrowing to £20.4bn in 2011 from £37.4bn in 2010. Weak growth should have meant some decline in the deficit, although the recession in the UK’s key export markets is an offsetting factor. Low wage inflation is one response to this, as it allows UK firms to be competitive, or at least more competitive than would be otherwise the case. It is also a positive for the UK’s economic prospects, as it signifies that people are willing to take cuts in real pay to offset the collapse in productivity, which is over 4% lower now than in 2007. If it had risen at the same pace as prior to the 2007 crises, it would be some 8% to10% higher.

A rise in the UK’s relative costs has not been offset by increased efficiency of labour or capital so leaving the economy vulnerable to shocks from abroad, of which inflation is just one example. This might be down to the trend decline in North Sea output and the subsequent rise in real energy costs for UK firms. However, and whatever the source, the widening in the current account deficit and fall in productivity are clear signs of a problem on the ‘supply’ side of the UK. Other ‘supply’ side candidates are a tighter regulatory burden or too high a share of government spending in GDP. It is promising though that at least the labour market has responded by showing a willingness to accept cuts in real take-home pay. The boost that this development has given to employment suggests that the UK is willing to work hard to get its economy back on track.

A rise in the domestic money supply, together with improved growth in the emerging markets and the US in 2013, should give the UK economy some prospects of recovering, albeit at the ‘new normal’ rate of 0% to 1%. In this environment, low interest rates are essential, as is a commitment by the authorities to reduce the fiscal deficit in the medium term. Asset purchases should be resumed if broad money (i.e., M4ex) looks as if it is falling once again, but otherwise should remain at £375bn.

What is the SMPC?

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

Current SMPC membership

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

In its most recent e-mail poll, completed on 27th November, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Bank Rate should be held at ½% on Thursday 6th December. Two dissenters wanted to raise Bank Rate by ¼% immediately, while another desired an increase of ½%.

Most SMPC members thought that there should be no additional Quantitative Easing (QE) for the time being. One reason was that Mr Osborne’s 9th November decision to transfer £37bn of gilt coupon payments from the Asset Purchase Facility (APF) to the Exchequer represented a de facto monetary easing. Several SMPC members expressed concern that the announcement blurred the distinction between fiscal and monetary policy, risked politicising the latter and brought forward revenues into fiscal 2012-13 at the cost of increased borrowing in later years.

The SMPC poll was largely completed before the announcement that Mark Carney would be the next Governor of the Bank of England. To the extent that SMPC members expressed a view of the appointment, it was that this was an excellent choice that sent a clear signal about the openness of the UK to global talent. The contrast between the strong Canadian economy and the weak British one helps explain Mr Osborne’s decision.

However, Canada has been helped by a noticeably less-competitive and internationally-open banking system and a far stronger fiscal background than Britain experiences. There was some concern that the new Governor might prove an unduly hard-line financial regulator in a way that was not appropriate at the current depressed point in the cycle.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate and pause QE.
Bias: Adjust Bank Rate and QE to achieve appropriate growth in broad money.

The last five years have been the most difficult for the British economy since at least the 1970s and perhaps since the Second World War. The disappointments on both output and inflation have been severe, and were more or less completely unexpected in 2007. It is therefore worth emphasising that the data of the period are again consistent, in general terms, with the monetary theory of national income determination. A salient fact is that in the five years from mid-2007 to the third quarter of 2012, the compound annual growth rates of M4ex (2.4%) and nominal GDP (2.1%) have been extremely close. Despite the turmoil of events, the latest five-year period has seen both the lowest rate of increase in the quantity of money and the lowest rate of increase in nominal GDP since the 1950s. Moreover, in the period of the sharpest downturn from autumn 2007 to mid-2009, the parallelism of the changes in money and nominal GDP was striking, with money having a short lead over nominal GDP, just as Milton Friedman would have envisaged. The Great Recession in the UK, like the Great Depression in the USA, is to be interpreted – above all – as a monetary phenomenon.

The continuing validity of the monetary theory of national income determination needs to be emphasised not just to restate an essential truth in economics, but also to comment on two of the latest fashions. The first fashion is to claim that the effectiveness of QE is subject to ‘diminishing returns’, so that the Bank of England will have to find another, new method of conducting expansionary monetary policy. The ‘diminishing returns’ claim has been made, for example, by Professor Charles Goodhart of the London School of Economics and Jeremy Warner of The Daily Telegraph. It is bunkum. The state can always create money balances, simply by making larger payments to the non-bank private sector than the non-bank private sector is making to it, while the effect of a 1% (or 5% or 50%) increase in the quantity of money is to raise – roughly speaking – the equilibrium level of money national income also by 1% (or 5% or 50%).

Secondly, at various points in the last few years concern has been expressed about the risk of high and rising future inflation. Inflation has indeed been disappointingly high in the immediate sequel to the Great Recession and the official inflation target has been exceeded by more than 1% for much of the five years since 2007. However, to characterise the UK as in the grip of a runaway inflationary process, akin to the 1970s, would be absurd. Also, the increase in nominal GDP since 2007 has been lower than in any other quinquennium for the past sixty years, if not longer. The setbacks on inflation should be seen as the consequence of the big 2008 devaluation and the economy’s poor supply-side performance.

The point here is that alarmism about inflation is justified only if the trend rate of money growth is changing. The latest data do show an upturn in the growth rate of M4ex. In the six months to September, M4ex rose at an annualised rate of 6.1%. Given that the low return on money balances is compatible with a fall in the ratio of money to income/expenditure, that rate of money growth ought to be consistent with at least a 5% growth rate in nominal GDP. However, it does not seem to me that inflation is ‘out of control’ or anywhere near ‘out of control’. The recent upward blip in money growth can be attributed to the resumption of QE operations, for which the justification was far less than clear-cut than it had been in early 2009. The QE operations should be paused, at least for a few months until there is greater visibility in the money growth outlook. One possibility should be welcomed, that the UK banking system is now able – at last – to resume steady growth ‘under its own steam’. In other words, banks can respond to their customers’ credit needs by expanding their balance sheets, in the way that was seen as normal before the regulatory excesses of the Great Recession.

Before closing, it is worth making a couple of rather miscellaneous comments. The first is that the numerous media stories about ‘the UK slipping back into recession’, which appeared in the middle of 2012, were misleading. Admittedly, they were based on the official statistics compiled by the Office for National Statistics (ONS), but the UK’s GDP statistics are not reliable in short-run macro analysis. Far better in understanding the latest trends are business survey information and employment numbers; these have indicated an economy growing at about its trend rate or perhaps a little above it in recent quarters. The trend growth rate is maybe only 1% to 1½% a year. However, and in that context, growth of a mere 1½% to 2% is above-trend and we should be grateful for it! It cannot be overlooked that unemployment has been generally falling throughout 2012, while a detailed comparison of the ONS growth figures for the period 2002 Q1 to 2007 Q4 published in 2008 with the latest official estimates reveal that the ONS underestimated the growth rate by an average of 0.44 percentage points during this earlier period or a cumulated 2½% or so. If this 0.44% were added to the annual growth rate for every quarter in the past three years, the present ‘recovery’ would look appreciably more like a ‘normal’ cyclical recovery than the present ONS statistics are suggesting.

The second of the miscellaneous comments relates to the world economy and, hence, the international environment for British exports and for British companies with a high ratio of foreign to domestic earnings. Too much attention is paid to the Eurozone and to Europe as a whole. Sure enough, the various dysfunctional features of the single currency area are now glaringly on display. They have caused a major economic and social disaster in our neighbours, and seem likely to continue to do so for a few years yet to come. That is bad news and will hold back our own economy to a degree. However, the Eurozone now accounts for only a sixth of world output and its share is falling rapidly. There is nothing much the matter with the rest of the world economy and it is reasonable to envisage a trend growth of total world output of at least 3% a year in the rest of the 2010s. In particular, the USA seems likely to enjoy a relatively standard cyclical recovery in 2013 and 2014. The US banking system has absorbed most of the losses of the sub-prime mortgage debacle and is now well-capitalised by past standards. The hullabaloo about the USA’s ‘fiscal cliff’ is entirely misplaced. The return to positive broad money growth in the last few quarters and virtually zero short-term interest rates imply a rather good year for US economic activity in 2013.

As far as the UK’s monetary policy dials are concerned, my view is that there is no hurry to move to a higher level of short-term interest rates for the present, although it is possible that a rise in interest rates will be needed during the course of next year. The overriding objective should be stable growth of the quantity of money at a low non-inflationary rate. As mentioned above, with broad money growth quite strong in recent months, QE should be paused. However, the pausing of QE does not mean that debt management policy is unimportant or that it has ceased to be effective as an instrument of macroeconomic policy. The Bank of England, HM Treasury and the Debt Management Office (as a Treasury agency) need to coordinate the management of the public debt at all times, so that the state’s transactions in public debt help in maintaining a low and stable rate of money growth.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; no change in asset purchases.
Bias: Additional asset purchases, ideally in private assets.

UK Consumer Price Index (CPI) inflation remains above the 2% target. It is unlikely now to fall below that level until the end of 2013 given larger-than-expected increases in domestic energy prices and the effect of the government’s decision to hike university student tuition fees. Does this invalidate the Bank of England’s decision to continue with ultra-easy monetary policy? A gaggle of commentators continue to argue that the explosion of the Bank’s balance sheet represents a major threat to price stability in the UK. Based on a crude version of the quantity theory of money, this view should be refuted with vigour – broad money, the variable that is relevant for nominal demand and ultimately inflation (M4ex in Britain’s case) has barely grown over recent years. Monetary indicators do not suggest that medium-term inflation will exceed the Bank’s target. If anything, absent a swift pick-up in UK broad money growth (which remains unlikely without another large dollop of asset purchases), monetary data continue to suggest downside risks to price stability.
Concern about inflation, such as it is, stems from the real side of the economy. Output has been broadly flat over the last couple of years. Survey evidence suggests activity is growing but only just. Although real GDP expanded by 1% between the second and the third quarters this figure was heavily distorted by the loss of working days in the second quarter caused by the Diamond Jubilee and the August Olympics. There remains considerable debate about the causes of this weakness. Does it reflect permanent supply-side damage which has worsened the trade-off between output and inflation? Is it caused by temporary factors which have depressed effective supply? Or is it simply caused by insufficient demand? Undoubtedly, all three explanations are relevant. Amongst UK policymakers there is a growing sense that the weakness of UK output is a supply-side phenomenon, and that it is likely to be permanent. The MPC, for instance, recently revised down its expectations for UK growth in the medium-term and argued that underlying productivity, which has been extraordinarily weak in recent years, would only expand slowly in the years ahead. This is a notable admission – the Monetary Policy Committee (MPC) not only believes that the crisis has had a large one-off effect on potential output, but also that it will constrain potential output growth over the medium-term.

Yet, the MPC also places weight by the view that demand and potential output will move together over the years ahead; i.e., that the weakness of productivity is in large part due to effective supply failures and sluggish demand. If so, a failure to stimulate demand sufficiently today will cause lasting and avoidable supply-side damage. MPC members are right to acknowledge the limits of asset purchases, and monetary policy more generally – monetary action cannot bring about the necessary real adjustments in the UK economy and elsewhere. However, the MPC, and other UK policymakers, are increasingly being gripped by policy defeatism. In the aftermath of a severe banking crisis, the feedback loops between demand and potential output are likely to be much more powerful than in normal times. Overall macroeconomic policy must err on the side of doing too much in the current environment. In light of the planned fiscal tightening, the heavy-lifting must be done by the Central Bank. Ideally, this would be supported by an easing of capital and liquidity restrictions on UK banks, which although desirable in the long-term, are counterproductive in the current environment. The transfer of accumulated coupon payments on the BoE’s gilt holdings to HM Treasury represents an additional degree of monetary accommodation. As the funds are transferred, the government’s need to issue gilts to fund the budget deficit will be reduced – this should boost broad money by an equivalent amount and work in a similar manner to Bank of England asset purchases. The benefits of the Funding for Lending Scheme (FLS) should also filter through to overall monetary conditions in the months ahead. It is worth waiting to see how much support the scheme provides. Monetary policy will also have to respond quickly if conditions in the Eurozone worsen. On balance, however, additional monetary ease is likely to be needed, even if the Euro area muddle-through continues.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: Maintain asset purchases at £375bn; only increase the total to offset declines in M4ex.

We live in a world where the monetary transmission mechanism works well most of the time, but at certain times it fails. Keynes called this problem ‘magneto failure’ (i.e., comparable to the failure of the electrical system in a car). What Keynes meant was that in a modern economy broad money is created mainly by commercial banks making loans, not by central banks creating bank reserves. In normal times, the rate of growth of broad money is a good guide to the rate of growth of nominal spending. However, when households or firms or financial institutions are reluctant to borrow – as they tend to be after a bubble has burst, and when, in addition, banks are reluctant to lend, then the monetary transmission mechanism does not work. Under these conditions, no matter how low interest rates fall, the reluctance to borrow and lend may frustrate the authorities’ wish to maintain adequate rates of money growth to ensure full employment GDP.

In Keynes’ 1930 Treatise on Money he argued for extreme measures of monetary expansion (“monetary policy à outrance”), or QE as we would say today. “These extraordinary methods are, in fact, no more than an intensification of the normal procedure of open-market operations. I do not know of any case in which the method of open-market operations has been carried out à outrance.” However, he had concluded by his 1936 General Theory that the authorities would either not do this (“Central Banks have always been too nervous hitherto”) or that the economy could remain far below full employment for extended periods even with such measures. Consequently Keynes came to the view that the economy should fall back on government borrowing and spending to ensure adequate aggregate demand at such times of ‘magneto failure’.

Central banks and government Treasuries face exactly the same dilemmas today. On the one hand, the Bank of England, the US Federal Reserve and the European Central Bank (ECB) have all been expanding their balance sheets. The Bank of England and the Fed have done this mainly by adding to their holdings of securities, while the ECB has done it mainly by making loans, and yet real GDP growth in each area remains far below desired growth rates and levels, while unemployment remains disappointingly high. In general, central bankers are nervous about going to extremes and flooding their economies with excess money as this would arouse fears of inflation. Similarly, and on the other hand, governments have been increasing their borrowing and spending in order directly to boost incomes, output and employment. Yet they, too, are acutely nervous of excessively increasing their indebtedness beyond some undefined limit in case investors react by rejecting their debt offerings, driving up government bond yields, and having knock-on effects on other public and private borrowing costs.

If this is the intellectual backdrop to the debates on QE and austerity in Britain today, what should policy makers do – follow the Keynes of 1930 or the Keynes of 1936?

On the monetary side the key question is: what is the appropriate rate of growth of broad money? If Keynes were alive today he would surely say that ‘animal spirits’ were depressed and the reluctance of households and financial institutions to borrow and the reluctance of banks and others to lend was inhibiting the rate of money growth as a consequence. On the face of it, this means that there is a strong case for continued asset purchases by the central bank. However, the problem here is that while M4 declined by 3.5% in September compared with a year earlier, M4ex (which excludes intermediate other financial corporations’ holdings) increased by 4.1% over the same period and by over 7% p.a. on a three month annualised basis. This was probably, in part, due to the £50 billion asset purchase programme initiated in July.

Since CPI inflation has recently increased to 2.7% in October, the Bank should probably err on the side of caution for a while. Having made the serious error of presiding over excessive monetary growth between 2004 and 2009 (with M4 growth mostly in the range 8% to 14% p.a.), the Bank of England should now be much more careful to maintain broad money growth below 8% for the foreseeable future. In my view, therefore, the Bank was probably correct to suspend asset purchases in November. Nevertheless, this question should be reviewed if money growth shows signs of weakening in future. Against this background, the Bank of England should hold rates stable at ½%, but be prepared to undertake additional asset purchases if M4ex growth falls abruptly.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; gradually withdraw QE.
Bias: To steadily raise Bank Rate to 2%, then pause to review.

The economy will grow faster over the medium term if interest rates are closer to the natural rate – which probably sits at around 3.5% at present and hopefully will rise to about 5% over the next five years. With positive GDP growth last quarter, the MPC has another window of opportunity to raise rates. With inflation rising again, it should find that straightforward to explain in terms of the inflation target, insofar as that is still a relevant determinant of policy – i.e., very little. A rise of ½% initially then increments of ¼% to ½% each month until 2% is reached would provide an initial phase of normalisation.

QE was originally envisaged as gradually phasing itself out as coupon payments came in and bonds were redeemed. With the Treasury's decision to take £37bn in interest payments as a notional ‘profit’ on QE - notwithstanding the fact that the scheme currently stands to lose £48bn on a hold-to-maturity basis - the Bank of England faces a situation in which its original intention to withdraw £37bn of QE automatically next year will not be realised, unless there is an explicit decision to do so. Without such a decision, QE would only be withdrawn as bonds are redeemed or, alternatively, if bonds are sold into the market. However, the latter course would surely result in a significant fall in bond prices. There has already been too much QE. Nevertheless, it would shake confidence to explicitly withdraw QE at this stage by selling bonds. It would be better to allow QE to be phased out gradually by retiring the money of coupons as they are paid and for the Treasury then simply to make its standard claim on the profits of the Bank. This should be done.

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

Unfortunately, it is difficult to talk about monetary policy today without referring to regulatory policy. These two branches of policy will now be put under one roof, with the new Governor of the Bank of England in charge of both. It is hard to feel much confidence in the future conduct of either branch.

Looking over recent events, we observe that inflation has been above its target for several years. It was forecast to come back below 2% by the end of this year, but it now looks as if it will rise again towards 3% or more over the next twelve months. The Bank’s response to this further failure of control is to blame ‘individual price rises’ yet again; this time it is university tuition fees besides the old favourite of utility prices. Of course any month’s inflation figure is bound to be the result of some individual price rises but the point about higher inflation is that this is the way it always presents itself. The Bank has again taken no action in the face of this deteriorating inflation outlook. True, it has not done any further QE but neither has it ruled out more QE. As it has noted, the ceding to the Treasury of the debt interest on the gilts it has acquired represents a monetary loosening in the sense that it allows the Treasury to issue less gilts to private lenders than otherwise – it is as if the Bank had done this much QE and bought gilts issues to this amount.

It is now hard to see the Bank as independent of the Treasury and this government. The implicit ‘deal’ had been that: a) there would be fiscal tightening; b) this would be ‘offset’ as far as possible by monetary loosening, regardless of the inflation developments; and c) there would be extensive regulative tightening of the banking system. The Bank is a wholly-owned subsidiary of the Treasury so none of this is new. What is new is the subservience over the one part of the Bank’s remit where it was supposed to have ‘instrumental independence’ – viz. the targeting of inflation. The Bank was to be the outward manifestation of the de-politicisation of inflation, the keeper of the new anti-inflation consensus, much like the Bundesbank once was in Germany. Instead, it has neglected its credibility and inflation is adrift in a potentially dangerous way.

The one thing that is holding inflation down is the other major failure of this policy: the regulatory attack on the banking system that has resulted in the collapse of lending, especially to small companies. The UK’s ramping up of the Basel III requirements for capital and other tiers has made lending highly expensive, particularly for borrowers with high risk status. The point has repeatedly been made by Per Kurowski that Basel biases lending heavily away from risky borrowers anyway, since at the margin banks must not only suffer the extra risk of these loans but also load on the extra tier-capital costs the loans imply. Thus banks are incentivised only to lend to ‘low-risk’ parties – viz. certain governments and at a pinch top corporate borrowers.

So we have the worst of all worlds: a paralysed banking system awash with liquidity which it is unwilling to lend, so holding back growth in the economy. However, the fears aroused by this liquidity are undermining the inflation target’s credibility. It is said that we need all this regulation to stop future crises. But the evidence we have been able to gather in our recent research on the US, the UK and the Euro-area (see my academic page on www.patrickminford.net) suggests that crises will happen anyway and that if we have a banking system that is appropriately active in lending such crises will often involve the banks too. Furthermore, the UK as one of the great banking centres will necessarily have large foreign asset and liability positions: this has been its role through the ages and a major way the UK has earned its GDP. The liabilities are mainly deposits and the assets loan positions around the world. The Bank of England has been proud to be the overseer of this activity in the past. Now, and partly under orders from a government ignorant of such things, it is presiding over the ruin of this system in what can only be seen as a colossal loss of nerve.

We need to remind ourselves that efficiency in banking suggests that the margins between deposits and loan rates be kept to the minimum. Individual risk is not social risk in lending; socially there is pooling of individual risks. Society is best off when lending is cheap and priced as competitively as possible – see recent papers on the role of banking and regulation by Anton Korinek of the University of Maryland. Recent regulatory action is driving us further and further away from this social objective. It is ironic that the UK government, which should be supporting its major industry, is helping to organise its destruction.

It is said by the Vickers Commission that the investment banks must be deprived of access to deposits that are insured by the taxpayer; hence the proposed ‘ring-fencing’, a sort of bureaucratic Glass-Steagall arrangement. Yet the commercial banks used these deposits to make loans that went as badly wrong as did the investment banks with their more exotic loans. Deposit insurance is there to prevent runs on banks by making small depositors feel secure. Banks still lose money if they make poor loans, surely a powerful incentive against the ‘moral hazard’ of being secure about keeping their depositors. The main implication of the social optimum is that we need competition between banks, to drive down rates and encourage lending again. Bureaucratic schemes like ‘Funding for Lending’ cannot substitute for such incentives.

When policy is so badly adrift, it is hard to know what advice to give for that branch of it that merely deals with monetary policy. Some SMPC colleagues have naturally been impressed by the banking paralysis and the slow growth in the economy of which this paralysis is an important cause; these have prompted them to recommend keeping rates low and open the QE taps more. Yet it is obvious that these actions have not led to any rise in lending nor have they produced (as a result of this failure to stimulate lending) a healthy rise in the money supply. All that has been achieved is a very low cost of government borrowing and record low returns to savers on safe assets.

Getting monetary policy right, however, could lead to an improvement in regulatory policy, since then the government would realise that it could not rely on monetary ease to substitute for excess regulative enthusiasm. It would be forced to ease the regulative burden by the need to get lending and money supply growth and so growth in demand going up again against a backdrop of rising interest rates and reversed QE.

It is for this reason that interest rates should be raised forthwith by ¼% with a bias to raise Bank Rate further in a steady manner. QE should be stopped and reversed steadily over the next twelve months. These actions should be taken to remove the future threat to inflation posed by the QE-induced liquidity overhang; and by the loss of Bank credibility over its inflation target. As monetary policy is returned gradually to normality, excess regulative burdens should be removed from the banking system and competition reintroduced in a manner mimicking the entry of building societies into the banking high street in the 1980s and foreign banks in the 1990s. To help this process on its way, the Treasury should dispose of its stakes in Lloyds and the Royal Bank of Scotland group by breaking these huge banks up into competing parts.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Raise Bank Rate by ¼%; hold QE.
Bias: Avoid regulatory shocks; break up state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

It is increasingly likely that the 1% increase in UK GDP in the third quarter – which was confirmed by the revised estimate released on 27th November – was an aberration that largely reflected a catch-up from the negatively distorted second quarter figure. The very sketchy output and expenditure data for the fourth quarter suggest renewed weakness, although a lot will hang on the strength of household demand over Christmas. The UK is not alone in this fourth quarter faltering, however, and recent figures show a closeness of fit between the annual increases in UK real GDP and that in the wider OECD area which suggests that the British economy is to some degree being swamped by the turbulent events happening overseas. This is unfortunate because international indicators suggest that activity in the leading industrialised economies lost momentum in the fourth quarter. One example is the latest Munich based CES Ifo ‘World Economic Climate Indicator’, which continued to fall in 2012 Q4, albeit only slightly. The decline was due to less favourable assessments of the current situation and reduced expectations for the outlook over the next six months. The largest drop in the CES Ifo measure was recorded in Western Europe, and there was a more mixed picture in North America. However, even Asian respondents reported that current economic activity remained at an unsatisfactory level. The conclusion drawn by the CES Ifo economists was that the world economy was currently treading water. This seems to be as fair an assessment as any of the international background in which the UK economy is trying to operate.

Turning now to domestic matters, this commentary was prepared before the announcement of Mr Osborne’s 5th December Autumn Statement and the release of an updated set of forecasts from the OBR – the first time that these will have been updated since the 21st March Budget. There is little point in speculating about the details of the Autumn Statement, given that it will be announced only a few days after this note is released. However, it is clear that the March Budget forecasts for the public finances have proved overoptimistic and that the Chancellor’s fiscal policy strategy is badly off course. The fundamental reason is that, in practice as distinct from rhetoric, Mr Osborne has been attempting a Type 2 fiscal retrenchment predominantly weighted towards tax increases, rather than a Type 1 strategy in which spending discipline takes priority and taxes are not raised. This explains the sogginess of national output – although the situation has clearly not been helped by the weakness of many of our trading partners – and the unfavourable nature of the current output/inflation trade off. Unfortunately, the Chancellor also appears to have failed to get a grip on departmental spending. In particular, civil servants appear to have been running rings around Mr Osborne when it comes to their reward packages by using all the re-grading and other tricks they first learnt during the incomes policies of the 1960s and 1970s. It is questionable whether this situation can be turned round in time to fight a successful election campaign in 2015. Fundamentally, the Conservatives wasted their thirteen years in opposition, when they should have been devising a market-based, pro-growth strategy. They have since been learning from their mistakes while on the job but have done so too slowly to get a grip on events.

The contrast between the strong performance of the Canadian economy over the past five years and the worse performance of the British one may be one reason the Bank of Canada Governor, Mark Carney, has been appointed to follow Sir Mervyn King in June 2013. However, while the Bank of Canada clearly performed well in avoiding the worst excesses of the pre-2007 international credit boom and the subsequent crash, it was helped by a less highly-competitive and internationally-exposed banking system than Britain’s and by a far more responsible fiscal policy background. The latest figures from the OECD indicate that General Government outlays amounted to 39.4% of Canadian GDP in 2007, compared with 43.9% in Britain. Government outlays then soared to 48.7% in Britain in 2012, according to the OECD, but were still only 41.8% in Canada. The Canadian government had enjoyed a financial surplus of 1.4% of GDP in 2007 and its General Government Financial Deficit appears to have been a modest 3.5% in 2012. In contrast, Britain had already suffered a General Government Financial Deficit of 2.8% of national output in 2007 when it should have been running a substantial surplus on normal Keynesian demand management grounds. This deficit figure was still 6.6% in 2012, the ratio having peaked at not quite 11% in 2009. Fortunately, the strong international reputation of the new Governor will add to the credibility of UK macroeconomic policy. This is important given the poor outlook for fiscal consolidation and the need to avoid a collapse in overseas confidence ahead of the next general election. However, Mr Carney may have to undertake a major institutional re-building of the ‘old’ parts of the Bank, which failed badly in 2007 and 2008, as well as having to integrate its new regulatory responsibilities.

Meanwhile, it has been revealed by the independent Stockton review into the forecasting capability of the MPC, mounted on the Bank’s website on 2nd November, that the Inflation Report forecasts have been largely generated by a new macroeconomic model – known as ‘Compass’ – since November 2011. This has replaced the previous Bank of England Quarterly Model (BEQM) that had underpinned the Bank’s forecasting efforts for many years and was heavily criticised in the author’s May 2007 Economic Research Council paper Cracks in the Foundations? A Review of the Role and Functions of the Bank of England after Ten Years of Operational Independence (www.ercouncil.org). One of the main criticisms of BEQM in 2007 was that it contained a highly simplistic model of monetary policy in which only one short-term rate of interest was included and that there was no representation of other traditional monetary tools such as funding policy. According to the Stockton review, Compass represents an even more parsimonious Dynamic Stochastic General Equilibrium (DSGE) approach than BEQM, with only sixteen variables at its core. As far as one is aware, a detailed technical account of the new model has yet to appear in the public domain. However, it is unlikely that any of the so-called unconventional monetary policy tools, such as QE, now being employed by the Bank can be represented in the context of such a small model.

Another issue that probably cannot be encompassed in the new Bank model is the effects of negative regulatory shocks to the supplies of money and credit which have caused so much concern on the SMPC. Here one can only express agreement with Patrick Minford’s comments in this note and add four minor points. First, the payment of state-backed deposit insurance should be limited to a number of say 90% rather than the present 100% up to £85,000. This would encourage prudence on the part of depositors. Second, the most senior bank executives should have unlimited personal financial liability. There is ample historic evidence that this would remove a major source of moral hazard where the behaviour of senior executives is concerned. Third, because all the major banking groups are the product of numerous mergers over many years, the simplest approach to the ‘too big to fail’ problem would be to break them up into their original constituents using normal anti-monopoly legislation. Finally, some arrangement would have to be made to allow the demerged banks to share their computer systems for cheque clearing etc. on a fair basis until they have time to develop their own. This could probably be done by voluntary agreement. However, there might have to be an official arbiter on standby for cases of disagreement.

The more one thinks about the Chancellor’s 9th November decision to transfer gilt coupon payments received by the Asset Purchase Facility (APF) to HM Treasury, the harder it becomes to understand the political thinking involved. What may have happened is that the internal briefings on the forthcoming 5th December Autumn Statement indicated that the public finances are not coming right and this was a book cooking attempt to bring cash receipts forward – at the risk of an offsetting or larger reverse flow in future – in order to make the figures look better or, alternatively, too complex for anyone to understand. However, that means less cash flow in future, which is odd if one is thinking in terms of a 2015 election. The PSNB was already being pushed down by the once-and-for all £28bn receipts from the Post-Office pension fund in the present financial year. Even before the 9th November announcement, there was the likelihood of a sharp borrowing rebound in fiscal 2013-14 given the lack of progress in reducing the underlying deficit. The fact that the Post Office and APF announcements have artificially reduced borrowing by a total of £65bn in 2012-13 at the cost of large extra financial commitments in later years has substantially increased the likelihood that the government will go into a May 2015 general election with the PSNB way off track. Under these circumstances, massaging down this year’s borrowing at the expense of even worse figures in the run up to the election seems political suicide.

Meanwhile, the latest inflation figures show that the target CPI increased by 2.7% in the year to October, compared with 2.2% in September, while the all-items RPI and the old RPIX target measure increased by 3.2% and 3.1%, respectively. The ‘double-core’ retail price index – which excludes mortgage rates and housing depreciation and is the most historically consistent inflation measure – rose by 3.2% over the same period, compared with the 2.7% recorded in September. Producer output prices, which some people consider an early indicator of consumer prices, showed an unchanged year-on-year inflation rate of 2.5% in October, while the yearly rise in producer output prices excluding food, beverages, tobacco, and petroleum products accelerated slightly to a still modest 1.4%, compared with 1.2% in September. With the annual increase in economy-wide earnings a modest 1.8% in the year to the third quarter, there seems to be little risk of UK inflation accelerating too far in the immediate future, as long as confidence in sterling holds up, whatever one fears about the longer term inflation risks associated with current fiscal and monetary policies.

As far as the December Bank Rate decision is concerned, the temporarily reduced uncertainties in Continental Europe suggest that there is a window of opportunity to raise rates and that it is now time to introduce a modest ¼% hike in Bank Rate. The medium-term aim should be to get Bank Rate into the 2% to 3% range at which it re-engages with the money market rates that determine borrowing costs. The 4.2% annual rise in M4ex broad money in the years to both August and September, and the signs that broad money growth is accelerating, suggests that there is now a much weaker case for holding Bank Rate at the low emergency levels appropriate when the authorities were acting as a lender of last resort. Mr Osborne’s recent grab for the interest savings generated by QE has confirmed that such free funding has generated political moral hazard and allowed the Chancellor to avoid the hard public spending decisions required to stabilise the official finances. QE should be strictly reserved for lender of last resort purposes from now on and not employed as an instrument of day to day monetary policy.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

The weakness of corporation tax receipts is a warning not to read too much into the 1% rebound in third quarter GDP. The fiscal outlook for the economy has worsened appreciably this year, not so much because of weak growth as the legacy of the latest inflationary lapse. Indeed, public sector services made a chunky contribution to economic growth in the third quarter. The evidence is accumulating that more can readily be achieved with less (fewer employees) in the public sector, which can hardly come as a surprise. Unfortunately, productivity has been weakening in a number of other private sectors, including financial services.

Of even greater concern is that the impetus behind corporate investment has faltered again. This partly reflects the depressing messages from the Eurozone economies, but possibly a more general perception that the developed world is locked into a low-growth phase. The downgrading of future capital expenditure requirements may help to explain why asset lives are lengthening throughout the developed world and why so many global corporations are willing to return cash to shareholders. What does all this mean for the conduct of monetary policy?

The Bank of England must not lose sight of its goal of normalising short-term interest rates. Running policy on the basis of a permanent emergency is sending a progressively negative message to the entrepreneurial sector. The more reckless the policy, the greater is the risk to the real return on capital spending. If there is a role for ‘forward guidance’, it is to reassure of the Bank’s determination to take rates back to the region of 2% to 2.5% over the next two years. For now, the economy could do without any more tinkering. QE has reached the end of the road.

Comment by Mike Wickens
(University of York and Cardiff Business School)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate.

The immediate background to the next monetary policy decision is Mr Osborne’s December statement on fiscal policy. This will be for a British economy that remains flat and has a high and still rising level of debt – the latter constrains any scope for a fiscal stimulus. The only good news for monetary policy is that smoothed inflation has fallen somewhat, despite the uptick in October, due to energy price rises a year ago now dropping out of the year-on-year CPI.

The main problem for the UK economy is a lack of demand. Household expenditures are still suffering from the sharp rise in the savings rate in 2008 as households tried to reduce debt. This has been sustained by households saving for big ticket items rather than borrowing as previously. Investment expenditures and house building also remain depressed. These are both significant constraints on the effectiveness of monetary policy and QE. Historically low interest rates and plentiful bank reserves have failed to offset rock-bottom household and business confidence. To make matters worse, exports have fallen in 2012 due to recession in the EU – a main export market – and imports have risen. A steady appreciation of sterling during 2012, reflecting in part the perception that the UK is a safe-haven, has contributed to this worsening of the current account.

Falling government expenditures have added to stagnant aggregate demand. Even so, it is worth noting that in 2011/2012, as a proportion of GDP, the primary deficit has continued to increase as revenues have fallen more than expenditures. The consequent continuing rise in government debt – when combined with the fear of having to pay much higher interest rates as a result – remain a major constraint on the government’s willingness to borrow more to finance a substantial fiscal stimulus.

To make matters worse, according to recent public statements made by various members of the MPC, including the current Governor, there is little that monetary policy can do to provide a stimulus. Interest rates are already close to their lower bound and bank lending is no longer liquidity constrained. Furthermore, a flatter term structure due to further QE is highly unlikely to induce more private sector borrowing for business investment or for household expenditure. Significantly, QE is not much different from new government borrowing and therefore has done little more than offset the negative effects on the economy of this additional borrowing. It is worth noting that the lower-bound constraint on interest rates shows up in simulations of macroeconomic models as a negative monetary policy shock, implying that monetary policy is tighter than it would be if unconstrained.

A recent announcement is that £37bn in interest payments to the Bank of England arising from its purchases of government debt from the market will be returned to the Treasury. How to interpret this in terms of its effects on monetary and fiscal policy depends on how the ONS decides to incorporate it into the national accounts. Assuming that the interest payments are still included in the government budget constraint, then this is an increase in the money supply which will reduce the deficit and hence new debt issuance. The consolidated government budget constraint, which combines the government and the Bank budget constraints, is unaffected, however.

With monetary policy ineffective at present, there has been mention of an even more unconventional monetary policy: i.e., making a so-called ‘helicopter’ drop of money. This is a theoretical concept associated with Milton Friedman and the printing of money. The attraction is that it puts immediate spending power into the hands of income- and credit-constrained households who should then spend it, in theory. In practice, this could be achieved by a one-off cut in taxes or increase in benefits that is money, and not debt, financed. The apparent objection of the Bank of England is that it would be inflationary and would destroy the hard-earned credibility of the inflation anchor, probably the most important achievement of monetary policy since 1992. Although it would be expected to raise inflation temporarily, this fear would only be justified if the expansion of money growth were permanent and not one off. It may, therefore, be worth giving this serious consideration in order to get more growth. Such a policy would not, of course, be pure monetary policy; rather, it would remove the separation of fiscal and monetary policy of recent years.

Comment by Trevor Williams
(Lloyds Bank Wholesale Markets)
Vote: Hold Bank Rate.
Bias: Neutral.

In the minutes of the November meeting, the MPC highlighted the continued fragility of UK economic recovery. Whilst overall policy remained unchanged this month, the MPC is clearly watching domestic and global events carefully and is poised to react as and when necessary. However, the first question that arises is which way are the current economic trends pointing? In summary, they seem to be pointing lower where activity is concerned. However, there then comes the follow-up question of how to ease most effectively? A new approach may arrive with the new Bank of England governor, Mark Carney or, perhaps, not.

The MPC meeting saw only one vote for a further £25bn increase in QE, which was largely in line with market expectations. The 8 to 1 majority in favour of maintaining QE at its current levels was undoubtedly influenced by the early November announcements that the £37bn accumulated net interest on gilts that the Bank already held was to be transferred to HM Treasury. The effect of this was deemed to be akin to QE, negating the need for further monetary easing, according to the minutes of the MPC November meeting. However, that does not mean that further QE is completely off the agenda. The MPC did not rule it out. Instead, the monetary authorities were willing to assess the impact of programmes like the Government’s Funding for Lending Scheme, which appears to be finding some traction in particular in household borrowing.

Following wide consultation with a number of financial bodies, the MPC was explicit in ruling out any reduction in the bank rate from the current ½%, which was widely expected. It noted that a cut would hit the profitability of financial firms, further undermining confidence and future economic recovery. Regarding inflation, the effects of increases in household energy costs, rising fuel duty and higher tuition fees led the MPC to anticipate that the rate of inflation will remain above target over the coming year. Nevertheless, they project a return to around the 2% target once these pressures subside.

On that basis and considering the potential for a slowdown in output in the UK and the Eurozone in the final quarter of this year, the MPC acknowledged that there may be a case for further monetary easing in 2013. Despite the higher near-term inflation profile, the MPC noted that ‘a case could be made for a further easing in monetary conditions’. The minutes said that undertaking further stimulus could help to discourage ‘any further appreciation of sterling’ and ‘might help to avoid lasting damage to the supply capacity of the economy’.

My recommendation is that policy stays on hold, but if inflation were to approach last year’s levels of 5%, rates might have to be increased, given the damage that inflation has done to real growth. Nevertheless, this outcome seems highly unlikely as weak growth in Europe – and only a modest recovery elsewhere – do not suggest that we are on the cusp on an inflation surge. The question of what is damaging UK growth cannot be addressed by monetary policy alone. Also, the question of balance sheet adjustment – whether it is a supply of credit problem or a demand for debt problem or neither – cannot be addressed by interest rate policy. Hence, low rates may be here for some time.

What is the SMPC?

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

Current SMPC membership

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

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 16th October, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Britain’s Bank Rate should be held at ½% on Thursday 8th November. Among the dissenters, one wanted to raise Bank Rate by ¼% and another wished to see a ½% increase while – at the opposite extreme – one shadow committee member thought that Bank Rate should be reduced to a nominal 0.1%.

Looking further ahead, six SMPC members believed that Bank Rate should be raised in the near future, provided there were no further major shocks arising from overseas, and seven said that there should be no additional tranche of quantitative easing (QE). However, two members voted to increase the stock of QE by £50bn and £200bn, respectively. In addition, several SMPC members argued that QE would be more effective if it included the purchase of more private sector assets.

There was a widespread view on the IEA’s shadow committee that a substantial part of the UK’s poor growth performance since 2008 reflected supply-side weaknesses, including those caused by the hugely increased share of government and government-financed expenditures in national output since 2000, and that these weaknesses could not be overcome by injecting more nominal demand into the system. Unfortunately, the contrast between the weak output figures and the stronger trend showed by the labour market data up to 2012 Q2, made it hard to know how much spare capacity was available. However, the strong third quarter GDP figures, released after the SMPC gathering on 25th October, suggest that the underlying growth trend currently may be the equivalent of some 1¼% per annum.

Minutes of the meeting of 16th October 2012

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

Chairman’s Comment

The Chairman said that he was pleased that one of the newer and younger members of the SMPC would be doing the background presentation that evening, for the second successive quarter. Any committee that had maintained as much of its original membership as the SMPC had done since its establishment in July 1997 – he noted that no less than four founder members were physically present that evening – needed an infusion of new blood from time to time. He added that the SMPC was not a closed shop and that applications to join the committee from qualified younger monetary economists would be welcomed. The Chairman then invited Jamie Dannhauser to give his assessment of the global and domestic monetary situation.

The Global Economy

Jamie Dannhauser referred to his presentation which showed that the recovery in world trade had been slower than that which had followed any other world trade downturn since 1974. Global industrial investment had slowed. The savings and investment figures for the advanced and emerging economies indicated a history of excessive saving and overinvestment in the global economy. Fiscal consolidation had continued in the developed economies that had seen recent deficits in excess of wartime experience. World monetary and credit conditions remained weak and the lending survey of banks in emerging markets showed gradually tightening credit conditions. The Chinese economy had experienced a sharp growth slowdown. A hard landing had already occurred and there would be little policy stimulus until after the leadership changeover in China. There were some signs of improvement in the current quarter but underlying growth in China could remain weak for some time.

Recent work by the International Monetary Fund (IMF) on fiscal multipliers indicated the potential impacts of the expected US fiscal squeeze in 2013. The consolidation programme was taking place against the backdrop of easing credit conditions. The commercial banks in the USA had increased credit availability. However, the growth of US broad money on the M3 definition, which was currently around 4% year-on-year, had been boosted by portfolio outflows from bank debt into monetary assets, which suggested an increase in money demand rather than in money supply. There remained other reasons for caution, one of which was the still low level of real business lending relative to other post-war recoveries. Another reason was that US banks were still heavily reliant on foreign funding from non-banks.

In the Eurozone, lending to the public sector continued to grow but lending to the non-bank private sector had fallen. Broad money had grown moderately but the European Central Bank (ECB) lending survey indicated a continued tightening in lending standards. To the extent that the Spanish bailout package imposed even deeper fiscal retrenchment, it could be a disaster for Spain if the country was to sign up. It had the validity of a treaty and Spain would be stuck in an agreement that would be undeliverable with the outcome of a potential walk-away by Germany.

Bank lending rate spreads to firms and households have continued to widen and coincident indicators of activity in the Eurozone continue to point downwards. Nevertheless, money market conditions were much improved as evidenced by the continued decline in the Libor-OIS and FX swap spreads.

UK Monetary Conditions

In the UK, the underlying monetary picture remained weak. Spreads on syndicated loans had been rising. Nevertheless, companies were sitting on cash. The corporate liquidity ratio had been rising and there was no issue of a lack of access to credit by the company sector as a whole. Spreads on mortgage products had increased in the past year and were now in the range of 300 to 500 basis points (bps). Meanwhile, the marginal cost of sterling funding to UK banks had been falling. The Bank of England credit conditions survey indicated that, except for mortgage loans, credit availability was unlikely to change much in the coming quarter.

The Funding for Lending Scheme (FLS) represented a sizeable funding subsidy, which should encourage a greater supply of credit. How big a monetary stimulus it would provide remained unclear, however a Financial Services Authority (FSA) rule change had allowed banks to use their existing capital base to support new loans under the FLS which effectively imposed a zero risk-weight on new loans funded by the scheme.
UK Activity and Inflation Trends

Activity indicators showed a stagnant profile for the British economy. The UK economy was bumping along the bottom and experiencing zero-growth but there was probably no double-dip recession. Firms were prioritising cash on the balance sheet. UK goods exporters were benefitting from the weakness of sterling. However, this was being offset by declining exports from the services sector.

Household net worth and the savings ratio had risen but the story was less of a balance sheet repair than a labour market one. Employment intentions suggested a slowing in employment growth. Unit labour costs were rising and this would lead to deterioration in the jobs market if it continued. Real government departmental spending was expected to decline in absolute terms over the coming years. Fiscal multipliers under normal circumstances would be low but this was questionable in the current circumstances.

Inflation at 2.2% was marginally above the official target and was expected to rise in the coming months under the pressure of rising energy costs. The above-target outcome for inflation was entirely because of the pass through effects of increased costs. Underlying inflation was about 1½%. Inflation expectations on indirect and survey measures had fallen. While the recession had destroyed capacity, estimates of the output gap were probably in the region of 4%.

Discussion

Peter Warburton questioned Jamie Dannhauser’s conclusion that there had been over investment in the pre-2008 period, saying that the figures were based on a dubious adjustment for purchasing power parity (PPP). Jamie Dannhauser responded that he believed the figures were appropriate but would go back and check the basis on which they had been compiled. Akos Valentinyi said that the backdrop to the fiscal consolidation in the developed economies was the emergence of the sort of budget deficits previously only encountered in wartime. Jamie Dannhauser said that what was important was what the monetary offset would be.

Andrew Lilico and David B Smith then discussed whether the Chinese economy would slow down to in a similar way to the Japanese one, which had also enjoyed 10% plus real growth rates in the 1960s and early 1970s. The general view was that it would be another twenty years before China’s economy began to resemble the Japanese situation, although the longer-term demographic outlook for China was clearly not favourable.

Peter Warburton said that fiscal consolidation may not result in actual fiscal change. Jamie Dannhauser said that considerable political uncertainty existed about the fiscal consolidation programme in the USA. Akos Valentinyi said that the uncertainty of the fiscal consolidation extended to Europe with the problem of the democratic deficit in Greece, no structural adjustment was likely to occur.

As Roger Bootle had indicated that he had to leave by 6.30pm and time was pressing, the Chairman next asked him to make his comments before asking everybody else to cast their votes. These are listed in alphabetical order below. Because a full set of nine SMPC members had attended the meeting, there was no need for any votes in absentia this quarter.

Comment by Roger Bootle
(Deloitte and Capital Economics)
Vote: Cut Bank Rate. Increase QE.
Bias: Carry on increasing QE as necessary.

Roger Bootle said that he was puzzled about the underlying truth of the economic statistics. In his experience, London did not feel like a city in recession. However, the outlook was not very good. There was no hope of an expansion in bank lending. Real disposable income would rise if inflation eased but the signs were that inflation would rise in the short term. The discrepancy between the stronger employment data and the weak GDP figures remained a puzzle and QE could be used more effectively to stimulate activity, in his view. He therefore voted to cut the rate of interest further to 0.1% and to increase QE by a further £200bn, to take the total QE stock to £575bn.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate. Do not extend QE.
Bias: To increase QE and expand asset purchases to include private-sector assets, specifically bank debt.

Jamie Dannhauser said that he was not as bearish as Roger Bootle, although he generally held a similar view. He said that he wanted to wait and see what the effects of the FLS would be. The stresses related to the Eurozone had fallen back but he remained deeply concerned about the ultimate resolution of the crisis. He added that he was concerned about the hysteresis effects of a stagnating economy. Jamie Dannhauser’s conclusion was that rates should stay on hold but QE needed to be extended to include non-bank private sector assets.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼%. No QE.
Bias: To raise Bank Rate.

Anthony J Evans said that it looked as though a corner has been turned in the domestic economy but that the recovery would be like a barbeque – long and slow. Monetary policy had a role as a preventative but QE was now suffering from diminishing returns. Nominal GDP was increasing but this was largely through price increases. He said that this pointed to a supply-side problem. Inflation was set to rise. Monetary policy could still be useful if the situation changed and there was a genuine liquidity emergency. However, if interest rates were to return to normal at some point, they needed to be increased. It was unlikely there would be an ideal time to do this. Nevertheless, there was currently a window of opportunity and policymakers might also learn important lessons about the transmission mechanism from a moderate rate rise. Policy had to be rebalanced. He said that there should be no further QE and Bank Rate should be raised.

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

Andrew Lilico said that policy makers missed the chance to raise rates in 2010 and early 2011 and now should be looking for every new opportunity that presented itself. The correct policy concern was to raise the medium-term rate of growth, not the short-term rate. There existed a real danger of unemployment rising: firstly, as firms shed low productivity employees, and, secondly when, inflation having risen, policymakers do finally act against it. Credibility was not just about what rate of inflation is expected but about the belief that, if inflation were to rise, the Bank would conduct appropriate policy to bring it down — such credibility had gone, and it would be expensive to get it back. He said that the economy could experience both rising inflation and rising unemployment. Monetary policy had long-since done all that it could, and there was a need to normalise as quickly as could be achieved without tipping the economy over into slump. He voted to raise Bank rate by ½% with no further QE.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate. No further QE.
Bias: To raise Bank Rate.

Kent Matthews said that there was growing evidence that this particular financial crisis had been followed by significant capacity destruction. Research published in the American Economic Review showed that financial crises could lead to permanent and unrecoverable output contractions. The problem for monetary policy was that, if the output gap was small as a result of a permanent contraction in output, then QE was not just ineffective but was also storing up an inflationary balloon that would eventually burst with negative consequences for future monetary policy.

Kent Matthews added that there was a need to return to a ‘normality’ in which real interest rates were non-negative. The question of when Bank Rate needed to rise was a matter of fine judgement. With each passing month, economic uncertainty provided further reasons for keeping interest rates where they were. Right now, the weakness of Europe dominated the short term position of the UK. However, interest rates would have to rise in the near future to bring the economy and economic policy back into the realms of normality. He said that he was less optimistic about a resolution to the Eurozone crisis, which would continue for the foreseeable future and economic uncertainty along with it. If the crisis were to worsen, it would be better for the Bank to have room to manoeuvre by lowering rates from a position of normality. Supply-side policy should be the medium-term objective of the government.

He said that he too wanted to give the FLS a chance to work. However, and if it looked as if the commercial banks were using the scheme to widen spreads and increase liquidity rather than to increase lending, the case for raising rates was strengthened. For now, Kent Matthews voted to maintain Bank Rate at its present position with no further QE.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate. No additional QE.
Bias: To avoid regulatory shocks, raise Bank Rate and hold QE.

David B Smith said that he had attended the Office for National Statistics (ONS) conference on the discrepancy between the output and employment data immediately before coming to that evening’s SMPC meeting. Furthermore, a paper dealing with the issue by Peter Paterson The Productivity Conundrum, Explanations and Preliminary Analysis had been placed on the ONS website that day (i.e., 16th October). Nevertheless, it still remained difficult to reconcile the weak GDP figures with the strong employment data. He added that his main concern about Roger Bootle’s call for a further substantial bout of QE was the political ‘moral hazard’ it gave rise to in encouraging fiscal fecklessness. He accepted that the immediate economic impact of further QE need not be inflationary provided that the broad money supply was constrained by other – but probably, inherently undesirable – means such as regulatory-induced credit rationing, which was where we were at present. He was also concerned that, if Roger Bootle’s proposal was implemented, the gilt-edged market would be so socialised that it would cease to function properly or be available as a normal implement of monetary policy thereafter.

David B Smith added that his recommendation was to hold Bank Rate, but with a bias to raise it in the near future, and that it was time to prepare the financial markets for a putative rate rise. He also said that there should be no further use of QE, except in a lender of last resort situation. The increase in government’s share of the economy, which had been accompanied by increased and damaging regulation of the financial and energy sectors, had slowed the growth of potential GDP. International growth studies suggested that the rise in the share of the economy devoted to public sector consumption since 2000 had knocked the growth of potential GDP down from 2¾% to 1¼% at best.

Current policy was dominated by the short term. If the Coalition was not prepared to tackle the fiscal crisis through a package of genuine public spending cuts and lower taxes, then it was essential that it did everything in its power to improve the supply side through other measures, such as deregulation of the labour and goods markets and tax simplification. He added that an open economy, such as the UK, which had experienced a current account balance of payments deficit of 4% of market-price GDP in the first quarter and 5.4% in the second quarter was not obviously suffering from a deficiency of aggregate demand relative to total supply, to put it mildly. For much of the post-War period, officials would have argued that the balance of payments equalled the Keynesian demand gap with sign reversed.

His final comment was that institutions did matter. Like a defeated army, the Bank of England now needed a thorough institutional overhaul and the choice of the new Governor of the Bank of England would be crucial in that respect. Monetary policy was discredited and a new Governor had to restore credibility to the Bank through rebuilding its existing institution as well as taking on its new regulatory responsibilities. However, he welcomed the story on the front page of the 10th October Financial Times that the Financial Services Authority (FSA) had been quietly relaxing its crucial capital and liquidity rules in order to stimulate lending. This suggested that regulatory policy would be less perversely pro-cyclical than it had been hitherto, with consequent benefits to the real economy.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate. No additional QE.
Bias: To raise Bank Rate.

Akos Valentinyi said that the coordination of fiscal and monetary policy was important but that growth before the crisis was above potential. Part of the downturn was the correction in output from this overshot position. However, there remained uncertainty about the size of the gap although his view was that there will be inflation pressure in the future. Political uncertainty also impinged upon policy and there was a case for keeping rates on hold in consequence. He voted to end QE and to raise rates in the near future.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate. No additional QE.
Bias: To raise Bank Rate and diversify QE into private sector assets.

Peter Warburton said that UK macroeconomic policy was at a dangerous juncture and risked coming apart at the seams. The whole presumption that it was possible for the Bank of England to operate an independent monetary policy was at stake if the Government were to steer away from fiscal normalisation. Subject to a re-affirmation of the fiscal policy course on 5th December, it was appropriate to leave monetary policy on a loose setting. Indeed, the case for an easing of banks’ capital constraints was mounting, given that these appeared to be binding on economic outcomes, particularly the achievable rate of real economic growth. Abstracting from a number of temporary distortions, it seemed reasonable to suppose that the underlying growth rate for the UK was in the region of 1%, much less than before the global financial crisis. The financial crash was part of the crowding out transmission mechanism.

Over the longer term, this constraint could be lifted by improved supply-side policies, but the concern in the short term was that attempts to stimulate economic growth would merely deliver high and unpredictable rates of inflation. Given the likely positive impact of the FLS, Peter Warburton believed that there should be no further asset purchases of gilts. These had created an undesirable boom in the gilts market, which had been exacerbated by foreign demand for bonds that were not contaminated by the situation in the Eurozone. Bank Rate should stay on hold while the FLS was being evaluated but there should then be a bias to tighten. The existing QE pool should be diversified into private sector assets.

Comment by Trevor Williams
(Lloyds Bank Wholesale Markets)
Vote: Hold Bank Rate. Increase QE by £50bn in November.
Bias: Neutral.

Trevor Williams said that the global economy was weakening and the challenges facing the UK remained as intense as at any time in the last year, with some risks predominating to the downside. Key amongst these was the weakness in our key export markets and the deleveraging by households and companies. Hence policy should remain loose for now. With the backdrop just described, the announcement of a further £50bn tranche of QE in November seemed appropriate. However, the increased QE needed to be concentrated on private sector assets rather than gilt-edged securities, as hitherto. Thereafter, policy should be kept neutral, with a bias to tighten should recovery become sustainable. The outlook for fiscal policy should become clearer after Mr Osborne’s 5th December Autumn Statement. However, an expansionary monetary policy looked as if it had to be one of the offsets to economic weakness until such time as recovery appeared more certain.

Policy response

1. On a vote of six to three the committee agreed that Bank Rate should stay on hold.

2. Six members said that Bank Rate should be raised in the near future and seven said that there should be no further QE activity.

3. Two members voted for an immediate rise in rates and one voted for a further cut.

4. Two members voted to increase QE and two voted to extend QE to include private sector assets.

In its most recent e-mail poll, completed on 25th September, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Britain’s Bank Rate should be held at ½% on Thursday 4th October.

Two of the dissenters wanted to raise Bank Rate by ½% immediately, while another desired an increase of ¼%. There was a further divergence with respect to quantitative easing (QE). Most SMPC members thought that QE should be held at its present level. However, there was one who wanted a phased withdrawal on counter-inflationary grounds, while another believed that additional monetary stimulus would be needed if the recent improvement in financial-market sentiment proved transitory.

The Draghi proposals for the Eurozone, which had led to the improved market sentiment, were believed to have bought time but not, necessarily, to have produced a permanent solution.

In addition, there was a body of opinion on the SMPC that the longer-term risks associated with current monetary policies were increasing and could lead to a damaging upwards ‘gear shift’ in inflationary expectations. The US Federal Reserve’s QEIII proposals were a particular concern because of their open-ended nature. There were also reservations as to whether the European Central Bank’s theoretically unlimited commitment to purchase peripheral Eurozone debt could be anything more than a gigantic bluff.

Most of the sixteen German Federal States were themselves net fiscal recipients. This meant that the Eurozone’s public debt stock was effectively being underwritten by Bavaria and, to a lesser extent, Baden-Württemberg, not Germany.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; continue with agreed asset purchase programme.
Bias: Additional monetary stimulus.

The release of the detailed ‘Draghi plan’, and the announcement of additional monetary stimulus in the US, has buoyed financial markets. Equities have rallied further. There have been even more dramatic moves in Eurozone periphery government bond markets. For instance, the yield on Spanish ten-year paper has fallen by nearly 100 basis points (1 percentage point) since the early September European Central Bank (ECB) meeting. There have been signs of further improvement in bank funding markets as well. An indicative measure of UK banks’ marginal funding costs for variable rate sterling loans has fallen further in recent weeks and is now around 150 basis points below its May peak. This could be due, in part, to actions by the Bank of England to ease funding pressures on UK banks. The Extended Collateral Term Repo (ECTR) facility has brought sterling London Inter-Bank Offered Rates (LIBOR) closer to the expected path of Bank Rate. The fall in sterling LIBOR-OIS spreads has been larger than that for other major currencies, consistent with a beneficial impact from recent Bank of England initiatives. The Funding for Lending Scheme (FLS) is unlikely to have had much effect on the market cost of funding. However, it will offer UK banks a major subsidy, the size of which will be linked directly to the quantity of lending to the real economy. Commercial banks with outstanding loans to UK households and non-financial businesses of some £1,200bn have applied for access to the scheme. Relative to what would have happened otherwise, it should reduce both the cost of credit and the degree of credit rationing, potentially to a substantial extent. This should boost demand and potential output, leaving the effect on inflationary pressures uncertain.

Upward pressure on global food and energy prices suggests the near-term path of UK inflation will be slightly higher than previously expected. The implications for medium-term inflation are, however, limited. Higher food and energy costs have occurred alongside softening emerging world growth and downward revisions to global growth further out. This suggests that they are driven predominantly by supply disruption. The net effect on UK domestic spending is likely to be negative to the extent that credit constraints are preventing the normal process of consumption smoothing. At a global level, demand may also be reduced – higher commodity prices generally transfer income to countries with lower spending propensities.

However, the most difficult monetary policy judgement relates to the Eurozone crisis, and the lasting effects of the ‘Draghi plan’. These proposals could have a dramatic impact on asset prices and demand in the near-term, if they manage to reduce uncertainty about the Euro’s future and the disaster premium that is evident in parts of the financial markets. A clear path to resolving the mess in the Eurozone would go a long way to lifting the cloud of uncertainty that hangs over the global economy, notwithstanding the widespread concern surrounding the ‘fiscal cliff’ in the US. The Federal Reserve’s promise of open-ended monetary stimulus, until its employment objective is achieved, is an important move. It would seem to be the first of many steps towards the more formal targeting of nominal demand.

However, downside risks remain significant. Although Europe has cleared two important hurdles – the German constitutional court ruling and the Dutch elections – successfully, there remain several still to jump. Thus, the progression towards banking union in the Euro area is already stumbling. The farce in Athens continues. Spain is yet to apply for a bailout, and therefore ECB bond buying. While it looks like it will get there soon, there is the potential for a bust-up between Madrid and Berlin further down the line. Mr Rajoy is adamant that he will not take orders from the Troika on fiscal policy or supply-side reform. However, he may have to, given that Spain looks set to miss its budget targets by some margin this year – the general government deficit appears to have been 9% of GDP in the first half of 2012, compared with a full-year target of 6.9% of GDP. Then, we come to Italy, where application for a bailout remains a distant prospect.

In short, the improvement in market sentiment may not be long-lasting. Much can still go wrong. Now is not the time for a change in the monetary policy stance. In coming weeks, it will be important to assess the initial effects of the FLS on banks’ willingness to lend and the durability of the post-Draghi recovery in sentiment and risk appetite. On balance, it is still likely that additional monetary support will be required in the months ahead. As noted in previous months, this is not simply because demand will be insufficient to close the output gap; but also because persistently weak demand will impose unnecessary long-term costs on the economy, by depressing Britain’s long-run supply capacity. In the aftermath of a severe banking crisis, when demand, potential supply and the economy’s sustainable level of output are closely intertwined, monetary policy should err on the side of doing too much.

Comment by Anthony J Evans
(ESCP Europe Business School)
Vote: Raise Bank Rate by ¼ %.
Bias: Hold QE.

It continues to be troubling how the Bank of England has switched from an explicit inflation target to an implicit nominal GDP growth target. This goes against one of the key principles of the present monetary regime, which is transparency with the general public. While some savers can benefit from loose monetary policy – due to the subsequent increase in asset prices – those attempting to build their wealth are being hit hard. As the brilliant 19th Century French economist, Bastiat, would have pointed out, this is a classic case of policy makers favouring the visible – in this case, inflated asset prices – over the unseen (foregone returns). The counterfactual claim that, without monetary stimulus, all savers would be harmed on account of a financial meltdown cannot hang over the public indefinitely. We are now four full years from the height of the crisis, and need to take a step back. Recent Fed announcements come disturbingly close to an election cycle, and QE infinity is simply a free pass for profligate government spending.

At some point an attempt must be made to restore interest rates to their natural rate, and it cannot wait until conditions are ideal. As things stand, the Consumer Price Index (CPI) is stubbornly above target, output is sluggish but stable, and the Eurozone crisis is having a lull. There is a risk that tightening monetary policy now could change this. Nevertheless, if you believe that interest rates are some distance from the natural rate, a minor rate rise would still constitute a loose monetary policy. Furthermore, it would be useful to see just what impact such a rise would actually have on market rates.

The government continue to trial new policies attempting to improve the flow of credit to the real economy. The downside risk is that regime uncertainty is increasing. This can have the unintended consequence of dampening aggregate demand. It would be helpful if the Bank of England restated the full suite of monetary policy they have at their disposal, and clarify the conditions under which they would be used and, indeed, eventually retired. If the Eurozone implodes, or a stock market crash occurs this autumn, interest rate decisions now will not make a massive difference. It is important that the Bank of England is willing and able to prevent liquidity crises. Nevertheless, the pre-emption of tail risk should not be part of the monthly vote on Bank Rate. Rather, that should be guided by the level of interest rates consistent with an economy growing at or near potential, with low inflation, and a sustainable equilibrium in the market for loanable funds. This may appear to be a somewhat schizophrenic approach to monetary policy, but there is no such thing as a policy decision that’s right for all scenarios.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold at 0.5%.
Bias: Maintain asset purchases at £375bn; only increase the total to offset declines in M4.

The British economy continues to make slow progress against at least three headwinds: firstly, the need to repair balance sheets in the household and financial sectors; second, the weakness of economic activity abroad, particularly in the Eurozone, our largest trading partner, and, third, the tendency for inflation to exceed personal income growth over the past year or two, thus eroding purchasing power in the crucial consumer sector. None of these headwinds will be overcome quickly, and none can be suddenly circumvented by any magical fiscal or monetary solution.

Given the high levels of outstanding debt among householders and the overriding need to restore stability to the banking sector, policy-makers can only take limited measures to accelerate balance sheet repair. A review of the historical evidence on the recoveries from past financial crises suggests that the time taken to achieve a full recovery depends on factors such as: the extent of leverage at the onset of the crisis; where, or in which sectors, the leverage was concentrated; the national savings rate, and the underlying growth rate. Unfortunately, Britain scores very poorly on all these measures, implying a prolonged and painful climb back to full economic health.

The repair of household and financial sector balance sheets is proceeding slowly. The debt-to-disposable income ratio of households has declined from a peak of 175% in 2008 Q3 to 152% in 2012 Q1, equivalent to the leverage ratio reached in 2005. Some economists have pointed out that financial assets of households have increased by an amount comparable to the growth of debt, implying zero increase in net debt, but this is simply the consequence of the buyers or borrowers paying the sellers for their assets. What matters is that, since house prices have declined and credit conditions have tightened, a substantial fraction of households have a debt level higher than desired and wish to reduce it. It is impossible to know how far households will wish to reduce their debt-to-income ratio. However, and based on the experience of the 1990s this is likely to take the best part of a decade, as it did then.

With respect to the banks, they entered the crisis with leverage ratios in excess of 50 times (measured as un-weighted assets to common equity) and that ratio has declined to about 33 times. For better or worse, Basel III is proposing a leverage ratio of 22 times (4.5% capital to risk assets, supplemented by an additional 2.5% capital buffer) and the Vickers Commission has proposed a leverage ratio of 10 times for large retail banks, so there is still a considerable way to go.

On the external side, the crisis in the Eurozone (and the consequent recessions in the periphery and slowing growth in the core), the sub-par growth of the US economy, and the slowdown in China and the rest of east Asia are all contributing to weak demand for British exports. Slower growth of Britain’s exports than might otherwise be the case implies a longer period will be needed to rebalance the economy away from consumption and housing towards exports and business investment. Needless to say, the UK government can have almost no meaningful influence in accelerating the recoveries of foreign economies.

Probably the area where the authorities can make the most contribution is in overcoming the tendency over the past year or two for inflation to exceed personal income growth, which has had the effect of eroding purchasing power in the crucial consumer sector. However, the solution is not straightforward even here. Promoting additional domestic spending by monetary or fiscal means may weaken sterling and encourage inflation; restraining domestic spending too much could weaken the recovery and delay private sector rebalancing.

CPI inflation slowed to 2.5% year-on-year in August, and should decline further. The fact that Britain has suffered higher CPI inflation than either the US or the Eurozone over the past two years reflects three factors: the surge in monetary growth in 2009 and 2010; the fiscal choice to raise indirect taxes such as VAT, fuel duties, and air passenger duties, and the weakness of sterling. However, now that monetary growth has slowed as the demand for loans has plummeted and the fiscal accounts are gradually improving (albeit too slowly to meet the Coalition’s target of stabilising the debt-to-GDP ratio by 2015/16), there are better prospects of nominal incomes exceeding inflation in 2013. This in turn should promote real GDP growth. In this environment, the Bank should hold rates stable at 0.5%, but be prepared to undertake additional asset purchases if monetary growth plunges again.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; complete the latest £50bn QE stimulus.

Sir John Major tempted fate recently with his talk of the ‘green shoots’ of economic recovery and the omens remain poor at present. Even though the 2012 Q2 GDP figure may be revised up again to show a fall of 0.4%, compared with the preliminary 0.7%, as a result of the latest revisions to the construction output data, the underlying picture looks depressed ¬– even if there will almost certainly be a positive GDP ‘bounce’ in 2012 Q3. The employment figures remain, at face value, puzzlingly strong. However, once allowance has been made for: the rise in part-time work; higher self-employment; an increase in the numbers on government training schemes, and a short-term ‘Olympics factor’, the increase in employment looks less impressive. It is admittedly true that there has been a pick-up in August’s Markit Purchasing Managers Index (PMI) for the services sector but the balance (at 53.7) remained down on the figures recorded earlier in 2012. Meanwhile, the August PMI for manufacturing merely showed an “easing in the downturn” – i.e., no green shoots there – and the construction PMI recorded the “fastest drop in new orders since April 2009”.

The Chancellor recently announced the date of the Autumn Statement (5th December) when the revised forecasts from the Office for Budget Responsibility (OBR) will surely show a further deterioration in the projections for both GDP and the public finances compared with March. The latest official statistics indicate that the cumulative PSNB in the first four months of the 2012-13 fiscal year was around £10bn higher than in the equivalent period of 2011-12, once allowance has been made for the £28bn transfer of the Royal Mail pension fund. It seems almost certain that meeting the rolling fiscal mandate will slip another year – i.e., to 2017-18 – compared with the 2014-15 date originally forecast by the OBR in June 2010. In addition, the fixed ‘supplementary target’, which specifies a falling debt/GDP ratio in fiscal 2015-16, will probably be missed. It seems unlikely that the Government has the appetite for the spending cuts and/or tax hikes required to meet this target. Indeed, the markets are already being softened up for the target to be missed. Sir Mervyn King said recently that it was ‘acceptable’ to miss the target if the economy continued to grow slowly.

Under these circumstances, the Bank of England looks set to maintain its very accommodative monetary policy for months, if not years, to come. Nevertheless, the Bank is unlikely to make any further move before November as officials are in ‘wait and see’ mode. They will take stock of the impact of both the current £50bn of QE stimulus and the FLS scheme before making further moves. More QE is anticipated before the end of the year, but the Bank is not expected to cut interest rates further. It makes sense to continue to support a very accommodative monetary policy, but the time to consider a further tranche of QE is November at the earliest. Bank Rate should be left at 0.5%. There is little point in cutting it further.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no more QE.
Bias: To raise Bank Rate further and restore interest rates to 2% in fairly short order.

Relatively little has changed in the macroeconomic picture in recent months. Data-miners search for evidence of turning points in car sales or sentiment indices or try to cast doubt upon the GDP figures by comparing them with employment data. Suppose that both the GDP and output data are correct – output is falling slightly whilst employment is rising. What would that mean? If we think of a fairly standard production function, in which there is capital and labour and each has a share in output (for the technically-minded, I have in mind a Cobb-Douglas form), then if output is falling whilst labour rises, that must mean either that labour's share in output is falling or that the stock of capital is falling. Given that wages have been rising more slowly than prices for some time, it might be natural to imagine that the key factor is a fall in labour's share in output; prices are rising more quickly than salaries, so salaries comprise a reducing proportion of total expenditure. There may be something in this, but it is also true that a significant driver of price increases has been rises in the cost of other factors, including energy and raw materials.

An alternative, and not-incompatible, hypothesis is that the real output value of the capital stock is falling. There are many reasons this could be so. There is the straightforward one that with business investment so low there may be depreciation. However, and more significantly, there is a good chance that a significant portion of the current capital stock is obsolete. Partly, that could be the result of technological developments. Investments might have been made in the late 2000s on the basis that, with total demand growing rapidly, there would still be residual demand that would not be satisfied by internet-based or other new technology based services. However, the shrinkage in the economy has made it possible to serve a larger portion of the demand purely with new technologies, rendering the capital supporting older technologies obsolete.

There could also be significant geographically-based obsolescence. Much human or other capital could have been based on servicing demand stemming from the Eurozone. However, the composition of UK trade is likely to switch decisively away from the Eurozone over the next few years. This could be driven by regulatory changes such as the UK's departure from the EU or by big shifts in international tastes (e.g., increasing future Chinese tastes for consumption).
Reflecting upon these points, we note first that the GDP and employment data may not be as incompatible as they first appear. Secondly, if the above factors are in play, then the economic challenges the economy faces are even less likely to be malleable through monetary policy. If labour's share in income is indeed falling, then even some output recovery may not see wage-based households finding it easier to service their debts (e.g. their mortgages), implying an even more challenging five-year outlook for the UK's banks. If capital is obsolete – and likely to become more so, potentially – then attempting to stimulate demand through low interest rates and QE is futile and counterproductive.

Monetary policy is an excellent and powerful short-term tool. Active demand management can have potentially extremely valuable impacts over a timescale of, say, nine months to three years. However, we are now five years in to the financial crisis and have seen interest rates at zero for three and a half years. Monetary policy cannot help the economy any more than it has already done. It is long past time for it to withdraw from the field. From here, desperate and futile attempts to engage in ever more monetary stimulus can only serve to increase the risk that, if and when the economy does finally start to recover, we have to deal with strong inflationary pressures – meaning a further recession early in the true recovery. As monetary policy-makers, we have done our best. It is time for active monetary management to retire gracefully from this battle and leave the task to other more suitable mechanisms.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks.

The steadily improving labour market data suggest that the British economy is now growing. It seems likely that the third quarter GDP figures will show a good rebound when we get it in a month or so and that the process of upward revision of the previous figures will continue. This is why, disregarding the arithmetic implied by the earlier Office for National Statistics (ONS) estimates, we will continue to show growth for the current year. There have been some side benefits of the poor GDP figures and all the popular talk of ‘double dip recession’. These have come in the form of several policy changes, as the coalition have had to focus on ways of delivering growth, at the expense of their previous priorities of the green agenda, anti-banker populism with manic reregulation, and infrastructure decisions designed to make non-economic points (such as the HS2 rail link and the denial of the third Heathrow runway). Mr Osborne has taken charge of the new direction and we now have: 1) the new FLS programme under which the marginal costs to the banks of making extra lending will be cut; 2) urgent consideration of how business lending can be boosted – perhaps by creating a new business bank, perhaps by spinning off parts of the two behemoth banks under government control as new banks, designed to boost competition and lending on the high street; 3) a review of airport provision, opening up the issue of runways from 2015; 4) a new labour regulation reduction for Small and Medium Enterprises (SMEs) based on much of the Beecroft Report, and 5) a new Cabinet in which the balance has tilted towards ministers who want to deregulate more actively, and a programme to liberalise planning decisions.

How far these measures will make a difference remains to be seen. However, with the help as well of a calming of the Eurozone crisis by the ECB’s announcement of direct purchases of weak governments’ bonds when their yields are threatened by crisis, we may now see an easing of the great credit freeze-up, which may well be the key factor holding back the recovery.
We still have poor news on the progress of public borrowing. However, there has undoubtedly been a large cutback in public sector employment. After allowing for reclassification, this reduction has been around 600,000 since 2010, or about 10% of the total. Benefit payments have been boosted by indexation to the soaring RPI. However, it should become easier politically to cut benefit packages as growth strengthens and, with employment improving, payments should gradually fall back automatically. Furthermore, and with profits having grown substantially, the big corporate tax-gathering season in the final quarter of the present fiscal year should be a lot stronger. With retail sales finally rising in volume terms at around 3% we should also see better VAT receipts.

Now that the government has finally come around to a pro-business agenda, the achievements in other areas are starting to come into focus. The first is the austerity programme. Second, is the reform of the National Health Service: it is to be hoped finally embedding the ‘internal market’ started by Lady Thatcher. Third, is the strengthening of the new independent schools programme started by Tony Blair; and the associated attempts to raise the standards of teaching and those set in examinations. Last, but not least, there is the withdrawal of benefits from middle-income households under the various attempts to reform the benefits system. The previous tax credit system had begun to pervert the incentives of the better off. Unfortunately, there is not much that can be done in practice about the effect of the benefit system on the least well off. The best that can be achieved is that the pressures to get into the labour market can be increased, people can be pushed into cheaper housing and huge payments to dysfunctional families can be curbed. Nevertheless, the political commitment to help the poor ensures that incentives at the bottom are weak. The key is to stop the system before it reaches up to pollute incentives for the middle classes. This is politically possible, and economically desirable, even if it produces points just below middle income where marginal withdrawal rates get very high; generally these have little effect on middle class people.

Against this background, monetary policy may be able to get back to some normality in the UK. It is clear that growth is gradually returning in line with improving market fundamentals. If the latest initiatives mean that lending improves, this will help the process along. As recovery proceeds, it will become increasingly dangerous to leave the vast reservoir of bank liquidity created by QE, let alone to add to it. QE, which has mainly had the effect until now of making government borrowing extremely cheap and depressing returns to savers, could start to pose a serious inflationary threat. We could move from credit famine to credit binge rapidly. So the Bank needs to move in good time to withdraw this threat; these things cannot be left until the moment the binge is underway.

The decision by the US Federal Reserve to go for a third round of QE by printing US$40bn a month to buy mortgage-backed securities, until such time as unemployment comes down, is an astonishing decision which seems to forget the basic tenet of macroeconomics: that monetary ease cannot create employment except when applied temporarily as an attempt to counteract a negative shock. The Fed risks an even worse inflationary threat than here in the UK since its commitment is so bare-faced and open-ended.

Summing up the situation in the US and the UK, we have a slow recovery and weak growth; bank credit seems to be frozen. We have a huge regulatory reaction to the past crisis that, with the Eurozone crisis, may well account for this freeze-up. QE seems to have lowered the cost of government funding but not apparently the terms of credit to smaller firms, while it has added massively to bank reserves. It would have been better to tackle the credit problem at its root in excess regulation; and keep some control on the reserves injection. As it is, both governments are beginning to understand the regulative issues and trying to ease up on them. The US is directing QE directly into the credit market, while the UK is subsidising banks’ marginal lending costs. There is a desperation now engulfing monetary policy which looks dangerous – much like the desperation that engulfed the Heath government’s policies in 1971, with every lever being pulled to target unemployment. This desperation needs to be curbed. Interest rates should start to rise and QE should be stopped and then reversed. Bank Rate should go up to 1% at once, with further increases to follow, and QE should be steadily reversed. The unfreezing of credit should be done by easing of capital and liquidity regulations, on top of the new FLS.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate; no immediate increase in QE.
Bias: To avoid regulatory shocks; break up large state-dependent banking groups; raise Bank Rate, and maintain QE on standby.

Both international monetarists and the domestic closed-economy variety might take some comfort from the fact that the annual increase in both the aggregate Organisation for Economic Co-operation and Development (OECD) stock of broad money and its British equivalent appear to have accelerated during recent quarters, albeit continuing to run at historically low rates. In the case of the OECD area as a whole, broad money growth fell precipitously from a rate of 9% in late 2008 and early 2009 to not quite 2½% in the first quarter of 2010 but then started accelerating into the 6¼% to 6¾% range where it has broadly fluctuated since the second half of 2011. Likewise the growth of Britain’s M4ex broad money supply definition had averaged only some 1½% to 1¾% in 2010 and 2011 but had picked up to 3.9% by July 2012. Since these rises are running somewhat ahead of inflation, which was 1.9% in the OECD area in the year to July, real money balances are now growing. At the same time, the demand for the interest-bearing bank deposits included in broad money remains weak because of the low or negative real returns being paid on such assets. The relative strength of oil and non-oil commodity prices, the modest recovery in equity markets since May, and the emergence of positive annual house price inflation in the UK (the ONS index increased by 2% in the year to July), also suggest that there is now a broadly adequate supply of money relative to the demand for it, both overseas and domestically. The fact that there has been only a limited output response so far is consistent with the view that we are still only in the earliest stages of the monetary transmission process towards recovery.

There are three caveats, however. The first is that broad money is notoriously difficult to define and measure. The OECD figures may be distorted because they now include relatively high inflation economies such as Turkey. The OECD used to publish a useful series for broad money excluding the high inflation economies, and its consumer price index equivalent, but ceased to do so a few years ago. The second concerns the distinction between money and credit, in a situation where banks are holding an increasing share of their balance sheets in government debt – partly, because they are obliged to do so on alleged regulatory grounds. The accepted view is that it is the money stock that matters in the long run, irrespective of whether money is being driven by credit extended to the private sector, loans to government, regulatory changes or transactions with the overseas sector. However, the availability as well as the price of credit can be a powerful influence on activity in the short run, even if firms can economise on its use in the long run, just as they can do with other inputs into the production process such as energy or raw materials. The extent to which businesses chose to reduce their reliance on a particular input, such as credit, depends on the costs and benefits involved. However, some two-thirds of small businesses seem to have more bank deposits than debt and would benefit from higher rates of interest. It is important not to be unduly swayed by a vocal minority of credit-hungry businesses, particularly as the credit is often used to support speculative activities rather than the creation of real wealth.

The third caveat is that there is no recovery so robust that it cannot be de-railed by really dumb actions on the part of politicians, the central bank or financial regulators. There have been far too many such blunders in the 21st Century. There are several reasons why the recent recovery has been disappointing. Nearly all of them can be blamed on the political and bureaucratic classes rather than the citizenry. First, the supply side of many leading Western economies has been garrotted by the large increases in government spending since 2000 or so. Almost all the leading economies appear to have moved onto a permanently lower growth path as a consequence. Second, the globally-synchronised move towards increased financial regulation has been introduced at precisely the wrong point in the business cycle. Over-regulation may be in the best interests of the bureaucrats concerned, for ‘public-choice’ reasons. However, it is stopping global banks from properly supporting a private-sector recovery. The third reason has been the tax uncertainty associated with current large budget deficits. The statistical evidence indicates that budget deficits crowd out private activity under most circumstances and do not stimulate it as Plan B advocates allege. Furthermore, there is strong evidence that such crowding out is especially powerful in open economies, with a floating exchange rate and a public debt to GDP ratio approaching 100% – all of which applies to Britain. Finally, politicians have created huge uncertainty for all private-sector economic agents by their misguided policies and grandiose projects. This is an important reason why business is not investing and consumers are reluctant to spend. Here, European Monetary Union (EMU) is the stand out example. However, EMU is almost certainly doomed; if for no other reason than it is impossible for the 12.5m population of Bavaria and, to a lesser extent, the 10.7m citizens of Baden-Württemberg to underwrite without limit the debts of the 317m inhabitants of the Eurozone. The other fourteen Federal German states absorb more fiscal resources than they generate in taxes. So, the Eurozone is effectively being backed by Bavaria, not Germany.

The target CPI increased by 2.5% in the year to August, while both the all-items RPI and the old RPIX target measure increased by 2.9%. The ‘double-core’ retail price index – which excludes mortgage rates and housing depreciation and is the most historically consistent inflation measure – rose by 3% over the same period. These figures are not particularly low by international standards. Annual Eurozone inflation was 2.6% in the year to August and Chinese inflation was 2.0%. The equivalent US and Canadian figures were 1.7% and 1.3% (July), respectively, while the consumer price indices in Switzerland and Japan have fallen by a respective 0.5% and 0.4% over the past twelve months. The ONS series for producer output prices, which some people consider an early indicator of retail prices trends, accelerated from a year-on-year inflation rate of 1.8% to 2.2% between July and August but was still well down on the rates of 6% or just over recorded in the third quarter of 2011. Furthermore, the unchanged yearly rise of 1.2% in producer output prices excluding food, beverages, tobacco, and petroleum products recorded in August was also well down on the recent peak of 3.7% recorded in September 2011. With the annual increase in economy-wide earnings only 1.5% in the year ending in May/July, there seems to be little risk of UK inflation accelerating in the immediate future, whatever one fears about the longer term inflation risks associated with current fiscal and monetary policies. The recovery in the sterling index since the summer of 2011 has been a useful aid to constraining domestic inflationary pressure, even if it has not been a deliberate policy goal.

The latest Beacon Economic Forecasting (BEF) projections suggest that Britain’s national output will contract by an average of 0.3% this year, given the published data available on 25th September – unfortunately, this report had to be finalised before the publication of the revised national accounts on 27th September. The UK economy is then expected to grow by 2.1% on average next year, before accelerating to 2.7% in 2014. However, this assumes that the current official data are reasonably accurate. This is something that many data users have reservations about. It would not be a surprise if the 2012 growth rate were to be revised up to a positive 1% to 1½% in the fullness of time, for example, given the strength of the labour market indices. If one maintains the supposition that the ONS data is reasonably valid, then CPI inflation is expected to ease to 1.9% in the final quarter of this year and 1.5% in 2013 Q4 but then accelerate to 2.4% in the closing quarter of 2014. The annual increase in the ‘double-core’ RPI is expected to be 2.3% in the final quarter of this year, 1.9% in late 2013 and 2.9% in 2014 Q4. However, a disturbing feature of the ten-year ahead BEF projections is that inflation continues to pick up thereafter, with both UK CPI and OECD inflation rates breaking through the 5% barrier in the latter years of the decade.

This predicted shift onto a higher inflation plateau is essentially a delayed consequence of the hyper-loose monetary conditions that have prevailed in recent years, which may take more than half a decade to fully work through. This is an issue that badly needs to be debated, if central banks are to achieve their inflation goals and maintain the credibility needed to avert stagflation without having to aggressively slam on the brakes at some stage. As it is, Bank Rate is expected to be held at its present ½% until the third or fourth quarter of next year before rising to 2% or so by the end of 2014. There have recently been some noticeable downwards revisions to the earlier published figures for Public Sector Net Borrowing (PSNB) which seem to result from Local Authorities – who have also done much of the public sector job shedding – not fully spending their financial allocations. The ONS now claim that PSNB was £119.3bn in fiscal year 2011/12. The BEF projections show the PSNB falling to £86.7bn in 2012-13, rising to £129.7bn in 2013-14, and then easing to £117.1bn in 2014-15. However, these figures have been distorted by the £28bn transfer of assets from the Royal Mail Pension Fund after the start of the current financial year. Without this distortion, the PSNB would have been projected at just over £114.7bn in the current financial year.

As far as the October Bank Rate decision is concerned, the temporarily reduced uncertainties in Continental Europe suggest that there is a window of opportunity to raise Bank Rate and that the Monetary Policy Committee (MPC) should be preparing the financial markets for such a move, perhaps before the year end. However, a rate hike is not being advocated for this month because the markets have not been psychologically prepared and the authorities are metaphorically walking on eggshells where confidence is concerned. The medium-term aim should be to get Bank Rate into the 2% to 3% range at which point it may re-engage with the money market rates that determine borrowing costs. The authorities also strongly need to resist ill-considered regulatory proposals, which unduly hamper the credit- and money-creation processes. Finally, QE should be reserved for lender of last resort purposes only and not employed as an instrument of day to day monetary policy.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

Over the next few weeks the Chancellor of the Exchequer, George Osborne, and his Treasury colleagues have some very important decisions to make in regard to the Pre-Budget Report on 5th December. Since the original budget deficit reduction plans were laid in June 2010, the lacklustre performance of the UK economy has forced a postponement of the date by which the structural element of the deficit is eliminated. Merely to repeat this exercise of ‘extend and pretend’ will fool no-one, least of all the accursed rating agencies whose favour the Chancellor continues to curry.

To fail at the hurdle of fiscal prudence now, despite the obvious disappointment over recent borrowing trends, would carry a deeper significance. If the coalition loses its nerve at this juncture and simulates the policy dilution that Ed Balls has long advocated, its legitimacy will be rightly called into question. Recent activity, trade and employment data suggest that there is no cause for panic on the fiscal front. With the Bank plainly in unconditionally easy mode, it is vital that Osborne holds the line on fiscal normalisation.

The alternative, which is close to becoming a reality in the US, is to open the door wide to a fiscally-generated inflation in which inflation expectations are cut adrift from central bank targets or objectives. The UK may regard itself as a cut above the Eurozone average, but its over-dependence on foreign gilt purchases is a potential source of vulnerability. As UK inflation outcomes explore the upside again, this is no time to abandon ship on the fiscal objectives. This discipline has to come from the Treasury, since the Bank has forfeited the means to offset the absence of fiscal restraint. The UK is at risk of conceding the inflationary argument if it fails to reiterate its commitment to budget deficit reduction. Bank Rate should remain on hold until the UK reasserts a positive GDP growth rate.

Comment by Trevor Williams
(Lloyds Bank Wholesale Markets)
Vote: Hold Bank Rate.
Bias: Neutral.

The UK economy has moved on since QE was announced just a few months ago, with signs that the downturn in the first half of this year is coming to an end. Certainly, the data from early leading indicators, including Lloyds Bank proprietary data, would suggest that the economy will return to growth in the third quarter, perhaps anywhere between 0.5% and 1%. Broadly speaking, the economy appears to be flat. But data point both ways on this. The PMI surveys are suggesting that services and manufacturing activity are either close to or heading above the critical 50 expansion level, so heralding some month-on-month growth in output in these sectors in the quarter ahead.

That having been said, the volume of retail sales fell back by a modest 0.2% in August – or by 0.3% if fuel is excluded. Following July’s pick-up in inflation, the annual rates of increase in the CPI and RPI inched lower in August, driven by slower increases in clothing and footwear prices and the absence of utility price increases, compared with last year. To be more specific, CPI inflation eased from July’s 2.6% to 2.5% in August. Looking ahead, a combination of supportive base effects and a high degree of spare capacity should continue to pull CPI inflation lower. Service sector prices inflation fell from 3.4% in July to 3.2% the following month. Excluding seasonal factors, CPI fell from 2.3% to 2.1% in August. However, the acceleration in global food and oil prices, together with the prospect of a renewed round of domestic utility tariff rises, threatens some upward pressure on inflation going into the end of year. This makes it harder to see a very sharp drop occurring.

Meanwhile, the public finances were a little better than market expectations and basically showed stabilisation on the year. However, 2012-13 has got off to a poor start with the cumulative deficit some £13bn worse than this time last year, excluding the effects of one-off capital transfers. Notwithstanding the other figures, the unemployment data remain most powerful. The labour market report showed further evidence that, notwithstanding the reported contraction in economic activity in the first two quarters of 2012, employment has risen sharply. In the three months to July, employment rose by 236,000 – representing a pace of job growth historically associated with robust economic activity. Despite the strong rise, unemployment only fell by 7,000 people as job growth was met by a sharp rise in the labour force over the same period. Meanwhile, the timelier claimant count measure of unemployment continued to post marked falls, suggesting labour market strength continued into the third quarter. The labour market poses a puzzle for the broader economic picture and continues to cast some doubt on the scale of output loss recorded over the current recession.

The MPC minutes for September’s meeting showed that the official rate setting committee was unanimous in its decision to leave Bank Rate and the asset purchase target unchanged in September. However, some members thought further stimulus was more likely than not in due course, with one member stating there was “a good case” for additional easing this month. Yet uncertainties over the underlying pace of economic activity and the surprising strength of employment growth make October’s decision relatively easy. Bank Rate is expected to remain on hold in October and this will be the right decision for the economy. At the moment, the best policy option is to leave rates on hold and keep the policy bias neutral.

The SMPC

The SMPC is a group of economists who have gathered quarterly at the Institute of Economic Affairs (IEA) since July 1997. That it was the first such group in Britain, and that it gathers regularly to debate the issues involved, distinguishes the SMPC from the similar exercises carried out by a number of publications. Because the committee casts precisely nine votes each month, it carries a pool of ‘spare’ members since it is impractical for every member to vote every time. This can lead to changes in the aggregate vote, depending on who contributed to a particular poll. The nine independent analyses correspondingly should be regarded as more significant than the exact vote. The next SMPC gathering will be held on Tuesday 16th October and its minutes will be published on Sunday 4th November. The next two SMPC e-mail polls will be released on the Sundays of 2nd December 2012 and 6th January 2013, respectively.

In its most recent monthly e-mail poll, completed on 28th August, the Shadow Monetary Policy Committee (SMPC) decided by six votes to three that Britain’s Bank Rate should be held at ½% when the official rate setters meet on Thursday 6th September.

Two dissenters wanted to raise Bank Rate by ½%, while another desired an increase of ¼%. There was a further divergence with respect to the desirability of further quantitative easing (QE). Most SMPC members were content to complete the existing programme – except for one who wanted an immediate phased programme of withdrawal – but there was no consensus whether QE should then be held or a further tranche introduced later on this year. However, there was widespread agreement that QE would have to be used aggressively if the Bank of England again found itself in a lender of last resort situation, perhaps as a result of events in the Eurozone.

In addition, there was a consensus on the SMPC that the UK economy was broadly flat lining, but that the official growth figures were so dubious that it was impossible to be more precise. Several SMPC members noted the contrast between the weak output figures and the stronger picture painted by the labour market statistics.

A substantial body of opinion also thought that output was supply constrained – perhaps as a result of the massive increase in the socialisation of the economy in the first decade of the 21st Century – and that bold supply-side reforms were a necessary condition to get the economy motoring again. Without these, any further monetary stimulus would be dissipated in higher inflation.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: To hold for the time being.

The UK’s national accounts have often given a bad guidance to monetary policy decisions in the past. More reliable aids to understanding current conditions are business surveys and labour market data. These suggest that, for most of 2012, the British economy has been growing and indeed growing at least in line with a miserably low trend figure. Some slowdown seems to have taken place in the last month or two, in the backwash from the Eurozone crisis. However, this deceleration may prove transient. The international background ought, on the whole, to be improving. Monetary policy is being eased in China, while money growth appears to be reviving in the USA.

My recommendation is to leave policy unchanged, with Bank Rate held at ½% and QE maintained at the present level. It is possible that it will be appropriate to favour a rise in interest rates at some point in 2013. However, my bias is for the moment is best described as being for ‘no change’.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; continue with agreed asset purchase programme.
Bias: Additional monetary stimulus.

Following Mario Draghi’s remarks in London at the end of July, and his subsequent comments at the early August European Central Bank (ECB) monthly press conference, there has been a sizeable rally in global equities, an upswing in commodity markets and a generalised decline in credit spreads. These trends largely reflect declining risk premia rather than a re-assessment of global growth prospects. Although August is generally a quiet month in bank funding markets, there have been signs of improvement of late. European banks’ Credit Default Swaps premia have fallen by around 40 basis points on average since late July, most notably for troubled institutions in the periphery. Evidence from foreign exchange swap markets suggests access to short-term dollar funding markets has also improved of late.

Whether this hardening of financial market sentiment can be sustained through the autumn is debatable. For the moment, Mario Draghi’s pledge to do “whatever it takes to preserve the euro” is simply that – a pledge. He may believe that “it will be enough”, but he has to convince sceptical investors of that fact with concrete action. It is clear we will get some kind of ECB-led bond-buying programme; but to be successful in reversing the self-fulfilling loss of market confidence in Spain, Italy etc. it has to be both unlimited and unconditional. We know it will not be the latter – Draghi made clear that no bond purchases will take place until a country has formally applied for European Financial Stability Fund (EFSF)/European Stability Mechanism (ESM) support, i.e., there will be no reactivation of the Securities Market Programme (SMP) which bought sovereign paper without explicit conditionality. Moreover, the pledge to do ‘whatever it takes’ is unlikely to mean unlimited bond purchases across the yield curve. We are told that the ECB is only going to buy short-dated paper – since most of the sellers at this part of the curve are likely to be banks, the direct boost to broad money will be limited. It is even suggested that the ECB will confine itself to the treasury bills of those countries affected. Targeting the spread over bunds at the short-end of the curve is only one of many mooted options. In short, the plan is not shaping up to be either unconditional or unlimited. There is room for market disappointment when the plan is formally revealed.

Markets may also be buffeted by political gyrations this month. The German constitutional court will decide on the legality of the ESM. While it is highly unlikely to be struck down, there are concerns about the constraints the court may place on the Bundestag in providing future financial support to troubled Eurozone economies. On the same day as the ruling, Dutch voters go to the polls. On the basis of recent polling, there is scope for a major upset, with the main pro-euro parties in danger of losing their effective majority in parliament. There is also the continuing debacle in Greece. The next tranche of official financial aid is not yet assured. Antonis Samaras, the new Greek prime minister, has gone to Berlin and Paris with his begging bowl, hoping to be rewarded with additional time in which to meet the deficit reduction targets. He will no doubt receive some superficial hand-outs from the Germans; but it is clear that there will be no meaningful change in the fiscal adjustment expected in Greece. How robust the Greek coalition government will prove when this becomes obvious is anybody’s guess. It is an added dimension of uncertainty in a highly uncertain environment.

With another round of gilt purchases underway and the ‘funding for lending scheme’ (FLS) still in its infancy, there is merit in the monetary policy stance being left unchanged this month, despite the balance of risks to both growth and inflation being on the downside. There is a small chance that the Draghi plan, which is now due to be announced at the 6th September ECB meeting, has a meaningful, long-lasting impact on investors’ risk appetite and bank funding conditions. A credible bond-buying programme could alter the balance of risks to inflation in the medium-term. There is an argument in holding fire until we have more information from the ECB.

There is also considerable uncertainty surrounding the magnitude of the monetary stimulus that the FLS will provide. While the scheme is little more than a collateral swap facility, allowing banks to receive treasury bills in exchange for illiquid securities and loans, its cost and size is directly linked to the amount of net lending to the ‘real economy’ that banks undertake. At its least effective, the scheme will simply provide a (large) funding subsidy for lenders, which they will use to boost profits and capital. This should lower the cost of funding that banks have to pay in the markets, making them more likely to lend over the longer-term. At its most effective, the FLS will actively encourage banks to increase/reduce their lending more/less than they otherwise might have done, and make credit available to borrowers who otherwise could not get a loan. While it should reduce the effective cost of credit to existing borrowers, it may also alleviate some of the quantity rationing that banks are currently imposing. Relative to the counterfactual, the expansion of private credit and broad money could be substantial. There is a good case for waiting to see how banks respond to the FLS in the weeks ahead, even though any conclusions will be tentative.

The likelihood is that additional monetary stimulus will be warranted later in the year, however. Notwithstanding the difficulties in looking through the highly volatile GDP data, the economy appears close to stagnation. Business surveys suggest output was expanding very slowly in the first half of this year. Recent reports suggest the pace of growth has moderated, and in the case of manufacturing they show an outright drop in activity. After four months of falling new orders, the July Purchasing Managers Index (PMI) survey pointed to the biggest fall in industrial production since March 2009. Meanwhile, service sector activity also appears to have faltered, leading to a decline in investment and hiring intentions since the spring.

The recent upward lurch in global energy and food prices suggests the central path for inflation may be somewhat higher in coming quarters than was likely a couple of months ago. Nevertheless, and to the extent that these moves primarily reflect temporary supply shocks, they are unlikely to have much information regarding medium-term inflation. If anything, global, particularly emerging world, growth forecasts have continued to fall in recent months. Domestic price pressures remain fairly limited despite what appear to be extensive effective supply failures. ‘Supply-side pessimists’ take these to be a permanent cost of the financial crisis, arguing that the apparent weakness in labour productivity should be considered a reduction in underlying productivity.

In this line of thinking, the output gap is currently relatively small.
Potential output may have been depressed by the financial crisis, but this could have as much to do with weak demand, a collapse in ‘animal spirits’ and banking dysfunction, as factors which will permanently depress potential output. This is a vital distinction – if persistently sluggish demand growth is itself feeding the rise in risk aversion and the unwillingness of banks to lend, potential output may be significantly affected by the path of demand. Doing too little now may contribute to a permanent fall in the sustainable level of UK activity. There is a strong case for policymakers erring on the side of doing too much in this environment even if the central case had inflation at the 2% target in the medium-term.

Comment by Anthony J Evans
(ESCAP Europe)
Vote: Raise Bank Rate by ¼ %.
Bias: No additional QE but Bank should be on standby with other monetary tools.

The two main pillars of the Bank of England’s inflation targeting regime are: 1) hitting a Consumer Price Index (CPI) target of 2%; and 2) communicating its decisions and justifications in a transparent way. It is currently failing at both. Most economists accept that they have adopted a de facto Nominal Gross Domestic Product (NGDP) target of sorts, but its failure to confront this issue is dramatically undermining its credibility.

Although there are reasons to suggest that CPI remains above target because of temporary or external factors, the inflation target should reflect them all. The Bank’s job is not to deliver 2% inflation on the domestically determined components of CPI alone. Ascertaining the breakdown is only helpful in as much as it allows people to make forecasts about the future path of CPI – on this point, the US Federal Reserve Bank of Atlanta has an index of ‘sticky prices’ which would be interesting to replicate for the UK. However, we have overshot the target for over two years by now, and inflation is creeping up once more, from 2.4% in June to 2.6% in July. If the Bank intends to retain the inflation-targeting regime, they need to signal that inflation remains a priority. If they are willing to tolerate above target inflation to temporarily hold up NGDP, they should communicate this. Until then, they’ve tied their own hands and should remain true to that.

Richard Fisher, President of the Federal Reserve Bank of Dallas, has recently talked about the threat of over prescribing ‘monetary Ritalin’ and it is important that the risks of low interest rates are investigated further. Low yields increase pension deficits and this has the potential to divert corporate money from much needed business expansion to cover the shortfall. In addition, it is no bad thing to permit moderate wealth transfers from people with tracker mortgages to those with tracker savings accounts. The main problem in the economy is not insufficient liquidity provisions by central banks, but a breakdown in effective intermediation – which is partly due to capital requirements and other regulatory shocks – and supply side problems.

As more time passes since the 2008 crisis, it becomes clearer that it is supply side factors hindering the recovery rather than inadequate aggregate demand. Fiscal and monetary policies have both been accommodating, but stimulating aggregate demand cannot capture lost output if the long-term growth rate has changed in the meantime. The official GDP forecasts from the Office for Budget Responsibility (OBR) have been shown to be hopelessly optimistic. Even so, this does not necessarily mean that the output gap is widening. In terms of a basic aggregate demand/aggregate supply model, policymakers are attempting to get back to a long run aggregate supply curve that has shifted. Doing so will increasingly deliver inflation rather than output growth. In addition, permanent ‘crisis’ rates of interest will make the economy more vulnerable to future shocks, and generate capital misallocations.

The Bank of England should concentrate on minimising the distortions caused by ultra-low interest rates, and recognise the limits of what they can do. Although future events may make emergency liquidity provisions necessary, that should not prevent attempts to return interest rates to their natural rate now.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; complete the latest £50bn QE stimulus.

The Office for National Statistics (ONS) have revised their estimate of GDP in 2012 Q2, as expected, from a fall of 0.7% to a fall of 0.5%, reflecting less negative estimates for production and construction. After allowing for the extra bank holiday for the Queen’s Jubilee, underlying GDP was probably flat in the second quarter. Nevertheless, there has been much speculation that the ONS is underestimating GDP, even after this upward revision, because of the seeming buoyancy of the labour market figures. However, a fairly quick inspection of the employment data suggests that not all is positive. In the second quarter, the number of full-time employees was down compared with a year earlier whilst part-time employees and the self-employed, who may or may not be fully occupied, increased. In addition, the number of part-time employees who worked part-time because they could not get full-time jobs has increased. Furthermore, a recent survey from the Chartered Institute of Personnel and Development (CIPD) suggested that one in three firms were holding onto more labour than they needed in order to retain skills but that, ominously, there would be redundancies if the economy did not pick up.

Surveys of business activity have also been quoted in support of the ‘ONS is underestimating GDP’ school and, indeed, many surveys until fairly recently had been modestly upbeat. However, the latest Markit Purchasing Managers Index (PMI) surveys for July were discouraging. They suggested that manufacturing was indeed declining whilst there was very little growth in services and construction. The ONS may revise GDP data, indeed they are almost certain to revise the GDP data, but their picture of a stagnant economy, at best, looks credible.

Under these circumstances the Bank of England looks set to maintain its very accommodative monetary policy for months, if not years, to come. This remains the broadly correct policy, notwithstanding the unexpected pick-up in July’s inflation figures. However, they are unlikely to make any further moves before November for at least two reasons. Firstly, the current £50bn of QE stimulus will not be completed until end-October and, secondly, the Bank appears to be prepared to wait a few months before assessing the impact on borrowing costs and lending of the Funding for Lending Scheme (FLS). The Bank seems, albeit cautiously, to have high hopes for the FLS. Indeed in the August Monetary Policy Committee (MPC) Minutes they wrote of the FLS that “in response a number of banks had already announced reductions in the rates on certain mortgages and small-business loans.” On balance, the Bank’s ‘wait and see’ mode seems eminently sensible. The MPC does however seem to be hostile to any further Bank Rate cut. The June Minutes claimed “a reduction of Bank Rate below 0.5% might squeeze some lenders’ interest margins to such an extent that they became even less able to extend new credit.”

Suffice it to say that the Eurozone crisis rumbles on. However, and despite the blood-curdling and apocalyptic warnings about the economic effects of a ‘Grexit’ and accompanying ‘contagion’, the probability of a Greek exit rises by the week. It is impossible to say if and/or when Greece will leave the currency union but surely there is at least a 50:50 chance that the country will have departed from the Eurozone by the end of the year. Overall, I continue to support very accommodative monetary policy. However, the time to consider a further tranche of QE is November at the earliest. Bank Rate should be left at its present ½%; there is little point in cutting it further.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate; no more QE but no withdrawal of QE.

Inflation has long since ceased to be an important determinant of monetary policy. However, and if it were, the outlook would recommend a rise in rates. The rate of price increase continues to be well above target and, although there has been some recent reduction, the outlook for energy and food prices suggests that annual increases in CPI above 3%, again, may not be far away.

In truth, though, inflation is now almost irrelevant. The key factor is growth. The UK double dip recession goes on. The Eurozone crisis continues its wayward and extended course. Either Greece or Finland may leave as soon as October. A Greek departure could herald a turning point, with a rapid transition to a Single European State, ongoing year-on-year fiscal transfers, and the eschewing of debt pooling. A Finnish departure could herald a wider breakup from the wealthier members and the disastrous consequences that would entail. The UK government estimates that a disorderly collapse of the Euro could mean a further 7% contraction in UK GDP and there may be a 35% subjective probability of such a disastrous contraction. It is no surprise that UK corporates are not investing their cash in such an environment.

Monetary policy cannot help here, any more. All that macroeconomic policymakers can usefully do is to return policy settings to neutral and thereby facilitate the maximum medium term growth rate. We must not forget that medium term growth is not maximised with interest rates of zero. Only six years ago, anyone proposing that this would be how to maximise growth would have been laughed out of office. The truth has not changed; only the willingness of policymakers to hear it.

It is supply-side policy that can make the difference here. Government consumption spending should be cut. The efficiency of government spending (i.e., public sector productivity) should be raised. There should be reforms to areas such as planning regulation. Beyond that, all that macroeconomic policy can do is not to impede. Government debt should not be excessive. Interest rates should be raised back towards the natural rate.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks.

The latest statistics on GDP, employment and unemployment, business surveys and most recently public sector borrowing have created an unending debate between supporters of ‘Plan A’ and those who want to see Plan A abandoned in favour of extra spending on infrastructure. Yet, there is no real controversy here. The truth is that worthwhile infrastructure projects with a good long-term return are always welcome. Traditionally, they were entered in the public accounts ‘below the line’ so recognising that they are: 1) temporary, and 2) to some degree self-financing in the context of the inter-temporal government budget constraint.

What ‘Plan A’ rules out is permanent extra spending and capital expenditure with no proper return. It therefore cannot be a ‘general stimulus’, which often seems to mean in practice that extra money is printed via QE whenever left-wing politicians demand it. The trouble is that such infrastructure spending would probably be going on anyway under existing plans. The main difficulty with infrastructure spending at present is that the coalition cannot agree on what is necessary. Witness the disputes over the HS2 rail link – which is clearly about to be dropped as the white elephant that it is – and the third runway at Heathrow.

The economy itself is growing weakly and the GDP figures are likely to be revised up to reflect this. There has been no ‘double-dip’ recession. This weak growth comes three years after the end of the recession proper and it is astonishing that people are still calling for continuously loose monetary policy. Macroeconomic theory and the models we have that fit the facts suggest that monetary policy moves lose their effects on output once they are well-anticipated and of long standing. Instead, if they affect anything, they affect prices.

In the present context, it seems that they are not affecting anything since as fast as QE money is printed it winds up in the Bank of England as bankers’ balances. Banks are unwilling to make extra loans except to non-risky borrowers (i.e., some large companies) who have no demand for it, enjoying surplus cash and with low investment plans. When it comes to small- and medium-sized enterprises (SMEs) the new capital regulations force large costs on banks if they lend.

However, while QE has not affected bank lending and therefore has failed to increase the money supply, and by implication has not reduced the cost of credit, it has succeeded in reducing the returns to savers. This has happened two ways. First, QE has added massively to demand for gilts, taking by now nearly 40% of available gilts, even after the large increase in public issue to meet its borrowing; this demand from the Bank must have driven down the yield to persuade institutions that would normally require gilts for their balance sheet ratios to part company with them. Secondly, QE has driven down the banks’ cost of funds and hence its offers of returns to savers.

This distortion of the savings market is further encouraged by the very low Bank Rate. Commercial banks can obtain funds from the Bank of England at this rate, and their bankers’ balances also attract a rate related to this. Thus, this is the rate at which the massive QE is available to the banks as a funding source. Yet, the banks will not lend it to extra (i.e., SME) borrowers because of other regulatory costs. Hence what this QE and low Bank Rate do is to depress what they offer to savers, and build up bank profit margins on existing business.

So we now have a monetary policy that is not boosting output via increased lending and lower lending rates, but is depressing returns to savers, and with it the cost of funds to the government. As I have noted in previous SMPC comments, this is essentially what ‘financial repression’ does in developing countries via controls designed to force savings resources cheaply to government. Here the repression is occurring through the new controls on banking, combined with the massive printing of government-backed money.
The government has begun to realise that its new banking regulations are causing these effects and its latest gambit has been the new incentives for lending scheme, under which ‘extra lending’ is rewarded by the government/Bank with a subsidy to the cost of bank funds. There is no reason to believe this bureaucratic scheme will work to expand lending, as opposed to expanding ‘extra lending’ as lending that would have occurred anyway will be diverted into the scheme.

Unfortunately, the only way to reverse the malign effects of the new bank regulations is to reverse the regulations themselves. Furthermore, to force the banks to compete and not to continue as an effective cartel, with only a few players, the government should force the break-up of RBS and Lloyds into several competing units; it should not hang on to its stakes in their present form and build up their profits for a share sale. It would be better to have less capital return and a growing economy with a healthy credit supply. Alas, in the present political climate both in and outside the coalition, these actions are not likely. So the economy is stuck with a distorted savings market; a controlled credit supply, and an impotent monetary policy.

My recommendations for monetary policy are, first, for bank regulations to be greatly eased and for the banks to be broken up. However, and second, whether this is done or not (as seems more likely), interest rates should be raised and QE reversed to remove the distortion from the savings market. So the recommendation is for a rise in Bank Rate to 1% with a bias to raise rates further. In addition, QE should be reversed by £25 billion per month until liquidated.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate; no immediate increase in QE.
Bias: To raise Bank Rate; avoid regulatory shocks; maintain QE on standby.

Perhaps the best analogy for the current British economy can be found in Samuel Taylor Coleridge’s ‘Rime of the Ancient Mariner, published in 1798:
“Day after day, day after day
We stuck, nor breath nor motion;
As idle as a painted ship
Upon a painted ocean”.

Certainly, there has been nothing in the UK economic releases of the past month to change one’s view as to the appropriate conduct of UK monetary policy, even if there remain the well-established inconsistencies between the weakness of the ONS GDP statistics and the stronger trend shown by the labour market data. The ONS has published a paper dealing with this issue, The Productivity Conundrum, Interpreting the Recent Behaviour of the Economy, by Joe Grice, which was released alongside the GDP figures published on 24th August, albeit with somewhat inconclusive results. We are also promised an ONS conference on the subject this autumn. A long-shot suggestion is that there might be glitches in the new software introduced when the ONS switched from its ancient Heath-Robinson methods of calculating the national accounts to its new fully automated system last year. The possibility of a programming error would certainly be consistent with the unfortunate recent experiences of financial institutions such as Knight Capital Group and the Royal Bank of Scotland.

Meanwhile, the uptick in CPI inflation from 2.4% in June to 2.6% in July and the rise in ‘double-core’ retail price inflation – which excludes mortgage rates and housing depreciation and is the most historically consistent inflation measure – from 3% to 3.3% must be regarded as a disappointment, especially as US inflation eased from 1.7% to 1.4% between the same two months, Chinese inflation fell from 2.2% to 1.8% between June and July, and Eurozone inflation was unaltered at 2.4%. Recent trade figures, and the most recent public sector finances release also suggest that the two key financial balances of the current account balance of payments and the budget deficit are deteriorating, rather than improving.

On a more positive note, the growth of M4ex broad money seems to have recently stabilised in the 3% to 3½% range – it was 3.5% in the year to June – and annual UK house price inflation was positive at 2.3% in the years to both May and June according to the ONS index. The national growth rate was held back by the 11.9% drop in Northern Irish house prices, however, which probably had more to do with the property collapse in the Republic of Ireland than mainland UK conditions. English house prices increased by 2.8% in the year to June, Welsh prices were unchanged, and Scottish prices eased by 1%. The reduction in producer output price inflation from 2% in June to 1.7% in July, the drop in core producer inflation (excluding food, beverages, tobacco and petroleum products) from 1.7% to 1.3%, and the 2.4% decline in producer input costs since July 2011 also suggest that the upwards blip in CPI inflation in July is likely to be reversed. The double whammy of the Royal Jubilee and the Olympics has complicated the interpretation of some recent figures. However, the Jubilee-affected manufacturing output figures in June, which were down 2.9% on the month and dropped 4.3% on the year, were not as weak as the financial markets had feared, while the 2.8% increase in the volume of retail sales in the year to July, when the value increased by 3.1%, was also stronger than anticipated.

The Bank of England has estimated that the Jubilee shaved some 0.5 percentage points off national output in the second quarter, suggesting that the underlying figure was flat. Some of this undershooting is likely to be clawed back in the third quarter: Bank officials have also suggested that any Olympics effects in the third quarter are likely to be small. Unfortunately, while the UK growth rate may enjoy a ‘dead cat bounce’ in 2012 Q3, the survey evidence from overseas is less positive. The Munich based CES Ifo world economic climate indicator, published on 16th August, fell in the third quarter, after two successive increases. The decline was due to both unfavourable assessments of the current economic situation and a less positive six-month economic outlook. The Ifo survey results were particularly downbeat for Western Europe and North America. In Asia, confidence was held back by the poor current situation, but there was also some optimism that matters would improve over the next six months.

One factor that has not helped either business confidence or the real economy has been the recent rise in the price of a barrel of Brent crude oil from a temporary low point of US$89.2 on 21st June to US$112.6 on 28th August. This development has partly resulted from the increasingly effective sanctions on Iran, but there have also been output losses in South Sudan, Syria and Yemen while North Sea production has been cut by heavy maintenance schedules and a strike in Norway. This has offset a marked increase in Saudi Arabian production and strong production growth in the US and Canada. The increased oil price should, correspondingly, be regarded as a genuine supply shock, rather than a wider indicator of global economic activity. Nevertheless, dearer energy costs will act as a drag on global recovery, regardless of their cause.

For at least three decades time series statisticians have been using statistical techniques in an attempt to distinguish between demand-side shocks, and supply-side ones. The essential distinction is that demand side shocks are considered to be ‘transitory’ in their effects, while supply side effects are considered to be ‘permanent’. There is also quite compelling evidence for a wide range of developed economies that supply-side shocks were at least as common and powerful as demand side ones before the ‘Great Recession’. This makes it all the more surprising that the current period of weak output, which has now persisted for roughly four years, is widely treated as being purely a demand-side problem and one that would respond to naïve 1960s style Keynesian remedies. Furthermore, it is perverse to treat the current difficulties as a failure of capitalism when one of the most obvious features of the 21st century has been the huge increase in the socialisation ratios of most of the worst-hit leading economies, and the noticeably better performance of countries such as Germany, Canada, Australia and Switzerland where this did not happen. The latest figures from the Organisation for Economic Co-operation and Development (OECD) show that the ratio of general government outlays to the market-price measure of GDP rose from 38.8% in 2000 to 43.2% in 2011 in the OECD area as a whole, but increased from 36.5% to 49.1% in Britain and 33.9% to 41.7% in the US. There is long-standing evidence that increases in the government spending ratio induce a slowdown in the rate of increase in GDP per capita. Moreover, there is some statistical evidence for the OECD in aggregate that, once the government spending ratio exceeds around 38%, or so, all further increases in the government spending are reflected one-for-one in the ratio of the budget deficit to GDP.

As far as the September Bank Rate decision is concerned, the continuing uncertainties in Continental Europe – which represents a gross failure of the Continent’s political class and not of capitalism – warrant a tactical hold. However, the medium-term aim should be to get Bank Rate into the 2% to 3% range at which point it may re-engage with the money market rates that determine borrowing costs, while desisting from ill-considered financial regulatory initiatives that unduly hamper the credit- and money-creation processes. Once the current tranche is completed, additional QE should be kept on standby in case there is a renewed threat of a banking meltdown caused by events in Continental Europe. However, QE should be reserved for lender of last resort purposes and not employed as an instrument of day to day monetary policy. Pace the Bank’s recent discussion paper on the subject – The Distributional Effects of Asset Purchases, 12th July 2012 – QE has created huge and morally totally unjustifiable windfall losses and gains for individual savers and borrowers even if the aggregate effects for a theoretical large and diversified national portfolio might cancel out. It also seems rather strange, from a political-economy perspective, that Bank of England officials are just about the last group in the country to still enjoy retail price index linked pensions. If any group should have their pensions unconditionally valorised at the CPI inflation target of 2%, surely it ought to be the people whose actions largely determine inflation in the first place?

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

It is becoming increasingly obvious that the Bank of England has lost control of UK retail borrowing costs. During the three years-plus that Bank Rate has been set at ½%, the average interest rate paid on banks’ and building societies’ notice deposit accounts has risen from a low of 0.17% in February 2009 to 1.83% in July 2012. Admittedly, the quoted monthly rates have bounced around, but the average for 2012 is 1.41%. This is a measure of the average cost of retail funds to the banking sector; the marginal cost is closer to 3%. On the other side of the balance sheet, Santander UK has recently announced a 50 basis point increase in its standard variable mortgage rate, to 4.74% from October. Clearly, the level of Bank Rate has played no role in the evolution of market rates for the past three years. The MPC’s consideration of a cut in Bank Rate is perverse and farcical in this context. As and when the UK economic news flow permits, Bank Rate should be raised in order to reconnect it to the structure of market rates. However, with UK activity indicators currently erratic and weak, now is not a good time to do this.

It is important not to lose sight of the beneficial purpose of raising Bank Rate, at least to approximate a zero real rate, and preferably a modestly positive one. The UK is subject to mounting inflationary risks. Some of these risks are visible and obvious; others are as yet latent. Unconventional monetary policy is associated with a much wider range of inflation outcomes than conventional monetary policy because unconventional interventions tend to be poorly calibrated. As the official Bank of England and Debt Management Office holdings of conventional government bonds approach 50% of the total in issue, it is time to wonder where the tipping point for inflationary expectations lies. The willingness of overseas investors to piggy-back on the Bank’s Asset Purchase Programme will one day evaporate and be replaced by a fearful rush for the exits because of Sterling depreciation risk. The loss of the sovereign’s coveted AAA-rated status cannot be far away now and this too could be a catalyst for overseas selling of UK government bonds.

Regardless of how soon this nightmare scenario arrives, there is plenty of inflationary concern that is already visible. Over the past five years, the UK has demonstrated a greater vulnerability to global inflation than other large European countries. Retail price inflation averaged 5.2% in 2011 and CPI inflation 4.5%. Inflation exceeded the year-ahead forecasts made by the Bank of England for the third year in succession. Factors influencing the pass-through of foreign pricing to domestic pricing include the lack of indigenous competition to imports; an oligopolistic distribution system, especially in food retailing and domestic electricity and gas provision; and a dramatic upward revision to clothing and footwear price inflation. Sterling has been fairly stable in terms of its trade-weighted index over the past three years, but economic weakness poses a renewed threat to the ‘safe haven’ status of its fixed interest market. The flexibility of Sterling to depreciate means that global pricing pressures have the potential for magnification, given that the UK is an effective price-taker in many sectors. Long after the Sterling depreciation of 2008, import price inflation of 5% or so has persisted.

The sluggishness of the UK economic recovery has reopened the debate regarding the potential medium-term growth rate. The Bank of England and the OBR routinely assume that the medium-term growth rate of the economy lies in the region of 2% to 2.5% per year, but in a credit-constrained world, these growth rates may be no longer attainable. The shocking manner in which the economic recovery has petered out since the summer of 2010 underlines the centrality of the role of credit, in its broadest sense, in healthy economic development. To the extent that cheap credit fostered the creation of excess capacity in the distributive and financial services sectors, for example, not only was their growth rate unsustainable but their peak level of activity was also artificial. Post-slump, the viable economic size of these industries may remain below their prior peaks for an indefinite period. This may already be reflected in stagnant productivity and rising unit labour cost inflation. After examining the behaviour of forty-four economic sub-categories, our conclusion is that the prevailing rate of sustainable economic growth may be as low as 1%. In these circumstances, economic stimulus whether monetary or fiscal, is liable to deliver an adverse mix of inflation and real activity.

The view of the Bank of England, reflected in the economic consensus (e.g., Barclays) is that an abatement of energy and commodity price inflation will allow the UK CPI to return to its target rate of 2% per annum and possibly fall beneath it during 2013. However, this has been the official view consistently and incorrectly for the past three years or so, regardless of the external realities. As ex-MPC member Andrew Sentance has pointed out, global inflationary pressures have strengthened since 2008 and 2009 and the UK is susceptible to them. Global goods deflation has been replaced by moderate inflation. The improvement in the non-food and energy inflation rate in 2011 and 2012 has been associated with a particularly weak sequence of economic outturns. Supposing that there is some recovery reflex, aided by the various policy stimulus initiatives, the Bank of England cannot rely on a stagnant economy to deliver its inflation objective, any more than it can rely on a sequence of good harvests to deliver low food price inflation. For some years now, domestically generated private sector inflation has departed from its stable low trend during 1993 to 2008, and there is evidence of a return to an inflationary mentality, reflected in term inflation expectations of the general public.

If the Bank of England was taking its inflation mandate seriously, it would have raised Bank Rate to 2% or more during the past three years. It has not and it now cannot.

Comment by Trevor Williams
(Lloyds Bank Wholesale Markets)
Vote: Hold Bank Rate; maintain.
Bias: To ease further via QE, with wider range of collateral.

It always seemed likely that the much-publicised very weak provisional GDP figures for the second quarter, which were published on 25th July and registered a fall of 0.7% on the first quarter, would be revised higher. The figures published subsequently, for retail sales but especially for employment, suggested that an upward revision was inevitable. In the event, the revised data published on 24th August showed a revision to a decline of 0.5%, a 0.2% better outcome though still a fall.

One of the most puzzling aspects of the performance of the UK economy in recent years has been the dichotomy between output and employment growth. While the level of UK output has reportedly contracted by around 4.5% since the onset of the downturn in mid-2008, despite rising public sector job losses, total employment is back to where it was prior to the onset of the 2008 recession. The divergence between output and employment has been particularly stark in recent quarters: while the level of GDP has contracted by a cumulative 1.4% since the third quarter of last year, the total number of employed has risen by 1.4% – its strongest three quarter gain since the third quarter of 1997. Although less pronounced, there is a similar divergence between the level of GDP and hours worked.

We estimate that, using employment trends alone, the underlying economy expanded by 0.2% in the second quarter; a similar expansion may take place in 2012 Q3, though the headline numbers might be flattering for the pick-up. Our survey data, from the monthly Lloyds Bank Economic Bulletin, also suggests that there is still underlying growth in the economy, albeit low. Trade data are implying that the rebalancing that had shown promising signs might be faltering.

Despite distortions, the Bank of England is right in my view to have eased policy via QE and other credit easing measures. Given continuing market volatility it is likely to remain vigilant, mindful of headwinds from Europe. I would therefore keep policy on hold, with Bank Rate at ½% and QE at its current rate.

What is the SMPC?

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

Current SMPC membership

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

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 10th July, the Shadow Monetary Policy Committee (SMPC) decided by seven votes to two that Britain’s Bank Rate should be held at ½% on Thursday 2nd August.

Both dissenters wanted to raise Bank Rate by ½%. There was a range of views with respect to the efficacy, as well as the desirability, of the additional £50bn of quantitative easing (QE) announced on 5th July. Two shadow committee members supported this move, another pair thought that QE would work better if the range of assets was extended to include more private debt, one did not want to see the extra £50bn implemented, and four were reasonably agnostic on the issue, while advocating QE in a lender of last resort situation.

More generally, there was a widespread view on the SMPC that, under the current unusual circumstances, small changes to Bank Rate, had the power of a rifle, and QE was the equivalent of a large bomb, but financial regulation had a destructive potential akin to that of a tactical nuclear weapon. The committee argued that the policy inconsistency between over aggressive financial regulation and the need to stimulate money and credit creation – to get the real economy moving – was more than cancelling out the stimulatory effects of the ½% Bank Rate and £375bn of QE.

There was also a strong consensus that the tax-and-spend policies pursued in the first decade of the 21st century – when combined with serious policy errors since the 2010 election, such as the VAT hike – meant that the sustainable growth rate of the UK economy was now little more than 1% per annum.

Minutes of the meeting of 10th July 2012

Attendance: Philip Booth (IEA-Observer), Tim Congdon, Andrew Lilico, Kent Matthews (Secretary), David B Smith (Chairman), Akos Valentinyi, Peter Warburton, Trevor Williams.
Apologies: Roger Bootle, Jamie Dannhauser, Anthony J Evans, Ruth Lea, Patrick Minford, David H Smith (Sunday Times observer).
Chairman’s Comment

The Chairman, David B Smith, began the meeting by saying that the Office for National Statistics (ONS) had published a rebased set of national accounts with the volume figures expressed in chained 2009 prices, rather than the previous 2008 price basis, on 28th June. Unlike last year’s catastrophic move to the new ESA-2010 definitions, this year’s rebasing had proceeded more smoothly and long back runs of the new data were available on the ONS website without the six month delay that occurred in 2011. However, the data had been published originally with a number of errors that were not disclosed until well into July. Anyone who had downloaded the ONS data on its first release would be well advised to check that it remained accurate.

A cursory examination, which involved running the Beacon Economic Forecasting (BEF) model with scaled pseudo-2008 price figures, suggested that there had been some changes to the composition of the expenditure measure of national income. In particular, household consumption was now believed to be weaker and private investment stronger than had been reported previously. There had also been a marked upward revision to the growth rate of real general government consumption in the year to 2012 Q1 from 1.9% to 3%.

These data changes slightly altered the terms of the current economic debate and also pulled the rug from under Labour’s claims that vicious spending cuts were undermining the recovery. However, the figures for the growth of overall gross domestic product (GDP) remained pretty much the same. The updated data produced a forecast of average GDP growth in 2012 of 0.4% using the BEF model. This was a smidgen higher than the projection using the old official data set but the difference was not significant.

The chairman then added that he had been shocked and surprised by the London Inter-Bank Offered Rate (LIBOR) scandal because he had always naively considered this to be an accurately measured free-market rate throughout his long City career. However, corporate borrowers with rates linked to LIBOR had gained from the downwards suppression of the true rate, just as large wholesale depositors had lost out. Furthermore, it was not clear that high frequency gyrations in LIBOR, which largely self-cancelled over the term of a normal deposit or loan, had had major adverse consequences for anyone other than financial speculators who were caught out on the wrong side of derivatives transactions. None of this justified the appalling behaviour of the banks involved. There were likely to be further scandals yet to be revealed. Concern had recently been expressed about the broadly similar way in which the quoted price of oil was determined, for example. Another important issue was what the Bank of England was doing at the time either to permit, or to be unaware of, such misbehaviour. The Chairman then called upon Akos Valentinyi to give his assessment of the economic situation.

UK Economic Situation

Akos Valentinyi then produced a hand-out of reference charts and commenced his presentation with a discussion of inflation trends in the UK. While recent months have shown a downturn, even Consumer Price Index (CPI) inflation excluding energy had shown an upward trend on a longer term perspective. Therefore, it was too early to say that inflation was definitely on a downward trend. Goods price inflation had been highly volatile but services inflation had been less volatile and consistently above CPI inflation. Producer price inflation still indicated some upside risk as did the Bank of England inflation expectations survey.

Aggregate demand remained weak with both household consumption and investment dragging down growth. Spending on consumer durables had risen but, again, there was little to suggest a sustained positive trend. The investment figures continued to show weakness with only equipment investment showing signs of unusual activity, although the latter may result from the extension of wind farms. The rebalancing of household balance sheets was evident in the decline in the ratio of personal debt to income and, also, in the rise in the savings ratio.

Growth was being driven by activity in the service sector but services growth remained anaemic. The decomposition of service sector growth showed weakness in all areas. Manufacturing productivity had risen as a result of the output drop not being as great as the contraction in employment. Britain’s terms of trade had continued to decline. This deterioration could be interpreted as a negative productivity shock, which exacerbated the decline in real disposable income. Yet, the rate of unemployment remained below the peak of the early 1990s recession. A simple plot of the change in the rate of unemployment against the growth rate confirmed that Okun’s Law still prevailed. The implication was that real GDP growth in the region of 2% was necessary to stop unemployment from rising.

In summary, the demand side of the economy remained weak in the opinion of Akos Valentinyi. There might have been some good news with respect to durables spending but the supply-side was also debilitated. The balance between weak demand – but even weaker supply – suggested that the longer-term risks to inflation were on the upside.

Discussion

The Chairman thanked Akos Valentinyi for his presentation before throwing open the meeting for discussion. David B Smith added that while the latest ONS figures showed that government consumption expenditure was up 3% year-on-year in the first quarter, general government fixed capital formation was down almost 33% year-on-year, and that both figures were now noticeably adrift – but in opposite directions – from the post-Budget projections of the Office for Budget Responsibility (OBR). The Chairman then asked for comments and questions from the committee.

Andrew Lilico asked whether the exclusion of monetary developments in the presentation was deliberate and how did Professor Valentinyi see quantitative easing (QE) working on the economy. Akos Valentinyi said that there had been no major changes in the pattern of credit flows. Given the weakness of household demand and the rebuilding of balance sheets, QE would have had little force. He suggested that there might be a threshold effect before QE started to work so that only after a particular level has been breached, would QE begin to operate. He added that, in an open economy, QE could leak out in capital flows to the overseas sector and not have any direct effects on home demand.

Tim Congdon said that he found the lack of discussion of monetary developments very disappointing. He also disagreed with Akos Valentinyi’s pessimism on inflation. The recent collapse in oil and other energy prices implied a sharp fall in inflation measures later in 2012 and in early 2013. By the end of this year, all-items CPI inflation would be lower than CPI inflation excluding energy. Nevertheless, he doubted that output was substantially below its trend level, largely because the UK’s trend growth rate of output was now only around 1%.

Kent Matthews said that no amount of QE would have any real effects if there was indeed as little spare capacity as Tim Congdon suggested. Peter Warburton added that the output gap should not be seen as a domestic constraint. Rather world inflation was related to a global output gap and its consequences for the UK were amplified or diminished according to the weakness or strength of sterling. Andrew Lilico said that the most recent tranche of QE had been driven by the Euro crisis. The function of QE was to push money into the economy. However, with low capacity growth, a low output gap and loss of inflation target policy credibility, the policy had lost its traction. The Euro crisis could be viewed as an adverse supply-side shock.

Tim Congdon said that QE was indeed necessary at the outset of the crisis and that things would have been worse in its absence. David B Smith said that the official push towards ever greater financial regulation was so severely restrictive in its monetary and macroeconomic consequences that a great deal of QE was needed simply to offset its negative effects. The logical course was no regulatory overkill and no QE. It was crazy to try to offset the collateral damage done by one set of policy-induced distortions with another damaging set of interventions. This was reminiscent of the policy blunders of US President Carter and Britain’s second Wilson administration in the 1970s, where distortions were piled upon distortions and the authorities ended up chasing their own tails. It took Ronald Reagan and Margaret Thatcher to cut through this Gordian knot the last time round. However, he saw little prospect of current politicians being up to the task required. Kent Matthews said that this argument was reminiscent of the Lipsey-Lancaster theory of the second-best, where an initial distortion caused by a market failure was corrected by a counter-balancing policy distortion. Peter Warburton said that QE was a third or fourth best option. He said that gilt purchases were only one type of QE intervention.

Another type was to swap out existing QE for more risky assets, at fair value, held on commercial banks’ balance sheets. The Bank of England needed to take more risk in order to break the deadlock. Tim Congdon said that the separation of activity between the Bank of England, Debt Management Office (DMO) and HM Treasury had created inconsistency in policy.

David B Smith concluded the discussion by suggesting that the stance of bank regulators can be best understood by applying public choice theory to regulatory bureacracies. Over-regulation made it less likely that there would be politically embarassing bank failures and a few big banks centred on London were easier to supervise than numerous small ones scattered across the country. In addition, complex regulations allowed officials to maximise their bureaucratic empires and better enjoy the fruits of office. This was not an argument for zero regulation. Rather, he was suggesting that there was a tipping point beyond which regulation did more harm than good to society, and that we were now well past that point. Tim Congdon added that, as there was unanimous agreement on the SMPC that regulation was making things worse, a common statement on the implementation of Basle III and other regulation should be included in the policy recommendation. The Chairman then called on the committee to cast their votes and make their comments on monetary policy. These votes are listed in alphabetical order. The vote of Ruth Lea was cast in absentia on 17th July, because she had been unable to attend the SMPC gathering.

Comment by Philip Booth
(Institute of Economic Affairs)
Vote: Hold Bank Rate.
Bias: Do not implement the round of QE recently announced.

Philip Booth said that there were considerable supply side risks. The Eurozone crisis should not be allowed to dominate monetary policy. He said that falling inflation was resulting in less negative real interest rates and therefore there was no need to tighten and raise Bank Rate in the short term. He said that he was satisfied with the status quo and that latest round of £50bn QE should not be implemented.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: Continue with QE as announced.

Tim Congdon said that the funding for lending scheme announced in the Mansion House speech was potentially important. There could be higher growth of the quantity of money, due to both the third exercise in QE and the funding for lending scheme in late 2012 and early 2013. He said that interest rates should remain on hold for the time being and QE continue as planned. QE, which was currently organized solely by the Bank of England, should be replaced by a proper policy of debt management, coordinated between the Bank, the Treasury and the Debt Management Office. The main purpose of debt management policy should be to maintain stable growth of the quantity of money. However, another important consideration was to ensure that banks and other institutions active in the money market had an abundant stock of liquid assets (such as Treasury bills) to trade.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: No change in Bank Rate; continue with latest announced QE stimulus.

The Bank’s latest £50bn tranche of QE, announced at the July MPC meeting, was wholly unsurprising. Faced with a struggling economy, the recent downgrade by the International Monetary Fund (IMF) to its UK GDP growth forecasts was only to be expected; the Bank, rightly, continued to pursue its very stimulatory monetary policy. The damaging uncertainties created by the on-going Eurozone crisis show no signs of abating as the Eurozone’s political leaders continue to avoid the painful and necessary measures required to ‘solve’ the Euro’s intrinsic problems. The Euro crisis blew up in early 2010 and a permanent solution is almost as remote as it ever has been – even after the latest summit. Regulatory pressures on the banks continue to act in a counter-cyclical manner, restricting the banks’ ability to lend.

Meanwhile there was no need to be concerned about inflation. June’s CPI inflation rate fell to 2.4%, better than expected, and earnings growth remains extraordinarily subdued. It is now quite possible that the Bank will meet the 2% inflation target by the end of the year, which vindicates its ‘wait and see’ policy and refusal to tighten monetary policy even though CPI inflation has been above target since 2010. As CPI inflation falls to target then the painful squeeze on real incomes should be eliminated, which in turn should support consumer expenditure.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To raise rates.

Andrew Lilico said that it was not the job of monetary policy to offset regulatory errors. In the current situation, there was little monetary policy could do. An extreme monetary stimulus had been carried on for longer than necessary. Some normalisation of monetary policy should be aimed at. The rate of interest needed to revert to a Wicksellian norm – i.e. a real rate of something around 2% and there had to be a reconnection of the policy rate to market rates. A return to an equilibrium growth rate could not be obtained with Bank Rate so low. A rise was appropriate at this stage as a step towards the normalisation of monetary policy.

Comment by Kent Matthews
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%; no additional QE.
Bias: To raise; QE to be used only in the event of another Euro crisis flare up.

Kent Matthews said that he was impressed by Tim Congdon’s comments that there was little spare capacity in the economy and that capacity growth was in the order of 1% a year. If this was the case, then QE would be ineffective. He said that he was also optimistic about the funding for lending scheme and that it did have the potential to kick start bank lending to the growth sectors that will capacity build. His argument for raising the rate of interest was somewhat different to Andrew Lilico’s. While agreeing that monetary policy had to revert to some norm meant that rates had to rise, he felt that the Euro crisis might carry on for far longer than people currently suspect. Interest rates at the current position left no room for monetary policy in the event of another flare up of the Euro crisis. Currently, interest rates had nowhere to go in the event of a crisis. Interest rates would have to move closer towards a level where real interest rates were positive, so that in the event of a crisis the Bank could cut rates and deploy QE as a countermeasure. He said that interest rates should start to rise in small steps. While he felt that QE should be held in reserve for a bad day, to not implement the announced policy would only signal what some market participants fear – i.e., that the Bank does not know what it is doing.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate. No additional QE
Bias: To raise Bank Rate, once the Euro-zone situation clarifies.

David B Smith said that policy should be geared towards boosting the long term rate of growth using deregulation, tax reform and other supply-side friendly measures immediately and a rolling back of the excessive size of the state as soon as that becomes practical. The massive increase in the governmental sector between 2000 and 2010 had led to the mother of all supply withdrawals where the UK was concerned. This was not a situation that could be corrected by injecting ever more nominal demand into the economy. Britain’s small open economy meant that the main role of monetary policy was to differentiate UK inflation from world inflation via changes in the external value of sterling, which had been reasonably strong recently. The cut in the oil price from around $125 for a barrel of Brent crude to $100 – which now seems to be the new Saudi Arabian goal – will be dis-inflationary in the short term but also result in a positive surprise to global output in 2013.

Regulatory policy had been totally perverse and business cycle-exacerbating where money and credit creation were concerned. Monetary policy had attempted to offset the negative effects of regulation but without success. Higher capital and liquidity ratios should have been imposed in the boom not in the recession. QE was not a silver bullet. The only remaining argument for it now was to offset regulatory mistakes that should not have happened in the first place. Private-sector agents were not spending and investing because they faced hugely excessive regulatory uncertainty, tax unpredictability, and political risk. Politicians and bureaucrats needed to stop making matters worse and cease their confidence-sapping anti-business rhetoric. The economy required a predictable and stable banking system. Competition in the banking system could be brought in by employing anti-monopoly legislation to break-up the bigger banks, perhaps into their original constituents that existed before the clearing bank mergers of the late 1960s. This would reduce the ‘too big to fail’ problem without requiring the wholesale socialisation of the banking system that current policies were engendering.

Comment by Akos Valentinyi
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate; no further QE.
Bias: To tighten.

Akos Valentinyi repeated that it was too early to say that inflation was on a sustained downward path. There remained significant inflation risks and expectations of inflation on the Bank of England’s own survey continued to point to an upward path. Low unemployment in the current stage of the recession could be interpreted as a positive inflation surprise. He said that there was no need for interest rates to rise immediately but his bias was for a rise in the near future. He said that QE should be put on hold for the moment.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Hold Bank Rate; diversify existing QE into non-gilt assets.
Bias: To raise Bank Rate.

Peter Warburton noted that the basis of policy recommendation could be either principled or pragmatic. The principled action was to normalise monetary policy by raising Bank Rate and begin to rebalance tracker interest rates in favour of existing savers rather than borrowers. Further QE, in whatever form, should be held back as an emergency measure. The pragmatic policy approach was to keep rates on hold – to avoid the difficulty of presenting this policy in a positive light at a time of economic stagnation – and to switch some of the existing £325bn of QE into riskier ‘available-for-sale’ investments on the balance sheets of UK commercial banks, acquired at fair value. This would reduce the banks’ requirement for regulatory capital and release balance sheet capacity for new lending.

Current monetary policy had left the realm of first best or even second best solutions. In seeking to counteract the contractionary force of international regulatory pressures on the UK financial system, monetary policy was deep into the territory of pragmatism and expediency. He said that he had deeper concerns about further gilt purchases in relation to regulatory interventions designed to raise collateral requirements. In addition, he was not optimistic about the impact of ‘funding for lending’ because there was little to suggest that banks lacked short-term liquidity. Rather, their problem was that of regulatory overload which should, ideally, be reversed at source. He said rates should remain on hold and the power of existing QE be increased by switching from purchases of gilts from the market to purchases of riskier assets directly from the banks.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold.
Bias: Widen scope of QE.

Trevor Williams said that the rate of interest had to remain on hold until the wider economic situation improved. Inflation would most certainly fall in the coming months. In the next twelve months, the beginning of the normalisation of interest rates could start to occur as real interest became less negative with the fall in price inflation, provided no adverse demand shocks arose from Europe. Regulation was having an adverse effect on credit supply. QE should be expanded to include a wider portfolio of collateral. QE should also be kept ready for use in the event of a wider Euro zone problem developing.

Policy response

1. On a vote of seven to two the IEA’s shadow monetary committee recommended that the official rate of interest should remain on hold.

2. Several SMPC members indicated a bias to raise Bank Rate in the future, while accepting that this was not appropriate at the moment.

3. There was a mixed response to the announcement of further QE. One member said that the announced policy should not be implemented, while two agreed that the policy should be continued. Four members felt that there should be no further QE while two members said that the scope of QE should be widened to cover a wider range of assets. Two members said that further QE could be deployed in the event of fallout from the Euro crisis. One member felt that in the medium term QE should be replaced by a more appropriate debt management policy.

4. There was unanimous agreement that excessive bank regulation, including the early application of Basle III, was having perverse effects on the ability of banks to lend. It was felt that the timing of domestic and international regulatory policy was unhelpful in creating the conditions for recovery. Any further regulatory policy impositions should be delayed until a firm recovery was in sight.

In its most recent monthly e-mail poll, completed on 27th June, the Shadow Monetary Policy Committee (SMPC) decided by a narrow five votes to four that UK Bank Rate should be held at ½% when the official rate setters meet on Thursday 5th July. Two of the dissenters on the shadow committee wanted to raise Bank Rate by ½%, while another pair desired an increase of ¼%.

There was also a divergence with respect to the desirability of further quantitative easing (QE). One shadow committee member wanted an immediate injection of a further £75bn and another asked for a £50bn increase. However, most SMPC members were content to leave the QE stock where it was for the time being – except for one who wanted a phased programme of withdrawal – but there was general acceptance that QE should be used aggressively if the Bank of England again found itself in a lender of last resort situation, perhaps as a result of events in the Eurozone.

There was a near unanimous view on the SMPC that there remained a serious policy inconsistency between financial regulators’ desire to gold-plate capital requirements and other restrictions on the size of commercial bank balance sheets and the official desire to get credit flowing again, especially to smaller enterprises. Some committee members thought that easing the regulatory push, while raising Bank Rate to a more neutral level, would represent a more coherent policy stance and bring increased credit growth and private-sector activity.

The two big unknowns identified by the SMPC were the likely consequences of developments in the Eurozone and how far to trust the weak official growth numbers, as compared to the more buoyant labour market and survey data.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: To hold for the time being.

Money growth trends in the so-called ‘leading’ nations have remained disappointing in the first half of 2012. In all the nations that have participated in the Basle III regulatory initiative, commercial banks have been obliged to restrict balance-sheet growth, or even to shrink balance sheets, in order to boost their ratios of capital to risk assets. Banks’ capital/asset ratios today are far higher in the USA than in the 1980s or 1990s, and – although the situation elsewhere is less clear-cut – banks in the Eurozone and the UK also seem to be operating with much higher capital buffers than in the years leading up to the Great Financial Crisis of 2007. The result of these developments is that the quantity of money, broadly-defined, has stagnated for the last three to four years. In extreme cases, such as the Eurozone periphery, the quantity of money has actually fallen at annualized rates of 10% or more last seen in the USA’s Great Depression of the 1930s.

The money stagnation/contraction has in turn been associated with feeble and unconvincing recoveries from the 2008/9 downturn or even with double-dip recessions (most notably in the Eurozone periphery where the banking traumas and money contraction have been most severe). In other words, the latest cyclical episode – like so many before it – confirms the validity of the monetary theory of national income determination.

In the UK, the banks have to cope with the regulatory demands of the Vickers Commission, which has gold-plated the international rules. Lloyd’s and RBS have said publicly that they are still trimming their balance sheets. So the growth of M4ex (i.e., broad money excluding the troublesome intermediate ‘other financial corporations’) has been weak for several quarters, despite the deliberate creation of money balances in two QE exercises. Happily, the inflation prospect for late 2012 is improving, which will make the policy environment more congenial for another round of QE. The aim remains that M4ex growth should run at about 3% to 5% a year. In conjunction with virtually zero short-term interest rates, that sort of money growth rate ought to be associated with a reasonable rate of domestic demand growth over the next few quarters.

It is dismaying that the artificial ‘funding for lending’ scheme should now be thought necessary by officialdom. Have not the UK’s regulators, central bankers etc. understood that the reason for banks’ hesitation in expanding their balance sheet is that they are under the cosh of the Vickers Report? If the Vickers Report and Basle III could be dumped or given five years or a decade to implement, UK banks would assuredly want to lend more to the UK private sector. Further, with such low interest rates, the private sector would assuredly want to borrow.

As far as this month’s vote specifically is concerned, I am in favour of no change in interest rates. Another round of QE should be implemented only to the extent required to ensure that the growth of M4ex runs at an annualised rate of 3% to 5%.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate; expand QE by £50bn.
Bias: To increase QE further.

The case for additional monetary stimulus in the UK remains strong. The recovery in real activity is close to stalling – if the current generation of data from the Office for National Statistics (ONS) is to be believed, the economy has already tipped back into recession. Nominal spending growth remains too weak to sustain a solid rebound in output. Since the recovery started in 2009 Q3, nominal Gross Domestic Product (GDP) has grown at a rate 1½ percentage points below the average recorded between 1992 and 2007. Pay growth remains moderate, and there is little sign that elevated headline inflation has passed through into wage settlements. Commodity prices have fallen markedly over the last year, particularly since the spring. Spot oil prices in sterling terms are down by over 20% since late March, for instance. This should reduce the risk that persistently above-target inflation becomes entrenched in inflation expectations. Most importantly, a ‘dark cloud of uncertainty’ continues to hover over the Eurozone. Even though a centrist coalition has been formed in Greece and European funds are on the way to recapitalise Spanish banks, we remain some distance from a resolution of the zone’s problems.

Business surveys suggest the British economy is still growing. The GDP-weighted composite Purchasing Managers Index (PMI) averaged 52.6 in April and May, for instance. A similar figure was registered for the composite new orders balance as well. However, prospective output growth could be very limited. The one-off distortions due to the Queen’s Diamond Jubilee could cause the headline GDP data to show another decline in the second quarter. This is all the more likely because of what appears to be a very sharp drop in April construction activity. Given the extreme volatility in some official monthly data, it is unusually difficult to assess the underlying pace of growth in the UK. Certainly, the 2011 Q4 and 2012 Q1 real GDP figures do look surprisingly weak. At best, one might say that the British economy is expanding gradually, but is close to stalling.

Consumer Price Index (CPI) inflation, at 2.8% in May, remains above the 2% target, but it has fallen significantly over the last six months. Most of this decline has been due to base effects, as higher energy prices and VAT fall out of the annual calculation. More recently, though, it has been driven by an outright decline in ‘non-core’ components of the CPI. Petrol prices, for instance, dropped by over 3% in May. The twelve-month change in the ‘core’ CPI index was still above target in May, at 2.2%. However, there is evidence that the weakness of underlying price pressures is becoming apparent in the CPI numbers. The three-month (seasonally-adjusted) annualised change in ‘core’ consumer prices was 1.7% in May, the slowest rate of expansion in eighteen months. These trends are set to continue. UK food and energy price inflation should fall noticeably over the second half of this year, as movements in global commodity prices feed through to the domestic market. CPI inflation should end 2012 below the 2% target and should remain there next year as well.

Any worries of an upward creep in inflation expectations because of persistently above-target headline inflation should now be dispelled. There remains considerable disagreement about the UK’s disappointing productivity performance, and its implications for future inflation. While there are good reasons for believing that the financial crisis will have done some damage to Britain’s supply capacity, it is not convincing that the vast bulk of the shortfall in output represents a permanent loss of aggregate supply. The argument that there is spare capacity that would come back on stream if demand were to pick-up is relatively convincing. It follows from this that there is a major risk of hysteresis-like effects, if demand weakness is allowed to persist.

The authorities need to do more. There are three main levers that could be pulled to achieve this. The pace of fiscal tightening could be slowed. This is neither likely nor desirable, however. The political reality is that the Coalition cannot deviate from Plan A. Moreover, government spending was the main source of excess demand before the crisis. There would seem to be strong grounds for reducing the share of government spending in GDP. Nevertheless, one can question the balance of spending cuts being proposed. For example, too little is being trimmed from current spending, particularly social benefits, at the same time as public investment is being cut too rapidly. Macro-prudential policies could be used to enhance the transmission mechanism of monetary policy. To an extent, this is already being done. In his Mansion House speech, the governor announced that the Bank would create a ‘funding for lending’ scheme, which provides subsidised financing to banks for a period of several years, collateralised by loans to the ‘real economy’. This could potentially be very beneficial in the current environment if the terms are sufficiently easy. Unconfirmed reports suggest banks will be able to borrow at a spread of 25 to125 basis points above sterling London Inter-Bank Offered Rate (LIBOR) – the greater the increase in their net lending, the greater the subsidy that lenders will enjoy. Elevated bank funding costs, which should be alleviated by the scheme, are a major impediment to the UK recovery. The governor also announced plans to activate the Bank’s Extended Collateral Term Repos (ECTRs), which provide six-month sterling loans at a small spread over Bank Rate against a wide array of securities and loans. It has recently become clear that the tightening of liquidity regulation may be constraining the lending of some banks. The activation of ECTRs should help in this regard.

How far these facilities go in easing credit conditions is unclear at this stage. We do not yet have full details of the ‘funding for lending’ scheme, for instance. To the extent that these changes enhance the effects of the Bank’s past gilt purchases, one might want to hold off on any additional monetary stimulus. However, given on-going financial dislocation in the Eurozone, the weakness of output growth in the UK and the large fall in global commodity prices, there is still a strong case for additional asset purchases. My vote is for another £50bn to be bought over the next three months. Further stimulus may well become necessary as the year progresses.

Comment by Anthony J Evans
(ESCAP Europe)
Vote: Raise Bank Rate by ¼ %.
Bias: No additional QE but the Bank should be on standby with other monetary tools.

On the surface, the UK economy is in a delicate state but not in a slump. M4ex is growing at a reasonable rate and nominal GDP is not forecast to contract. Inflation remains well above target, with almost 10% of the internal value of the pound being shred since November 2009. This is an enduring and serious catastrophe. Even though inflation has dropped to under 3%, this is due predominantly to falling commodity prices and not to a tight monetary policy. Indeed, inflation expectations remain anchored close to target. Survey data suggests that GDP is stronger than official figures suggest.

The Greek election paralysed decision making as people waited to see the outcome, and for some there was disappointment that there is no real change on that score – instead, bailouts, debt, and the political inability to confront reality. Of course, the Eurozone constitutes a large part of the UK’s export market. However, more important immediately is the unpredictable consequences of an abrupt change in expectations. Nevertheless, if UK policymakers are waiting for the situation with the Euro to be resolved, then they are implicitly committed to permanent crisis. If, or when, the Euro collapses, the Bank of England will have a job to do. Even so, there are risks involved in acting too quickly. If anything, special resolution schemes should be introduced to speed up this process and contain the fallout. Such crises present opportunities for the Bank to get interest rates back towards their natural rates without it being seen as the cause of the turmoil.

One useful thing that the Bank of England should be doing is improving on its communication regime. In October 2008, the Federal Reserve wanted the authority to pay interest on reserves and it utilised that authority immediately in order to do so. This led to a predictable contraction of credit – exacerbating the crisis – but it was believed that using the tool too early was better than not being able to use it in future. The Governor and Chancellor’s Mansion House speeches sought to lay down a framework for further monetary tools.

Furthermore, it is conceivable that the confidence-building effects of such an announcement would make it unnecessary to use them. However, the proposed changes also generate regime uncertainty. Credit easing gives even more discretion to the Bank of England and will almost certainly be conducted in an arbitrary way. It pays little attention to the type of credit being supported, since it moves us from a free-market to a centrally-planned volume of credit. The lender of last resort should only lend at a premium, and greater care needs to be taken in terms of distinguishing between liquidity and solvency problems. The lack of bank failures is a sign of the economy’s fragility, not strength.

The surprise downgrade of fifteen banks by the rating agency Moody’s in mid-June threatens to take control of interest rates even further from the Bank, and lending costs will almost certainly rise. It is possible that the Bank has missed its opportunity to re-couple Bank Rate with the market. It remains to be seen whether this downgrading represents an isolated opinion or whether Moody’s are simply the first of a number of news items pointing to a continuing deterioration. The Bank of England should keep a keen eye on developments. However, and if some of the more pessimistic scenarios transpire, further cuts to Bank Rate as discussed at the last Monetary Policy Committee (MPC) meeting or, indeed, further QE will not be sufficient.

Those who feel that the Bank of England was slow to act in mid-2008 may want to atone for this with pre-emptive action now. Nevertheless, past mistakes need to be factored into the new reality. Much of the output loss since then is a permanent destruction of wealth and cannot be recovered through stimulating aggregate demand. It is commonly believed that the Bank’s decisions are largely irrelevant on account of its impotence. In actual fact, there is a significant array of tools that the central bank can use to maintain nominal GDP stability should the need arise. This is all the more reason to take a cautious approach and curb the temptation to act too early.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; implement £50bn more QE.

The latest CPI inflation data were encouraging. The annual rate fell from 3.0% in April to 2.8% in May, which was better than financial-market expectations. The Bank of England’s upward revisions to the inflation forecasts, included in the May Inflation Report, now look to be on the pessimistic side, if anything, and this was conceded in the June MPC minutes. The Bank may even hit its 2% target by the end of 2012.

Inflationary pressures are undoubtedly easing and commodity prices have declined over both the past month and the past year. The Economist’s ‘all items’ index for 19th June 2012 was down 1.5% in sterling terms on the month and 12.0% lower on the year. In addition, the decline in oil prices has been marked especially since the spring of 2012. Brent crude oil was priced at around US$93 per barrel on 26th June compared with US$125 per barrel in the March and April period. Producer prices inflation is also on a downward trajectory, while earnings growth remains extraordinarily weak. Inflationary pressures should not be a concern.

Sir Mervyn King’s Mansion House speech (14th June) radiated gloom. He referred to the “black cloud of uncertainty and higher bank funding costs brought about by the Euro-area crisis”. Suffice it to say that the Eurozone crisis is nowhere nearer to resolution after the recent Greek elections than before. Europe’s politicians, having already frittered away two and a half years in which they could have built the foundations for a sustainable solution to the currency area’s inherent flaws, apparently remain in denial and seem to be transfixed by the horrors unfolding before their eyes. If Eurozone political union is not forthcoming, and there are no signs that either German or French politicians are prepared to completely submit the fates of their countries to Eurozone-wide institutions, then a break-up (partial or complete) is ultimately the only alternative.

In the meantime, Britain’s economy requires further stimulus. Real activity continues to disappoint, though the labour market seems, paradoxically, to be in more robust form. The proposed £80bn ‘funding for lending’ programme, in which the Bank will provide low cost funds to the commercial banks for them to lend on to businesses and households, is welcome. Details are, apparently, still being worked out. However, the announced proposals to date are encouraging. Small businesses, in particular, have been reporting increased difficulty in obtaining bank funds at affordable rates, not least of all because higher bank funding costs have led to higher lending rates.

More QE is also on the cards. June’s MPC minutes reported that the committee had agreed that “asset purchases remained an effective tool for lowering a range of market interest rates, supporting asset prices and so nominal demand” even if the impact may be dampened with gilt-yields as low as they are. Three MPC members voted for an extra £50bn of QE in June (the Governor, David Miles and Adam Posen) and Paul Fisher voted for £25bn. The remaining five favoured no more expansion at this stage.

Growth in the UK is faltering, stagnating at best. Meanwhile the Eurozone’s economies continue to deteriorate, whilst there appears to be a marked slowdown in the US – our other major trading partner. There remains a strong case for a very accommodative monetary policy. Bank Rate should be left at ½%. There is little point in cutting it further and the time is ripe for a further £50bn of asset purchases.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%; no more QE but no withdrawal of QE.
Bias: To raise Bank Rate.

There are three key issues facing the UK at present. One is that the underlying growth rate may be only about 1% over the medium term. For this, an interest rate of ½% is damaging. A second is the threat of banking sector collapse if the Eurozone disintegrates. For this, low interest rates and QE will not prevent it, and if it happens QE will be an insufficient instrument. A third is that regulation has attempted to force a large and artificial rise in capital ratios for banks, inducing unnecessarily low broad money growth. For this, regulatory reform, not monetary looseness, is the correct policy response.

As regards the medium-term issue, economies do not grow at their fastest rate over the medium term with the lowest interest rate. Instead, they grow fastest when interest rates are at their natural rate. This has been known since the time of Wicksell, and is a standard prediction of most orthodox models as used by international authorities such as the Bank of International Settlements (BIS). The BIS itself has noted recently that artificially low interest rates might be damaging medium-term UK growth. From a policy perspective, holding interest rates below the natural rate requires the justification that circumstances are temporary and can be alleviated by temporarily low rates. With interest rates having been at their current emergency level now for more than three years, it has long ceased to be credible that circumstances are temporary or that low rates are an emergency measure.

It is difficult to observe the natural rate directly, but it can be reasonably estimated as the sum of the sustainable growth rate and either inflation expectations or the policy target – so if the UK sustainable growth is now between zero and 1% and inflation expectations are 2% to 3%, that implies a sustainable growth rate of between 2% and 4%. If the sustainable growth rate can be raised or is not quite as bad as this, that implies a higher sustainable growth rate. To claim that the natural rate is anywhere close to 0.5% at present would require the belief either that expected inflation is negative or that the sustainable growth rate is considerably negative (say, even worse than minus 1.5%). Given that neither of these is plausible, it is clear that the natural rate is well above the current policy rate – damaging medium-term growth. Rates should be raised back closer to the natural rate, at least to the point at which they re-connect Bank Rate to the monetary policy transmission mechanism.

As regards Eurozone collapse, if that occurs and leads to some of the darker scenarios – which might include 20% contractions in Eurozone GDP and the collapse of much of the Western banking sector – QE (i.e. purchasing of second-hand government bonds) will probably be inadequate as a policy measure. Instead, the Bank of England will need to purchase government bonds directly or even simply print money to fund government spending, with all the attendant risk that entails. That bridge should be crossed if and when we come to it. For now, one merely observes that QE cannot stop the Eurozone collapsing and will be inadequate as a response to its doing so. QE is now irrelevant and no more should be contemplated for the moment.

The third issue is the unnecessary contraction in lending induced by regulatory capital ratios. This is part of the overall deeply misguided approach to the banking sector’s problems. The Bank of England seems, mercifully, intent on treating capital ratios as indicative rather than mandatory. The use of QE to offset a monetary contraction induced by regulatory policy is a case of the policymaker’s left hand fighting the right. It is not monetary policy’s job to do this. What we should be doing is to raise rates, just a little, and prepare our plans for the event that the Eurozone collapses. Raise Bank Rate by ½% for starters.

Comment by Patrick Minford
(Cardiff Business School, Cardiff University)
Vote: Raise Bank Rate by ½%.
Bias: To raise Bank Rate, while reducing regulatory burden on banks.

The debate over QE has finally become meaningful: first, with the intervention of Paul Tucker detailing some worries over the effects of regulation on bank lending; second, with the announcements in the Mansion House speeches that the Bank and government would reduce the marginal cost of lending to the banks, in a way related to extra lending. Frankly, this sort of bureaucratic ‘incentive’ is an abomination – reminiscent of the ‘corset’ device invented in the late 1970s to persuade banks to limit the former M3 broad money definition, which was the officially preferred measure at the time. Such interventions breed evasion and what is known as ‘fungibility’- i.e., you do what you planned anyway but dress it up as the necessary ‘increase’.

Far better to have had a ‘mea culpa’ from these bureaucrats with respect to their ridiculous plans for regulating the banks. Maybe the new intervention will be a cover for a quiet retreat from these plans. Who knows? However, we should not hold our breath. When the Kings, Vickers and Turners of this world are allowed sway over our affairs, they will not relinquish it with much speed. Unfortunately, Messrs Cameron and Osborne are like innocents abroad, ignorant and led by the nose on these matters. Their ignorance is not helped by their quasi-religious views on ‘debt’. The monetary intelligence of Alistair Darling, and even Gordon Brown, was of a far higher order.

Nevertheless, it is plain that there is a credit drought for Small and Medium Enterprises (SMEs). This part of our economy would be searching for new business opportunities otherwise, instead of just trying to survive. QE has not affected the supply of credit, it is plain. Some say the counterfactual is that credit could have declined further. This is pure invention. It is highly unusual for credit to keep on dropping after the end of recession (this is using general indicators, not the ONS’s suspect first estimates, as a guide to the pattern of activity). Furthermore, if one looks at the ‘events’ of QE injection, it is clear they had no effect on credit growth. No doubt, as my SMPC colleague Tim Congdon says, QE has added to M4 broad money. Arithmetically, it must; the money is printed and deposited; it then has been held in bankers’ balances. Thus, it is added to deposits; and also to M0 base money. However, the problem is that the ratio of broad to base money – the M0 multiplier - has collapsed because of banks’ unwillingness to lend. So the rise in M4 is small. Indeed it is hardly growing.

The only sort of QE that would add to SME lending in these circumstances would be direct use of the QE to buy SME assets or give them loans. However, this would be a bridge too far for the Bank. Indeed, even the US Federal Reserve which has bought all sorts of unorthodox assets, including corporate bonds and mortgages, has balked at doing this. Furthermore, it is not a good idea for the state to lend directly to business, as it lacks the monitoring capacity that commercial banks bring to this task. The Bank of England could buy mortgages, instead. This would get it nearer to the credit problem than buying gilts as it now does. The latter simply allows the government to print money to meet its deficit. Some argue that it drives down the yields on gilts. This argument relies on the ‘preferred habitat’ theory of interest rates by which there is a special demand for gilts for defined purposes; then to induce those demanding gilts to give them up one needs to bid up the price and so lower the yield. However, with the massive supplies of gilts on world markets, many of those holding gilts will be representative world bond portfolio holders. For them, the yield on gilts is set by the rate on competing international bonds such as US Treasuries plus any special UK risk premium. Gilt yields have fallen in line with the world appetite for safe havens. There is no discernible impact from QE ‘events’ on them. I would support QE purchasing of mortgages and any other unorthodox assets; their purchase could help the credit market to fire up again. However, there is no suggestion the Bank will do this.

As for QE purchase of gilts, it should be opposed on three grounds. First, it is of no use for the problem at hand: viz. the stimulation of credit and, except trivially, money. Second, it allows the bureaucratic classes to maintain the fiction that they are somehow ‘offsetting’ their disastrous regulative policies; this relieves the pressures on them to reverse those policies. Third, it substitutes money for bonds in the government’s financing, laying up risks long-term for the future control of money and making government dangerously dependent on money printing; in practical terms, when this has to be unwound, the government will face a sharp rise in its funding costs which will create unpopular pressure for further cuts – this will make reversal of QE difficult when it is necessary for monetary control.

Clearly, the endless crisis in the Eurozone continues to create monetary uncertainty. Nevertheless, there is evidence that the UK economy is managing to grow if only weakly in spite of the Eurozone recession. UK exports to non-euro destinations have grown 30% since 2007. While it may seem harsh in current circumstances to argue for a rise in interest rates, we must face the prospect that the Eurozone crisis will continue indefinitely. In my view, it is time for the Bank to regain control of the interest rate environment. The commercial banks’ marginal cost of funds is now just below 4%, which is way above Bank Rate. The Bank of England has recognised this divergence in its new scheme to subsidise the banks’ cost of funds in return for new lending. What the Bank should now do is raise Bank Rate (i.e., what it charges on direct lending to the banks) more into line with market rates, and simultaneously reduce the costs the banks face in terms of liquidity and capital regulations. By such moves, it could reduce the banks’ cost of funds while also getting its own lending rate to a more normal level at which its adjustment up and down would be meaningful again. It would also signal an end to the Bank of England’s hostility to the banking system and the beginning of a new regime that would liberate the banks to lend again, knowing they had the support of the key state player.

Therefore, no further QE is recommended, with a bias to its reversal; and a rise in Bank Rate to 1% with a bias to raise further. All this to be accompanied by a strengthening of the announced plans to reduce the banks’ cost of funds, but via a rollback of regulations and liquidity ratios, and without lending conditionality, which is a feature of planned, not market, economies.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate; no immediate increase in QE.
Bias: To raise Bank Rate; keep more QE on standby.

Several chinks of sunlight have recently appeared in the dark clouds overhanging the British economy. These include the better than expected May inflation data and the signs of a more buoyant private-sector jobs market in the most recent ONS Labour Market Statistics. This mildly favourable labour-market development is slightly surprising because the UK is a small, open and trade-dependent economy heavily influenced by overseas developments. Much of the recent news from abroad has been disappointing where the strength of global activity is concerned. Nevertheless, the fall in the price of oil from a monthly average of US$124.5 in March 2012 to US$93 on 26th June should prove disinflationary quite soon and expansionary in the medium term, once the positive output effects have worked through next year. The common view is that the lower price of oil reflects slowing global activity. However, it is conceivable that Saudi-Arabia is trying to achieve a permanently lower oil price for commercial and geo-political reasons. Cheaper oil reduces the incentives to develop technologies, such as ‘fracking’ which have the potential to knock the bottom out of the energy market in the long run. In addition, a reduced oil price cuts the financial resources available for Iran to develop its nuclear weapons capacity.

The current model of European Monetary Union (EMU) now looks beyond salvation, even if the Continent’s elites are likely to fight this development tooth and nail in a Verdun-style battle of attrition. Smith’s four rules of forecasting almost certainly apply here: 1) if economic logic says something has to happen, it will happen; 2) the ‘dead start’ before the event occurs will be longer than one expects; 3) when the event happens, it will be more sudden than anticipated, and 4) the size of the shock will exceed initial expectations. The pity of it is that EMU might well have worked if Continental politicians had not driven a coach and horses through the Maastricht fiscal convergence criteria. These were not just pious intentions but a necessary condition for EMU to hold together in the long run. In addition, the Eurozone seems to have suffered from a form of the ‘Walters’ critique’ – named after the late Sir Alan Walters, who was an early SMPC member – in that the move to a single rate of interest had the perverse effect of cutting real interest rates in high inflation economies – such as Ireland and Spain; hence, their credit booms – and raising them in low inflation economies, such as Germany. Several prominent German officials appear to have left the European Central Bank (ECB) recently. This suggests that the Euro is now considered either as a lost cause or, even worse, a charter for open-ended fiscal profligacy, the monetisation of public debt, high inflation and the imposition of open-ended future liabilities on the German taxpayer.

Numerous previous currency unions have broken up, of course, often because of the collapse of imperial powers such as the British Empire or Austro-Hungary, without the world coming to an end. As Sir Dennis Robertson amusingly commented in his 1928 Money describing the situation in the early 1920s: “Sometimes a wholly new monetary unit was invented: thus the European Zoo is now enriched by a number of species – the Lit and the Lat, the Polish Zloty and the Hungarian Pengő – which were unknown to our ancestors. In other cases, such as France and Italy the old unit was retained, but the weight of gold to whose value its value was to be kept equal was fixed afresh, in the former instance at about a fifth, in the latter at rather more than a quarter of the pre-war weight” (page127 in the Routledge re-print published in 2000). Rather than have a fit of the vapours, the useful thing to do now is to study earlier episodes of currency zone dissolution in order to minimise the collateral damage when EMU eventually joins previous currency unions in the waste bin of history.

Meanwhile, it would be a good idea if Mr Cameron stopped lecturing Germany from the side lines on why the German people should accept open-ended financial commitments in order to hold the Eurozone together. Not only do the numbers not add up – there are simply not enough Germans to support the rest of the population of Eurozone – but such actions give rise to serious moral hazard where the political classes of the non-Teutonic members of EMU are concerned and lead to the constitutional abomination of taxation without representation where the citizens of Germany are involved. Furthermore, it is hard to see why it is in Britain’s geo-political interest to have the Continent of Europe dominated by one large centralised power, if Eurozone banking, fiscal and political union ultimately emerge from the present debacle. One of the main aims of British diplomacy for at least the past four centuries has been to prevent Continental Europe consolidating in a way that might prove inimical to our economic or other national interests at some stage.

The banking measures announced in the 14th June Mansion House speeches appear to have three main aims. The first, and valid, psychological aim, was to steady financial market nerves by showing that the stock of monetary weapons available to the authorities had not been exhausted. The second was to ease pressures in the money markets and three-month money-market rates seem to have eased by some 9 to 11 basis points since the scheme was announced. The third was to encourage credit creation to industrial and commercial companies, especially to the SME sector. The problem here, as has been repeated endlessly in previous SMPC reports, has been the lunatic policy inconsistency between the regulatory overkill that the authorities have been trying to impose on the banking sector and the banks’ ability to maintain even the existing size of their balance sheets, let alone expand them by granting new credit. The point has been reached where new interventions are being employed to offset the adverse effects of earlier ones. It all makes work for bureaucrats to do but it is of strongly negative benefit to the wider society.

It would be more sensible to tackle the ‘too big to fail’ and perverse incentive structures within banking by four simple measures. First, break up the large publically-supported banking groups into several smaller banks, which can be sold off piecemeal. Second, use normal anti-monopoly legislation to break up privately owned banks that are too big to fail. Third, restrict deposit insurance to, say, 90% or 95% of the value of the deposits concerned, so depositors have an incentive to seek out the most prudent organisations. Finally, senior bank executives – say, those earning more than a million pounds a year – should have uncapped personal financial liability if their banking groups have to be bailed out by the state. Furthermore, such liability should remain on a diminishing scale for a period of, say, five years after the executive involved has left the financial organisation concerned. This last would be to ensure a prudent choice of successor and to prevent failed bankers walking away with undeserved ‘shedloads’ of money.

As far as the July Bank Rate decision is concerned, the continuing uncertainties in Continental Europe warrant a tactical hold. However, the medium-term aim should be to get Bank Rate into the 2% to 3% range at which point it will start to re-engage with the money market rates that determine borrowing costs, while stopping the more ill-considered financial regulatory initiatives, or pre-announcing that they will be phased in over a very long period. Unfortunately, the current SMPC poll had to be frozen before the release of the new 2009 chained national accounts on 28th June. When the ONS introduced the current 2008 based data last year there were growth revisions of more than 1 percentage points to previous ONS estimates for some years. The re-worked national accounts might reduce some of the discrepancies between the GDP figures and the survey data and labour market statistics when they appear on 28th June. However, extreme cynicism is the only appropriate response to the ONS data. Moving on, it is widely expected that the authorities will announce a further batch of QE either on 5th July or 2nd August. The latter would be just ahead of the August Inflation Report, whose forecasts would be available to the MPC. However, the 3.8% annual rise in M4ex broad money in the year to April, the 3.3% annual increase in the double-core retail price index in May and the 320,000 increase in the number of private sector jobs over the latest four quarters are among a number of indicators suggesting that there is no case for further QE immediately. Additional QE should be kept on standby in case there is a renewed threat of a banking meltdown caused by events in Continental Europe. However, QE should be reserved for lender of last resort purposes and not employed as an instrument of day to day monetary policy.

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

Since the escalation of the European financial instability threat last October, we have advanced the argument that the Bank of England, in the abruptness of its withdrawal of the £185bn Special Liquidity Scheme (SLS), was primarily responsible for aborting the nascent economic recovery in 2010. While the reintroduction of QE last year has improved liquidity conditions in financial markets, the flow of credit to the non-bank private sector barely has a pulse. Sir Mervyn King appears to have backtracked on his objections to the reintroduction of a similar facility, in the recent announcement of the activation of the Extended Collateral Term Repo (ECTR). Additionally, a new initiative, ‘funding for lending’, builds on the existing credit easing measures. The details have yet to be released, but his Mansion House speech stated that “the Bank would lend, as in its existing facilities, against a much greater value of collateral comprising loans to the real economy, to protect taxpayers”. Fundamental to the Governor’s support for the scheme is the approval and underwriting provided by the government.

While it appears that the ECTR, first activated on 20th June with a £5bn allotment, is reminiscent of the SLS programme, the ‘funding for lending’ is much closer to the unsuccessful National Loan Guarantee Scheme (NLGS), launched in March this year. Basically, the commercial banks have not yet figured out how the NLGS is meant to work! It is to be hoped that ‘funding for lending’ will not suffer from the same drawbacks. It is of the utmost importance that these initiatives lift credit constraints to the SME sector. There are obvious concerns that elevated European economic uncertainty will hold back credit demand quite independently.

As argued on numerous previous occasions, Bank Rate is a sideshow in current circumstances, disconnected from a market structure of interest rates that is drifting higher. To reiterate, a sensible plan would be to raise Bank Rate under the cover of these European interest rate stresses. In all probability, once the fuss surrounding the first rate increase dies down, there would be virtually no impact on the overall structure of customer interest rates, with mortgage tracker accounts making small transfers to saving tracker accounts. The sooner that Bank Rate is reconnected to the market structure, the better.

One of the common misperceptions regarding credit is that government policy should seek to lower the stock of private sector debt. In other words, to force an overall contraction in the amount of debt held in private hands. In a credit-driven economy, this would be a foolhardy policy. The analysis above argues that there were vintages of mortgages and business loans – most notably, those extended between 2003 and 2007 – which suffered from bad underwriting practices. The failure to either write down or quarantine these bad loans stands in the way of a meaningful private credit recovery. The credit losses that the banks are taking year by year relate primarily to these old loan vintages. By implication, an expansion of new lending, based on tighter criteria and lower loan-to-value ratios, does not present a threat to future financial stability. If these new initiatives allow poorer quality bank assets to be offered as collateral against net new credit to the private sector, then it is possible to become more enthusiastic about the economic outlook.

Comment by Trevor Williams
(Lloyds Bank Wholesale Markets)
Vote: Hold Bank Rate; extend QE by £75bn; purchase wider range of securities.
Bias: To ease further, if required.

The fragility of the world recovery has been heightened over the last week by the economic news emerging from the US and Europe. Meanwhile, the latest economic news in the UK suggests that the economy is at risk of another quarter of negative growth in 2012 Q2. The PMIs for manufacturing and construction and the April falls in manufacturing and industrial production, which fell by 0.7%, all point to the risk of a further GDP decline in the third quarter – making three consecutive quarters of negative growth. These risks are clearly forefront in the minds of Bank of England officials. The minutes of the last meeting of the MPC show that, though the vote was to maintain the existing programme of QE at £325bn, it was on a knife edge – just five votes to four in favour.

Interestingly, amongst the four who voted for further QE was the Governor himself. What the minutes suggest is that an increase in QE is almost inevitable in July’s vote, as the five who voted to maintain the status quo on this occasion, did so on the basis that they wanted to be sure that inflation remained weak and that there was greater clarity around the direction of the economy. Well, we now have more clarity and it is not of the kind that would prevent further easing, unfortunately. So, an additional £50bn is almost pre-ordained. Price inflation has fallen further, helped by lower petrol prices and the economy is showing renewed signs of weakness. Although core year-on-year inflation rose from 2.1% to 2.2% in May, this was mainly down to distortions to the May 2011 base. Meanwhile, the rise in the volume of retail sales in May masked real weaknesses. So, the real question is whether the additional QE in July should be as much as £75bn.

The Bank of England has also embarked on a programme of allowing institutions to borrow from it using a broader range of collateral. The new ECTR offers six-month loans, with a minimum borrowing value of £5bn. In his Mansion House speech, the Governor suggested that the Bank would also consider an effective revival of the Special Liquidity Scheme and a swap facility comparable to the European LTRO. He also implied that Bank would accept credit risk through taking on mortgage-backed securities and bundles of corporate loans; the Treasury effectively has indemnified the monetary authority to do so. This means that the Bank has added another batch of instruments to the toolkit that it can use to ease policy. It may well be that they will be required in the weeks and months ahead as the turmoil in Europe persists and events unfold in an unpredictable manner.

What is the SMPC?

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

Current SMPC membership

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

Following its most recent quarterly gathering, held at the Institute of Economic Affairs (IEA) on 17th April, the Shadow Monetary Policy Committee (SMPC) decided by a narrow margin of five votes to four that UK Bank Rate should be held at ½% on Thursday 10th May. Three members of the shadow committee wanted to raise Bank Rate by ¼%, while a fourth argued for an increase of ½%.

This result reflected the increasingly ‘hawkish’ trend in the SMPC vote that has appeared during recent months, while still leaving a narrow majority in favour of holding rates. All the IEA shadow committee members recognised the uncertainties attached to UK economic developments, events in the Eurozone, and the need to restore financial balance sheets, and were well aware that a flexible and pragmatic response to events was the only sensible course.

Most SMPC members thought that there should be no additional QE in the short term, although there was a divergence of view with respect to the appropriate policy subsequently. Some members believed that further QE tranches would be required because of the weakness of the economy, others wanted to hold the existing stock, and one member thought that QE now needed to be unwound to avoid longer-term inflation risks. The SMPC poll was finalised after the disappointing March inflation figure, which was released on the morning of the gathering, but before the publication of the negative first quarter real GDP growth figure on 25th April. However, the SMPC had already concluded on 17th April that the official data was no longer fit for purpose where the national accounts were concerned.

Minutes of the meeting of 17th April 2012

Attendance: Phillip Booth (IEA-Observer), Roger Bootle, Anthony J Evans, John Greenwood, Ruth Lea, Andrew Lilico, Patrick Minford, David Brian Smith (Chairman), David Henry Smith (Sunday Times Observer), Peter Warburton (Acting Secretary), Trevor Williams.

Apologies: Tim Congdon, Jamie Dannhauser, Kent Matthews, Akos Valentinyi, Mike Wickens.

Chairman’s comments

The Chairman started by suggesting that it would be useful to expand the range of issues discussed by the shadow monetary committee now that Bank Rate had been unchanged for some three years. He added that individual SMPC members had addressed wider macroeconomic and regulatory issues in the SMPC polls – something he wanted to encourage – but asked members to give further thought as to how the committee’s analysis might be made even more policy relevant. He then asked John Greenwood to present the monetary situation.

The Monetary Situation

International economic background

John Greenwood started by distributing a detailed presentation pack. He then proceeded to structure his comments around: the contrast between developed and emerging economies; a more detailed consideration of the international monetary situation, and, finally, the UK domestic monetary situation. He noted that for the emerging economies - but especially those in Asia and Latin America - their last real financial crisis had been in 2002. After a turbulent period from around 1994, when some Chinese banks had suffered an insolvency crisis, through the Asian financial crisis that started in Thailand in 1997 and continued for the rest of the 1990s there had been frequent crises in emerging economies. However, these nations had enjoyed a relatively high degree of stability during the past decade. This stability had been characterised both by current account surpluses and by a non-participation in the credit and housing bubble that had afflicted many Western economies. Household and corporate balance sheets were in good shape in much of Asia and Latin America. This meant that monetary and fiscal policy tended to gain traction quite quickly.

He contrasted this situation with that of the developed economies where the malign legacy of the credit and housing bubbles were still very much with us and where many countries still suffered current account deficits and households and financial institutions remained over-indebted and needful of balance sheet repair. In this context, monetary and fiscal policies were finding it difficult to gain traction, at least, policy in the conventional sense. John Greenwood continued this characterisation by observing that interest rates had been rising in emerging economies recently. Private sector credit demand had been relatively rapid and reflected in strong money supply growth. Furthermore, GDP growth was quite robust in many emerging economies and inflation had become more embedded. This meant that investors were looking for inflation protection. By contrast, in developed economies, interest rates remained exceedingly low. Nevertheless, the private sector demand for credit was still historically weak, giving rise to slow money and credit growth. GDP was only making an erratic recovery. In his opinion, inflation problems were transient and investors were focused on a search for yield.

John Greenwood illustrated the points he was making about the indebtedness of the developed economies by showing a series of slides on the US. His observation was that deleveraging in the US had made its biggest impact in the financial sector, while the government sector had been taking on more leverage in relation to national GDP at the same time. However, the US had perhaps been the most successful of the developed countries in reversing its excessive debt.

In fact, the most recent US data showed a recovery in corporate and household credit market debt. The growth rate for the US non-financial corporate sector had risen above 6% in early 2012, while the household sector had improved but was still in mildly negative growth territory. The overall result had been a growth of about 2% in US net private sector credit demand. John Greenwood noted that government borrowing was still playing an important role in replacing the sudden decline in private sector borrowing. He linked that particularly with the shrinkage of the ‘shadow’ banks. These he defined as broker dealers, financial companies, issuers of asset backed securities, funding corporations such as Structured Investment Vehicles and conduits and money market funds. The shadow banks had declined in asset size by around $4.8 trillion since their peak in 2008. John Greenwood stated that a flight to quality from non-banks to banks was an important phenomenon in America. He then drew attention to the fact that the M2 measure of US broad money supply had risen above the value of bank credit reflecting a desire for the liabilities of the banking system as opposed to the liabilities of the shadow banks. He also reflected on the recovery of US bank lending, which was now growing at about 5% per annum. In addition, he drew attention to two important distortions to the data that have arisen in the last three years. As a consequence of the flight to quality, the growth in US M2 broad money had been running at around 10% since August 2011. The shadow banks had stopped falling as violently as before but were still contracting at approximately 6% per annum. John Greenwood’s conclusion was that growth of the borrowing aggregate remained insipid once the shadow banks were combined with the institutions in M2. Turning to US economic growth, John pointed out that there had been an upward revision to the consensus forecast for US real GDP growth in 2012 in recent months from a low of 1.9% to 2.3% currently.

Moving on to the Eurozone, John Greenwood remarked how there was a deceleration in bank lending in the most recent months, particularly the closing months of 2011, and hardly any annual growth at all. M3 money supply continued to grow a bit faster at just over 2%. Breaking this down, John Greenwood considered that the money supply in the core Eurozone economies was generally growing somewhere between 2% and 6% currently. This contrasted with the situation in the peripheral economies, where with the exception of Ireland (which was enjoying double-digit money supply growth), Italy, Spain, Greece and Portugal were demonstrating particularly negative monetary trends towards the end of last year. In Greece, M3 was contracting at more than a 15% annual rate. John Greenwood reminded the shadow committee of the structural causes of the Eurozone crisis, namely the divergence of unit labour costs in the peripheral countries from those in the core. He pointed out that, despite the abatement in unit labour costs in Ireland and Spain (but not yet Italy), this had gone a very small way to closing the cumulative gap that has opened up with respect to Germany. He turned to the current-account imbalances within the Eurozone where Germany had recorded consistent current-account surpluses since 2005 whereas the peripheral countries of Italy, Spain, Portugal and Ireland had recorded collective deficits. Whereas these current account imbalances had been financed voluntarily through private flows until 2008, the financing had been from official flows directed from the core of the Eurozone since 2009 or 2010. Growth forecasts for the Eurozone in 2012 had been revised down heavily. In the spring of last year, the consensus expectation was for a 1.6% growth rate this year. This figure has declined to around minus 0.4% for 2012. Growth expectations for 2013 are also subdued at less than 1%.

Turning to China, John Greenwood noted that the country had avoided the credit bubble that had spread through the American financial system during the 2000s before the 2008 financial crash. However, China had been making its own response to the global credit crisis and had suffered a dramatic expansion in credit and broad money growth from late 2008 onwards. John Greenwood questioned whether there were serious bubble risks elsewhere in Asia. He pointed to money and credit growth in a variety of countries including Korea, Taiwan, Hong Kong, Singapore, Malaysia, and Thailand. He noted that these growth rates were comfortably in the 10% to 15% annual range. He was more concerned about bubble risk in Latin America where monetary growth had accelerated and a composite M3 calculation for Brazil, Mexico and Chile currently reported 18% annual growth.

UK monetary background

John Greenwood next discussed the UK monetary background. He characterised it as follows. There was still only a weak private sector demand for credit, which he attributed to the urgency of deleveraging, and noted also that household incomes had been eroded by more rapid inflation than in the past. M4 broad money excluding intermediate other financial corporations – hereafter, M4ex – was still demonstrating only very weak growth in the low single digits per annum. Banks net lending to businesses continued to contract although there had been some small improvement in lending to small firms. On the whole, mortgage lending was still subdued. He viewed the coalition government's fiscal cutbacks so far as modest. Nevertheless, the promise of spending cuts had still helped sterling to revive from around US$1.43 to the low US$1.60s and gilt yields had dropped from 3.8% to 2.1% in the case of a ten-year benchmark bond. The level of GDP remained over 4% below its peak value prior to the crisis and he expected only a negligible improvement for 2012 Q1 with little sign of the officially-desired rebalancing to exports or investment at this stage. Inflation had been 3.5% on the CPI measure in March but he thought that it was likely to fall back towards 2% to 2.5% by the end of 2012. He also mentioned the end of the stamp duty holiday for properties sold for less than £250,000. Some of the recent growth in mortgages and approvals may not be continued now that the deadline for this stamp duty holiday had passed at the end of March. He found it difficult to envisage a corporate-spending led recovery and suggested that household sector would have to recover before the corporate sector felt confident enough to expand its own spending. The UK's debt ratios had shown modest decreases for households and for non-financial companies. However, and as with the US, there has been a compensating rise in the government debt ratio which stood at 64.3% of GDP on the measure that excluded financial sector support. M4ex showed around 2% annual growth but headline M4 and M4 lending were both languishing at around minus 3% annual rates.

John Greenwood then showed the SMPC some other charts, which illustrated the weakness of bank lending to the private sector and the progressive decline in the value of unused sterling credit facilities of UK monetary and financial institutions over the past four years. Turning to the Bank of England’s Quantitative Easing (QE) policies, he noted that QE, at currently £325 billion, had not yet had a great impact on the broad monetary statistics and he expected the stock of QE to be extended beyond its current level. In the property market, he drew attention to the flatness of domestic house prices over the past year. The headwinds for personal consumption growth included weak employment and income growth. Thus, the rate of Labour Force Survey (LFS) unemployment was currently 8.4% and the claimant count measure of joblessness approximately 5%. Expressing household employee earnings growth in real terms resulted in the calculation of minus 2.9% in the year to January continuing the trend in the last couple of years of weakening real earnings growth. Retail sales volumes had been erratic but mildly positive. The survey measure produced by the Confederation of British Industry (CBI) had often been a bit brighter than the official retail sales figures. Even so, the CBI results had been hovering around the zero line indicating little or no positive momentum behind sales volume.

Manufacturing production lagged CBI's expectations and we had to wait to see how that would be resolved, in John Greenwood’s view. The order balance on the CBI measure was better than the capital expenditure measure thanks to stronger overseas orders and weaker housing. UK GDP remained almost 4% below its pre-crisis peak, with investment and consumption being laggards. There had been early signs of spending restraint by the government. Nevertheless, the task of eliminating the budget imbalance was daunting. John Greenwood had used the UK breakeven inflation expectations data to derive a measure of financial market inflation expectations. He deduced that these expectations remained subdued. John Greenwood was looking for CPI inflation to fall from its current 3.5% due to an easing in commodity prices and for this fall in inflation to revive real spending power in the economy. He expected another year of minimal growth until there was a stronger environment for consumer spending. The Chairman expressed his gratitude to John for leading the meeting through this detailed analysis. He then threw the meeting open to discussion.

Discussion

Patrick Minford opened the debate by saying that he believed QE represented an enormous hostage to fortune and that he was concerned about the potential for highly inflationary scenarios to develop. It was his opinion that we were employing regulatory overkill and were removing the incentives for banks to lend and take on more risk. The regulatory requirement to hold more capital had raised the wholesale cost of funding and was acting as a gratuitous break on economic recovery. He was worried by the negative effect on the supply side of the economy arising from a still bloated public sector and regulatory impediments to the financing of businesses. Patrick Minford expected slow production growth and indeed stalled global economic growth because of these policy errors. Furthermore, he believed that UK bank-regulatory policy had been pro-cyclical exaggerating the positive phase of the cycle and aggravating the negative phase. QE had produced little beneficial effect on credit growth and had mainly served to offset the negative consequence of the overregulation that has taken place. This was a blatant case of policy inconsistency.

Roger Bootle found it difficult to understand the strength of Patrick’s feelings about QE and believed that QE was working, albeit to a limited extent. He also believed that there had been portfolio effects arising from QE that had benefited the corporate sector. If QE had not been undertaken, sterling might well have appreciated in a way that would have further damaged UK recovery potential. In consequence, Roger Bootle supported the continuation of QE.

David B. Smith then drew the meeting’s attention to the fact that the Office for National Statistics (ONS) had indicated that it will be rebasing the national accounts to 2009 prices in late June, which was only six months after the ONS had belatedly published back runs for the current 2008 price data just before Christmas 2011. This rebasing of the accounts would again destroy the continuity of data and cause a serious problem for macroeconomic modellers and forecasters in both the private and government sectors. He thought that the GDP data were now so unstable and ineptly put together that he had lost all faith in the official figures. He also noted that the responsibility for official house price statistics had been transferred from the Department of Communities and Local Government (DCLG) to the ONS.

David B Smith then commented that the effective marginal rate at which commercial banks could borrow in the money markets was now somewhere around 3¾% so the gap over bank rate was probably some 3% to 3¾% rather than the ¼% to ¾% or so that would once have been considered normal. He then returned to a question that the SMPC has frequently considered in the past, without reaching an agreed conclusion. That is, if the Bank Rate were to be raised, would the gap fall to a more normal level so that it would be possible to raise Bank Rate without substantially altering the cost of corporate and mortgage borrowing? The Treasury had suggested not; its view was that any rise in Bank Rate would be passed through the interest rate structure to increase the interest rates paid by borrowers.

Roger Bootle replied that Bank Rate remained important in certain specific contexts. In particular, it represented the interest rate that banks received on their deposits at the Bank of England and it was embedded in many private sector contracts including mortgages. The repo rate at the Bank of England was also tied to Bank Rate. Andrew Lilico pointed out that the present very low Bank Rate only impacted on a shrinking proportion of commercial bank balance sheets as banks were now being forced to fund themselves from the retail sector. Furthermore, the relationship with gilt rates was not clear-cut; the abnormally low Bank Rate had had the additional consequence of undermining the medium term growth of the economy by reducing the risk-free rate. This had the effect of lowering the cost of capital but also the real growth of the economy.

David B. Smith then spoke about the impact of the large budget deficit on private investment. He believed that private investment was being crowded out by this large deficit because of the uncertainty it induced over future business taxation. Certainly, statistical models of private investment found that large budget deficits had a powerful independent negative effect on private fixed capital formation, after allowing for other obvious influences such as the level of activity, real short-term interest rates and taxes. There was a perception that the government was less than fully supportive of the business sector creating a political risk. In an environment where world trade growth was decelerating - and with it the demand for UK exports - this gratuitous political risk was yet another impediment to the recovery of UK business spending. He argued for tax and regulatory uncertainty to be ended – and for senior politicians to cease their mob-pleasing anti-business rhetoric – to pave the way for a better supply-side environment.

Andrew Lilico next raised the question of the sustainable growth rate of the UK economy; he suggested that the two main functions of monetary policy had been to maintain an appropriate rate of growth of money in the economy consistent with low and stable inflation and also to smooth out temporary shocks in the economy. He found it hard to justify the continued emergency low interest rates on the basis that the Office for Budget Responsibility (OBR) was forecasting 0.8% GDP growth this year. He believed that this was close to the current sustainable growth rate of around 1%. He questioned whether there was a crisis of demand growth as distinct from a poor supply performance and suggested that it was now time for interest rates to be moved back towards a more normal level.

Andrew Lilico then expressed his disagreement with John Greenwood’s pessimistic outlook for corporate sector spending; John had interpreted the building up of large corporate cash balances as an anomaly and supposed that there was a backlog of investment opportunities that had not been undertaken, implying that capital formation would catch up on these delayed investments. John Greenwood replied that the recovery of balance-sheet health was a more urgent priority than capital spending when balance sheets had been disturbed. This meant that he believed that corporate sector balance sheets would de-lever in preference to a new investment cycle.

Ruth Lea took issue with the longer term potential growth projections of OBR, that although the short-term growth profile was weak the OBR expected growth to reach its potential 2.5% annual growth within a few years. She believed this was not achievable. If that was the case, then the fiscal targets set out in the budget report were also unattainable.

David B. Smith bemoaned the lack of proper supply-side modelling on the part of the OBR and the Bank of England. He noted that the OBR had inherited its forecasting approach from the Treasury and now badly needed to completely rebuild the grossly inadequate forecasting methodology that it had been bequeathed. A model such as the OBR/HMT one, which set both the growth rate and inflation exogenously by assumption, would have been laughed at as hopelessly inadequate and cut off without a penny if it had applied for Economic and Social Research Council funding thirty-five years ago.

Peter Warburton raised the issue of the contrast that John Greenwood had made between the embedded inflation in emerging economies and what he viewed as an only transient inflation in developed economies. Peter Warburton expressed a contrary view that there was a powerful international inflation transmission running essentially from the producer economies in the emerging world to the consumer economies in the developed world and that this international transmission of inflation would compromise the inflation objectives of developed country central banks. The Chairman then stated that it had been a fascinating and wide-ranging discussion. However, time had run out and it was now time to take the votes of the nine members present. These are arranged in alphabetical order, in line with the normal SMPC practice.

Comment by Roger Bootle
(Capital Economics)
Vote: Hold Bank Rate.
Bias: To increase QE as necessary.

Roger Bootle was asked to give his vote for the meeting. Roger spoke about the political context of monetary management. He believed that it would be relatively straightforward to soak up the additional liquidity that the central bank has popped into the economy from a technical perspective. However, he feared that politicians might actually want inflation and that the outcome was not necessarily dependent on the monetary system in isolation.

He viewed the inflationary squeeze on real incomes in the UK as possibly being what politicians had desired to happen. However, he thought that inflation would fall more consistently and further this year allowing real incomes to grow again and consumer spending to recover in 2013. He foresaw a modest sign of that revival but there was still plenty of spare capacity in his view. Average earnings growth was not picking up and commodity prices could go badly wrong - i.e. weaken significantly - so he saw a potential for the inflation rate in the UK CPI to keep on falling. His vote was to keep Bank Rate unchanged with a bias to do more QE if the economy weakened. Roger Bootle wanted no further QE at the May meeting but favoured the expression of a willingness to do more if the demand side of the economy continued to be weak.

Comment by Anthony J Evans
(ESCAP Europe)
Vote: Raise Bank Rate by ¼%.
Bias: Hold QE.

Anthony J. Evans spoke of the problem of the counterfactual to QE, that it was difficult to demonstrate that an economy would not have been much weaker in the absence of QE. However, he believed that QE was subject to a diminishing effectiveness and he was sceptical of its further use. He regarded the supply-side issues as still needing to be resolved and that the conditions for increasing interest rates were present on the basis that the Eurozone crisis had receded temporarily. He asked the questions, what would be the trigger for a bank rate increase? Would it be to wait until inflation expectations had reached 5%? Was it not until GDP had registered moderate growth? He suggested that we were not far away from the threshold whatever that was and that interest-rate inertia was a risk. The public was getting used to low interest rates and to the additional spending power released by the low mortgage rates that accompanied this interest rate structure. He believed that about 40% of mortgage borrowers were on the standard variable rate. His vote was to raise Bank Rate by 25 basis points and he was of the view that it was worth the experiment regarding the impact on the household and corporate sectors. He thought there was a good possibility that bank margins would shrink in such a way as to not be damaged, i.e., for this rate not to be necessarily passed on in full to the private sector. His vote was to hold QE with no bias now to increase.

Comment by John Greenwood
(Invesco Asset Management)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; no more QE immediately.

John Greenwood believed that both the real economy and the financial sector performance remained fragile and he believed that there was no persuasive reason to raise interest rates at this time. He drew attention to the premature tightening in Japan in 2000 and the dangers of activating another negative episode of growth from premature tightening. His vote was to keep Bank Rate at its current level. He was concerned about the inadequate pace of domestic monetary growth and would like to see monetary growth back towards a 6% to 8% growth pace. He believed that, whilst he would not vote for more QE at the moment, more QE should be undertaken if the M4ex growth rates remained less than 3%.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; no more QE immediately.

Ruth Lea was not terribly concerned about inflation and relaxed about the inflation risk associated with the Bank of England's balance sheet. She bemoaned the burden of Financial Services Authority (FSA) regulation and capital requirements, believing these to be a detriment to private sector bank lending and economic vitality. Her vote was for no increase in Bank Rate and for QE to be on hold with a bias to do more conditional on economic weakness.

Comment by Andrew Lilico
(Europe Economics)
Vote: Raise Bank Rate by ½%.
Bias: No more QE.

Andrew Lilico argued that it was time for the Bank of England to lead interest rates back towards the natural rate and that there was a justification for this move from the persistence of inflation. Furthermore, there was no justification for leaving rates of this low level on the basis of temporary factors. He stressed the dangers of consumers assuming that emergency rate will be permanent and that this was the time when Bank Rate should be raised. His vote was to raise Bank Rate by 50 basis points straight away. He would retain the existing stock of QE, but with no further increase. Andrew Lilico agreed with Patrick Minford that there was indeed a latent medium-term inflationary danger associated with the QE that had already been done.

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

Patrick Minford stated that he was concerned about the nightmare scenario where suddenly bank credit could explode and the Bank of England would find it very hard to reverse engines so his vote would to begin the normalisation of interest rates straightaway with a token increase of ¼% at the May meeting and that QE must end. Indeed, he looked for QE to be withdrawn at the rate of approximately £50 billion a quarter to remove the incendiary material that might otherwise lead us into an inflationary scenario from which policymakers would find it difficult to exit.

Comment by David B Smith
(University of Derby and Beacon Economic Forecasting)
Vote: Hold Bank Rate.
Bias: To raise Bank Rate; no additional QE for time being.

David B. Smith said he was surprised that no-one had mentioned the recent strength of sterling, even if this was partly provoked by developments on the Continent of Europe. He believed that Britain behaved like a small, open trade-dependent economy and that changes in the external value of the currency were the main transmission mechanism through which monetary policy affected the economy. He certainly would not resist a further moderate rise in the external value of the pound, whose earlier depreciation was a leading cause of the inflation overshoot that had reduced living standards, damaged the economy, and undermined the Bank’s credibility. A major forecasting uncertainty was how much global spare capacity there really was – in other words, how much of the contraction in global activity since 2008 was permanent and how much was transitory. It was global – as distinct from domestic – spare capacity that was the most relevant consideration for projecting British inflation, because global inflationary trends had a powerful and rapid impact on the UK rate of price increase. The recovery in the UK was not solely dependent on personal and government consumption, as some people had argued. Private investment and stock building would both respond positively to any globally-generated upswing in UK non-oil exports. There was scope to raise Bank Rate for ‘normalisation’ and signalling purposes but he was a tactical hold this month. This was because of the strength of sterling and the scope for political upsets in the forthcoming French and Greek elections on 6th May, the outcomes of which might really put the cat amongst the Eurozone pigeons. He would hold off any further QE unless the increase in M4ex turned negative again.

Comment by Peter Warburton
(Economic Perspectives Ltd)
Vote: Raise Bank Rate by ¼%; refocus QE on less liquid assets within existing £325bn limit.
Bias: To raise Bank Rate.

While the UK economy continued to make weak and faltering progress, the presumption that Bank Rate should be held down at the current levels was erroneous, in Peter Warburton’s view. The pressures on market interest rates had grown in recent months, reflected in much better offerings to savers during the ISA season and higher standard variable rates by some mortgage providers. It was an open question whether small increases in Bank Rate would trigger a general increase in borrowing costs for the private sector, or whether Bank Rate spreads would absorb the increase. Peter Warburton tended towards the latter opinion. It was time to begin to withdraw the borrowers’ subsidy in favour of savers; to take steps to reactivate the interbank market and to signal the end of emergency low interest rates.

An important paper by Manmohan Singh and Peter Stella for the International Monetary Fund (IMF), entitled “Money and Collateral” had explained the limitations of a QE policy based solely on the purchase of government debt, which was prime collateral. “To the extent that the central bank merely substitutes central bank money for assets that have retained their value as collateral, not much liquidity relief is attained. In order to provide effective liquidity relief for the system, central bank money and liquid collateral must be injected against illiquid or undesired assets; the supply of unencumbered collateral has to increase.” Basically, the Bank of England’s QE had not loosened the collateral constraints on the commercial banks and hence had not motivated them to expand their private sector lending. Given the many regulatory constraints facing banks, it would require the Bank of England to take more liquidity risk in order to reactivate bank credit and broad money growth. The Bank could increase the effectiveness of its QE policy at the current size by switching its purchases to other, less liquid instruments such as mortgage-backed securities.

Peter Warburton’s vote was to raise Bank Rate at the May meeting by ¼% with a view to further increases as we gained a better understanding of the current relationship between Bank Rate and the prevailing structure of market interest rates. In addition, the Bank should announce a programme of discounted asset purchases of less liquid assets, financed by sales of gilts.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate and do more QE if money growth slows.

Trevor Williams believed that the demand situation was such that the economy simply was not strong enough to withstand a rise in the official rate. He believed that consumer confidence and business confidence were still too weak to withstand a rate increase. This meant that his vote was to keep Bank Rate on hold at ½%. He reiterated his concern about the impact of regulatory policy on credit supply but also believed that the underlying demand for bank credit remained weak. He considered that the sustained low level of gilt yields suggested that the market had brought into the coalition's fiscal plans. He was concerned about the international effects on inflation and believed that the UK has become a price taker of global inflation. He would hold QE and if the growth of the money supply were to fall back then he would be willing to do more QE.
Policy response

1. Five SMPC members voted that Bank Rate should be held on 10th May; three wanted to raise it by ¼%, and one member desired a ½% increase.

2. Most of the shadow committee members thought that there should be no additional QE in the very short term, although there was a divergence of view with respect to the appropriate policy subsequently. Some members believed that further tranches would be required because of the weakness of the economy; others wanted to hold the existing stock, and one member thought that QE should be gradually unwound to avoid longer-term inflation risks.

3. There was a widespread view on the SMPC that the British economy was suffering major supply side difficulties in addition to any possible demand shortfall and that clumsily excessive financial regulation posed a major threat to the real economy, as well as the supplies of money and credit.

4. There was also a strong view that the official ONS data was no longer fit for purpose where the national accounts were concerned, and a further concern that the forecasting frameworks employed by the OBR and the Bank of England were inadequate and likely to produce misleading policy advice.

Date of next meeting

Tuesday, 10th July 2012.

Note to Editors

What is the SMPC?

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

Current SMPC membership

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

In its most recent monthly e-mail poll, completed on 28th February, the Shadow Monetary Policy Committee (SMPC) decided by eight votes to one that UK Bank Rate should be held at ½% when the official rate setters meet on Thursday 8th March. The sole dissenter on the shadow committee wanted to raise Bank Rate by ¼%.

This was mainly to provide a clear signal about the future anti-inflationary resolve of the monetary authority. The predominant reason why most SMPC members voted to hold the official interest rate in March was their continuing concern about the uncertainties arising from the situation in the euro-zone together with the view that there remained ample spare resources in the British economy, despite some tentative and welcome signs that the first green shoots of recovery were starting to emerge.

Two things that the SMPC agreed on were that a Greek default was largely discounted in the financial markets and that there was a serious inconsistency in British monetary policy between hard-line financial regulation and the need to shore up the supplies of money and credit to sustain activity and the tax base.

The SMPC does not normally discuss fiscal issues, unless they have monetary consequences. However, the general view was that the November 2011 projections for public borrowing in 2011-12 would be achieved, but that there would still only be cosmetic tax cuts in the 21st March Budget. This was despite the view of some SMPC members that many specific taxes were on the wrong side of their ‘micro-Laffer’ curves, so that well-designed tax cuts would reduce public borrowing if Mr. Osborne were bold enough to try them.

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

Recent economic indicators on both sides of the Atlantic have shown some welcome signs of life. Nevertheless, the economy remains in a dire state. It is important not to bank on signs of recovery which may easily prove to be misleading. The euro-zone crisis may yet deal a devastating blow to confidence and the state of the banking system. Meanwhile, the size of the drop in output registered over the last few years is such that even a vigorous recovery could take place for a couple of years without stoking unacceptable inflationary pressure.

Inflation should continue to fall throughout this year, with the headline rate falling below the 2% target by the autumn, and continuing to fall thereafter. With unemployment set to rise, there is no foreseeable reason for pay inflation to pick up. It may even fall. Unless commodity prices undergo another sharp spike – which is possible, although I am not expecting it – then come next year inflation could be below 1%, with deflation a realistic fear.

In these circumstances, the Monetary Policy Committee (MPC) should keep Bank Rate at the current level, or even lower it a bit, in line with what the US Fed has done – and keep up its programme of bond purchases. Once it has completed its current programme of £50bn of quantitative easing (QE), it should embark on another £50bn and another after that. If the economy still looks weak thereafter, then the Bank should continue repeating the dose.

Comment by Tim Congdon
(International Monetary Research)
Vote: Hold Bank Rate.
Bias: To hold for the time being.

The cause of the Great Recession was official pressure on the banks – particularly in the UK, but across the industrial world – to ‘deleverage’ and shrink the risk assets on their balance sheets, and to hold more capital relative to such assets. This pressure was most forceful in late 2008 and early 2009, following the closure of the international inter-bank market in mid-2007. Because inter-bank lines were no longer available to the same extent, many banks then had difficulty in funding their assets and persuading financial markets that they remained solvent. The result of bank deleveraging was a dramatic fall in the rate of growth of the quantity of money, broadly-defined, which was common to all the main monetary jurisdictions of today (i.e., the USA, the euro-zone, Japan and the UK). Despite slashing the short-term money markets rates to zero, central banks could not offset the deflationary forces set in train by the regulatory changes which they had created to a significant extent.

The slump in money growth had the predictable effect of motivating falls in asset prices, demand, output and employment. One says ‘predictable’, as some economists have insisted on the validity of the monetary theory of national income determination even in the last few years, when that theory has been unfashionable. Nevertheless, very few economists – if any – actually predicted the catastrophic slide in economic activity in early 2009, because no sensible observer could reasonably have anticipated the idiocy of official actions in late 2008. The major central banks gave every sign of not having any understanding whatsoever of the debacle for which they were largely responsible.

A variety of mistaken theories – that national income is a function of bank lending (the credit channel version of ‘creditism’) or the monetary base (‘base-ism’, New Classical Economics) or the budget deficit (Keynesianism) or ‘financial frictions’ (the asymmetric information version of ‘creditism’) – were propounded by academic economists and received attention, far too much attention, in central bank research departments. The correct theory, that national income and wealth in nominal terms are a function of the quantity of money (i.e., of the quantity of bank deposits, more or less), had been developed decades earlier by such figures as Wicksell, Irving Fisher, Keynes and Friedman. The correct theory was staring the economics profession in the face in the Great Recession, just as it was staring it in the face in the Great Depression eighty years earlier. Nevertheless, most economists did not recognise it.

The point of this harangue is that – at least in the UK – the official attack on the banks is still not over. Royal Bank of Scotland (RBS) group is widely reported as being expected to shed about £120bn of non-core assets, in order to comply with the Vickers Report. Now, £120bn is equal to roughly 8% of the M4ex quantity of money. If RBS complies with the Vickers’ demand by selling the assets to non-banks, the non-banks will pay the banks by reducing their bank deposits. In other words, M4ex will fall by 8% because of transactions being conducted by only one bank. In practice, RBS will no doubt sell the assets partly to other banks (when M4ex would be unaffected) and partly to foreign buyers (when the monetary effects are complex), and the sales will be phased over time. Nevertheless, it beggars belief that officialdom appears to be indifferent to – and indeed even ignorant of – the monetary results of its regulatory decisions.

This analysis is important in appreciating the disappointing response of UK money, broadly-defined, to the latest round of QE. This round was of £75bn, about 5% of M4ex, and compressed into a mere three-month period (i.e., the three months from early October, more or less) and ought to have meant an extremely fast money growth rate in that period. In fact, M4ex fell slightly in the last three months of 2011. The discrepancy can surely be explained, mostly, by UK banks’ continuing measures to comply with official demands that they reduce their risk assets.

All is not gloom and doom. First, in the USA banks seem now to have gone a long way to meet the new regulatory standards. In general, banks are maintaining capital/asset ratios about 50% higher than was normal during the years of the ‘Great Moderation’ (i.e., the period of over twenty years from 1984 in which macro outcomes were much more stable than before). The American banking system appears to be expanding again, leading to low but positive rates of money growth. Secondly, in the euro-zone the European Central Bank (ECB) has embarked on extraordinary measures (i.e., the ‘long-term refinancing operation’, with three-year facilities at 1%) to ensure that banks can fund their assets and so to prevent the monetary contraction that might otherwise ensue.

It remains my view that the central objective of monetary management should be to ensure steady growth – at a low, non-inflationary, rate – in the quantity of money (i.e., to repeat, of bank deposits). One cannot judge the exact severity of the balance-sheet shrinkage facing UK banks post-Vickers but it is reasonable to assume some further shrinkage is needed to comply with the Vickers’ prescription. For the time being, a ½% Bank Rate should continue to be favoured together with receptiveness to yet another round of money creation by the state. It would be preferable if this money creation occurred through the government/Debt Management Office concentrating its financing of the budget deficit at the short end from the banks, rather than by the complex and awkward operation of QE, but let this pass. If officialdom does not see the rationale of stable money growth, it is unlikely to understand the technicalities of operations which would facilitate that goal.

Overall, this year should see a relatively benign global outlook, with the USA leading the upturn phase of the business cycle. The euro-zone is a mess. Nevertheless, the main message from the first few months of the Draghi presidency of the ECB argues that any deterioration in macroeconomic conditions is likely to be met by large and aggressive monetary stimulus.

Comment by Jamie Dannhauser
(Lombard Street Research)
Vote: Hold Bank Rate and QE.
Bias: To expand QE if euro deteriorates once again.

The UK economy has a difficult future ahead of it. Although the most immediate downside risks have diminished, the British economy is not yet out of the woods. Recent evidence does not suggest the economy is in recession, but it could still be some time before the recovery regains the kind of momentum that would be desirable given the scale of the 2008/09 downturn. In addition, there is still a risk that the euro crisis may worsen, causing the British economy real difficulty.

The recent increase in planned Bank of England gilt purchases – by another £50bn – may not have been justified based on the most likely path for CPI inflation; but it seems a perfectly reasonable pre-emptive step given the balance of risks to UK inflation and the wider threats to the stability of the UK’s financial system. Looking ahead, additional QE may well be needed, most obviously if the euro-zone situation deteriorates once again, but also if emerging world growth is more sluggish than currently expected. The outlook is also clouded by the possibility of increasing tensions, if not outright war, in the Middle East and the upward pressure this would place on oil prices.

Despite the usual media hysteria, there has been little evidence over the last few months that the UK was going back into recession. The 0.2% contraction reported by the Office for National Statistics (ONS) in 2011 Q4 is not supported by recent survey evidence. The monthly Purchasing Managers Index (PMI) reports, for instance, did point to a marked slowdown in growth at the end of last year, but did not suggest that private sector activity was falling. The average composite PMI of 51.9 in the fourth quarter has been consistent with private output growth of 0.2%, historically. In fact, over the last couple of months there has been a marked rebound in the PMI indices. The January reports for manufacturing, private services and construction suggest new business grew at its historical average. Giving support to the latest survey evidence, retail spending and car sales were surprisingly robust at the start of this year.

However, there is a danger in setting monetary policy on the basis of the recent data flow. Looking through the short-term volatility in measures of output and demand, it is clear that the economy remains under the weather. Nominal private sector domestic demand has grown by only 1.6% over the last year. Even if one looks at private final demand (i.e. including net trade), nominal spending growth has only been 2.9%.

It is also evident that underlying inflationary pressures remain limited. In the last two years, CPI inflation has run on average at 4%. However, if one looks at the gross value added deflator – a measure of whole-economy inflation excluding the effects of indirect taxes – inflation has been running at 1.9% over the same period. For the private sector only, the figure is a mere 0.3%. These last two data points would chime with evidence from the labour market that domestically-generated inflation is still very low, consistent with a large amount of spare capacity in the economy.

A considerable shortfall in nominal spending and widespread slack, especially in the labour market, would seem to justify a very easy monetary stance. The question is how easy it should be. There are upside risks to CPI inflation, e.g., from oil prices, a faster-than-expected recovery in emerging world growth or ongoing effective supply constraints because of the dysfunctional banking system; but these are offset, possibly more than offset, by factors that could bear down on inflation over the medium term. Although the large fall in the real exchange rate has started the process of demand rebalancing in the UK, it is threatened by the ongoing euro crisis. The ability of Britain to export its way out of its debt overhang is hampered by the ever-worsening growth outlook on the continent. Domestic spending, particularly business investment, may recover less quickly than hoped because of further disruption to the banking sector. In connection with this, broad money and credit growth remain extremely limited – neither have returned to levels consistent with the kind of above-trend nominal demand growth one would like to see.

Broadly speaking, the balance of policy in the UK is correct, even if one can criticise the government for putting too little emphasis on the supply-side, particularly tax reform. The overhang of private and public debt means low interest rates are necessary for forestalling wider financial instability. UK banks’ balance sheets are still stuffed full of assets that would sour quickly in the event of rapidly rising market interest rates. Low policy interest rates and a tight fiscal stance are both desirable at this stage. To encourage the shift in demand towards net trade, a cheap currency (in real terms) is also critical. The monetary policy stance does not need to be altered this month; but the balance of risks to growth and inflation suggests more QE may become necessary later in the year. In the event of a Greek exit from European Monetary Union (EMU), or the failure of a large European financial institution, the Bank and/or government must stand ready to expand the QE programme dramatically, including purchasing debt from UK banks.

Comment by Ruth Lea
(Arbuthnot Banking Group)
Vote: Hold Bank Rate.
Bias: To hold Bank Rate; no more QE immediately; no bias regarding future QE.

GDP slipped by 0.2% in the final quarter of 2011, according to the ONS. Even though household consumption chalked up its first quarterly rise in the year and General Government consumption rose by 1%, contrary to the centre-left’s rhetoric of ‘deep spending cuts’, the increase in inventories was well down on the third quarter’s increase and gross fixed capital formation fell by nearly 3%. On a brighter note, there was a healthy contribution to GDP from net exports after two very disappointing quarters, so this aspect of ‘rebalancing of the economy’ could be gaining momentum, despite the continuing travails of the euro-zone.

However, the mood has lightened even in the euro-zone since the closing months of last year, courtesy of ECB President Mario Draghi’s generous liquidity boost last December - and there is more to come. Greece’s second bailout package was eventually agreed, though whether the Greek people are prepared to endure more austerity is questionable. GDP has been falling since 2008 and fell about 7% last year. Unemployment is rising fast and is now over 20%. The latest European Commission forecasts suggest a mild recession for the euro-zone this year, projecting a fall in GDP of 0.3%. However, there is expected to be a glaring dichotomy in performance within this most dysfunctional of currency unions. Germany (0.6%) and France (0.4%) are expected to grow modestly, whilst falls in GDP are projected for Greece (4.4%), Spain (1.0%), Portugal (3.3%) and Italy (1.3%). Incidentally, the Commission expects Britain to grow by 0.6%.

The mood has also lightened in the UK with the latest Markit/CIPS PMI surveys for manufacturing and services picking up significantly. The expected fall in January’s CPI inflation, reflecting the dropping out of last year’s VAT increase from the twelve-monthly comparison, should herald further decreases in inflation throughout the year. CPI inflation should be down to about 2½% in the second half of this year, reducing the squeeze on real incomes and therefore supporting the growth of personal consumption and, hence, GDP. Such projections assume that there will not be another explosion in oil prices reflecting the tension in the Middle East. However, Brent Crude has already reached record levels in sterling terms.

January’s Public Sector Net Borrowing (PSNB) data were better than expected and the PSNB for fiscal year 2011-12 may be £115bn to £120bn compared with the £127bn forecast by the OBR in November 2011. (However, note that the OBR forecast £116bn in June 2010.) Given these numbers, there will probably be some tax cuts in the Budget to be held on 21st March but the Government will almost certainly resist a major fiscal stimulus as proposed by the Opposition. The recent warning from Moody’s, downgrading Britain’s outlook from stable to negative, was timely on this issue. However, the Government seems to be relying on the Bank to provide much of the economic stimulus, given the absence of effective supply-side policies. The MPC has obliged by sanctioning very accommodative monetary policy. It should continue to do so. There is no need for any change in policy at the moment.

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

Superficially, it may seem as if the Bank of England is getting away with its policy of allowing inflation to breach the target so badly for two years in a row. Inflation is falling, so far down to 3.6%. Most forecasts expect it to fall at least close to 2% over the next year or so. So what is not to like? One concern is that the Bank has now undertaken to do £325bn of QE. This means that nearly three years’ budget deficits’ worth of finance will have been provided by printing money. This represents about a third of outstanding public debt. Its objective is to stimulate growth by stimulating credit. However, there is no growth in credit and this may now be a key factor in holding back growth in output, since small business credit is in steep decline, as is Small and Medium Enterprise (SME) credit to a slightly lesser extent. The SME sector, which accounts for around one half of GDP, is the key source of the innovation and competition which spur productivity growth, in turn. Productivity growth has stalled.

The reason for this failure to achieve credit growth lies in the regulative onslaught on the UK banks. This will not achieve its objective of stopping future crises but it is preventing the banking sector from doing its job of lubricating the capitalist engine. The bureaucracy, having failed to prevent the crisis, is now taking its revenge on the supposed authors of the crisis, the banks. Yet they seem, on our analysis of the data through the lens of a model with banking processes in it, to be more the victims of crisis than its authors.

The fact that some banks needed bail-outs reflects on the slackness of regulators in the run-up to the crisis; these regulators failed to apply the ‘speed limits’ suggested in Basel II, speed limits that some foreign regulators (e.g. in Spain and Australia) fortunately did apply. The problem with our UK regulators’ revenge is that it is damaging the UK economy. Together with QE, it is causing a form of ‘financial repression’ under which the nation’s savings are directed at the lowest possible interest cost into the government’s coffers.

Now, consider the dangers the Bank of England is running into. It will meet its inflation targets if growth continues to fail to recover – because monetary stimulus is neutralised by regulative overkill. Thus, it will succeed if it fails. Now, suppose the economy does recover and credit somehow takes off with it. The banks will have a massive amount of liquidity to make loans with – around one fifth of GDP in the form of reserves held at the Bank of England. How quickly will the Bank be able to retake control and liquidate its bond holdings?

Suppose, finally, that the economy does not recover but that there is a renewed spike in oil and commodity prices as world growth picks up in 2012. The private sector, feeling more buoyant, notices and bids up wages, finally to compensate for huge real wage cuts; the inflation target is regarded as lost. Credit demands rise to pay for these target-busting wage demands. How easy will it be for the Bank to cut its bond holdings when so doing will reduce aggregate demand and return the economy to stagnation?

In the early stages of the Weimar Republic, politicians congratulated themselves on their sagacity in printing money to meet their bills. Unfortunately, they lost control of expectations and of prices and of the money printing process in one big descent into chaos. It is now time for the Bank to become more traditionally cautious – about QE and its balance sheet and about the breaching of the inflation target. It is vulnerable to the shocks already described and needs to become less vulnerable. The euro-zone crisis is in remission and can no longer be used as an excuse for a permanent loosening of policy. Clearly, it will stay with us for months, even years, but it is now becoming part of the normal background.

So, my policy conclusion is that interest rates should be raised at the earliest opportunity. The latest indicators are more positive; a signal needs to be given about monetary intentions. Bank Rate should be raised by ¼%; actual rates are in fact above 0.75% already, so little would change in the market. However, the signal would be understood. The extra £50bn of QE should also be abandoned; merely keep it in reserve and announce that every opportunity will now be taken to run down QE. On the macro-prudential side, it is time the Bank takes a stand on behalf of the banks in the regulative mess that is now emerging; it must stop overkill - defer Vickers sine die, stop the bonus populism (explain that banks are the closest we have to John Lewis) and encourage new bank entry and competition.

Finally, what can be done to kick-start lending? We see the Treasury struggling with a scheme of ‘credit easing’, which is already bogged down with problems to do with it being illegal state aid under EU rules. A simpler route would be to levy a tax (in the form of a negative interest rate, payable to Her Majesty’s Revenue and Customs, HMRC) on banks’ income from balances at the Bank and also on bank holdings of government debt. This could be offset by a reduction in the ‘bank levy’ or by a simple lump sum transfer to all banks. The measure would therefore be revenue-neutral for both banks as a whole and HM Treasury.

The consequence, however, would be that – by extra lending to the private sector – each bank individually would seek to avoid the tax by switching its Central Bank balances into lending. Of course, we know that at the aggregate level of all banks there would be no change in bankers’ balances since the extra credit to the private sector must be matched by extra deposits, which in turn will be re-deposited in the banks and thence into bankers’ balances. However, this is not the point; each bank will still wish to switch, making such an expansion of credit take place and with it an expansion in bank deposits. Within the banks, those banks that lend most aggressively could succeed in offloading their bankers’ balances onto other banks, hence obtaining a net reward from their switching at the expense of others that do less. Until banks can be forced into greater competition and the regulations can be eased off, this negative interest rate measure (which has also been used in the context of foreign depositors in Switzerland for example) can be used to encourage banks into lending.

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

The most important UK economic event this month will be the 21st March Budget, given that the scope for further policy initiatives from the Bank of England is probably exhausted – apart from yet more rounds of QE whose effectiveness has probably now hit serious diminishing returns. There is still a tendency to treat fiscal and monetary policy as belonging in separate boxes and to ignore the links between the two. However, fiscal and regulatory policy can make a major difference to the severity of the output/inflation trade-off facing the central bank. Furthermore, monetary attempts at demand stimulus can only operate on the private sector so monetary policy becomes increasingly irrelevant as the socialised sector expands. With roughly half of UK GDP now accounted for by general government expenditure – and some two-thirds in the North Eastern region, just over 70% in Wales and almost three-quarters in Northern Ireland – the reach of monetary policy instruments is now very limited in geographical as well as macroeconomic terms.

The data for the first ten months of fiscal 2011-12 suggest that Public Sector Net Borrowing (PSNB) is likely to come in at around £117bn to £120bn in fiscal year 2011-12. This is a poor figure by historic standards but it is probably good enough to restrain Mr Osborne from raising taxes any further. There may be trivial tax cuts on 21st March but these will almost certainly be politically motivated and cosmetic. There is now a strong probability that the UK is on the wrong side of the aggregate Laffer curve, as well as being on the far side of the numerous micro-Laffer curves that apply to individual taxes. At the micro level, rates are already too high in many cases even to maximise revenue, let alone the performance of the wider economy or social welfare.

One reason for expecting a slightly stronger growth performance from the UK economy from now on is that Mr Osborne is unlikely to do anything as damaging as his earlier decisions to hike VAT and employers’ NICs – presumably in an attempt to build up a war chest to fund pre-election giveaways – which probably cost more than a quarter of a million jobs, reduced national output by some 1¼% and actually made public borrowing worse rather than better according to simulations on the Beacon Economic Forecasting model that were published shortly afterwards (see: Chapter 2 in the 2011 IEA publication Sharper Axes, Lower Taxes: Big Steps to a Smaller State, Edited by Philip Booth, for further details). A ‘do-nothing’ Budget on 21st March would, at least, create no harm and would probably allow the economy to grow by around 1¼% this year rather than the not quite ½% which seems to be the present consensus.

Unfortunately, the ONS national accounts have not yet recovered from the trauma of the botched and belated introduction of the new ESA 2010 methodology last year. In particular, long-back runs of many important series are still not available before the later 1990s making any attempt at ‘scientific’ model-based forecasting virtually impossible. The relative strength of tax receipts so far in 2011-12 may indicate that the private sector is slightly stronger than the fourth quarter national accounts, published on 24th February, suggest. Nevertheless, the only safe conclusion is that any attempt to project the future course of the UK economy is lost in a statistical fog. Incidentally, the latest ONS figures reveal that the volume of general government current expenditure was 0.7% higher in 2011 Q4 than it had been at the time of the election in 2010 Q2, implying that there have been no real ‘cuts’ so far. The value of general government consumption rose by 3.2% over the same period.

The Bank of England has recently released a number of discussion papers attempting to quantify the wider macroeconomic benefits from QE. Having published a quantitative study in the June 2010 IEA Economic Affairs, one can only express some surprise at the power of the effects found by some of the Bank’s economists. However, nobody has denied that there are very large margins of uncertainty attached to all such estimates. A particularly interesting recent Bank of England Working Paper is no 442, The Impact of QE on the UK Economy – Some Supporting Monetarist Arithmetic, by Jonathan Bridges and Ryland Thomas. The paper employed a money demand and supply framework to estimate the impact of QE on asset prices and nominal spending and then tried to establish the impact of QE on M4ex broad money. The central case estimate was that QE had boosted the broad money supply by £122 billion or 8%. The estimated impact of QE on the money supply was then applied to a set of ‘monetarist’ econometric models, which articulated the extent to which asset prices and spending needed to adjust to make the demand for money consistent with the increased broad money supply associated with QE. The Bank authors’ central case estimate was that an 8% increase in money holdings may have pushed down yields by around 150 basis points in 2010 and increased asset values by approximately 20%. This, in turn, would have had a peak impact on output of 2% by the start of 2011, with an impact on inflation of 1 percentage point around a year later.

The interesting and highly important point about this paper is that, because it quantifies the impact of exogenous shocks to M4ex broad money on the wider economy, it can also be used to estimate the impact of regulatory shocks to the money-creation process about which SMPC members have consistently expressed grave concern. As Tim Congdon has pointed out in his contribution to this report, the proposals in the Vickers report imply that the Royal Bank of Scotland group alone might need to contract its balance sheet by the equivalent of 8% of M4ex, which is coincidentally the same figure as appears in the Bridges and Thomas paper. If one then assumes that the RBS group accounts for roughly one quarter of UK deposits, and that other major banks would be affected in a similar manner, then the Bank of England’s study implies that there could be a loss of 8% of real GDP, followed a year or so later by 4% off the price level. The strong conclusion is that worrying about 25 basis points on or off Bank Rate, or the impact of an extra £50bn of QE, is no more than an irrelevant distraction when compared with the massive damage that could be done from misguided financial regulatory interventions.

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

As a preface to this discussion concerning the appropriate stance of UK monetary policy, it may be helpful to repeat the comment made in January: “The disintegration of the euro remains a highly improbable outcome until the mechanisms and protocols for orderly departure from the euro area have been devised and formally approved. Disorderly exit of Greece, or of any other country, would carry grave consequences for French and German banks through their colossal exposures to interest rate swap contracts. It is a reasonable assumption that the euro area nations will not embark on a path of mutually assured destruction.”

Thus far, the assumption holds: the approval of the second rescue package and debt-swap for Greece and the ongoing three-year Long Term Refinancing Operations (LTROs) have reduced significantly the tail risks for European banks and sovereigns. While hardly anything has been resolved in a structural sense, the criticality of the European financial situation has been alleviated. How then, should the Bank of England conduct policy?

It is important to distinguish contingency plans from medium-term objectives. Hopefully, the interim Financial Policy Committee will assume ultimate responsibility for the systemic liquidity, capital and collateral issues that underpin the financial stability of the economy, leaving the MPC free to plot a course for the normalisation of monetary conditions. Central to this normalisation process is the restoration of Bank Rate to the region of 2% to 3%, within the context of a nominal GDP expansion of around 5% to 6% per annum. Pre-commitment to sustaining Bank Rate at a very low level is a misguided policy that is more likely to perpetuate economic stagnation than to relieve it. In particular, the revival of the interbank and securitisation markets, through which monetary policy formerly operated, is vitiated by near-zero interest rates.

Meanwhile, the UK economy has responded well to the ending of the Bank of England’s aggressive credit tightening, implied by the repayment of the Special Liquidity Scheme. The resumption of the asset purchase programme has also eased financial conditions and stimulated UK equity prices. In the real economy, the intensity of households’ real income squeeze has dwindled and this has contributed to an ongoing improvement in the contribution of net exports to UK growth, through the lessening of demand for imports. The New Build Indemnity Scheme, announced last November, is being taken up by UK house-builders and perhaps 25,000 to 30,000 additional homes will be built this year, with 95% loan-to-value mortgage finance guaranteed. Alongside the painful reductions in public sector part-time employment there is a remarkable growth in full-time self-employment and new business formation.

At the core of the resiliency argument for the UK economy is the consistent, if dull, growth performance of the dominant service sectors. Service sector output growth was 1.6% in 2011, as against 1.4% in 2010. While distribution, hotels, restaurants, transport, storage and communication sectors suffered deceleration in 2011, business services, finance, government and other services showed an improvement. Remarkably, the productivity of public sector services increased throughout 2011.

Recent data releases contain some more hopeful readings for the UK economy. The Markit/CIPS survey showed business confidence rising by its highest in the index’s history (on a month to month basis) from 64 to just above 70. The survey also indicated that the business activity index had increased to a ten-month high of 56 compared to 54 in December – the third consecutive rise in the index, boding well for 2012.

Furthermore, a rise in new work had encouraged companies to add to their payroll, resulting in the strongest increase in employment since March 2008. Growth in volumes of retail sales also surprised on the upside between December and January, rising 0.9% in contrast with economist predictions of a 0.3% fall. On a quarterly basis, retail sales also increased by 1.3%, reflecting the strongest growth seen since the summer of 2009.

Sluggish private sector loan demand and poor transmission of negative real interest rates to the real economy remain key impediments to a more vigorous UK recovery. Hence, this is not the moment to raise Bank Rate. However, the reconnection of Bank Rate with the market interest rate structure cannot be postponed indefinitely and a token Bank Rate increase should be pencilled in for later in the year. The Bank’s programme of gilt purchases appears to be suffering from the law of diminishing returns and should not be extended in its current form.

Comment by Mike Wickens
(Cardiff Business School, Cardiff University)
Vote: Hold Bank Rate.
Bias: To raise interest rates.

There appears to be a broad consensus - which now seems to include members of the SMPC - that UK monetary policy should remain very loose with Bank Rate being maintained at ½% for the foreseeable future, and more QE being desirable. The basis of this seems to be that although inflation is still over twice its target level, it is falling, implying that inflation is no longer a threat; output is still flat and so unlikely to cause inflation to increase; and QE is the only monetary tool available to raise output that has proved effective. Such views might provide a good prediction of future MPC decisions, but do they provide a satisfactory basis for monetary policy?

Ultimately, the aim of QE is to stimulate private expenditures, especially investment, the component of demand that has contributed most to the poor output performance in recent years. The Bank does not have an agreed story on how QE works. One view is that it increases the liquid funds available to investors and better enables them to finance expenditures, especially if they are facing credit constraints. Alternatively, investors may use the cash to buy other financial assets such as equity or corporate bonds, thereby reducing borrowing cost for companies. Another explanation is that the cash is used by companies to repurchase their debt and so again reduce their financing costs.

In their most detailed study of QE, the Bank conducted a counterfactual experiment, asking what would have happened if there had been no QE. The study assumed that the first £200bn had reduced the ten-year spread by 100 basis points and then estimated the effects of this on GDP. They came up with a number of estimates ranging from raising GDP growth by 8 percentage points at the top end down to only 2 percentage points, their preferred – and published – estimate. Since the higher estimate used the most sophisticated methodology, its implausibly high value casts doubt on the whole exercise. If we add to this that spreads increased over the period, that lending fell dramatically, that corporate spreads hardly moved and that accumulated new government borrowing has been nearly as large as the level of QE, it is difficult to have much confidence in the effectiveness of QE. More recent QE has been accompanied by very small reductions in yields. However, this has been a period dominated by a marked loosening of ECB monetary policy.

The evidence in support of QE is therefore very weak and, so low are yields already, further QE seems very unlikely to reduce them significantly. The aim of QE is to boost output rather than bring inflation back on target as the Bank’s remit requires. In effect, QE is simply a way of monetising government borrowing which so far has had little influence on banking lending or private sector investment. Its main effect is probably to depreciate sterling which adds to inflation.

Output is flat because expectations are so poor. It is not encouraging that inventories (previously over-estimated demand?) and government expenditures are the only significant contributors to positive demand growth in the latest GDP data for 2011 Q4, and that investment and consumption are flat. Exports and imports have fluctuated over time. As both have either risen or fallen together it seems unlikely that changes in competitiveness are the main driver; fluctuations in world economic activity seem more likely.

Inflation seems to have fallen mainly due to the elimination of VAT effects and a fall in oil prices (which have recently risen again). Neither is the result of monetary policy actions. The MPC may be correct in their forecast that the danger is that inflation may fall below target. Nevertheless, their forecasting record over the past few years has been so poor that it is tempting to conclude on the basis of their persistent forecast errors that inflation will be much higher than these forecasts.

All of this suggests that there is little that UK monetary policy can achieve in the near future. Although interest rates obviously need to increase at some time in order to better reflect the cost of saving, an immediate increase would open the MPC to much criticism. Additional QE would almost certainly be ineffective but, as in the past, would give the appearance that the MPC is doing something rather than nothing. In other words, at present, monetary policy is just a matter of appearance. All the action lies with fiscal policy.

Comment by Trevor Williams
(Lloyds TSB Corporate Markets)
Vote: Hold Bank Rate.
Bias: To hold; keep a further £75bn QE in reserve.

It looks as if the UK economy will avoid a technical recession (two consecutive quarters of negative growth) in 2012 Q1. After a fall in GDP of 0.2% in the final quarter of last year, the signs so far are that it will rebound by about the same magnitude in the first quarter of this year. The latest data showing the breakdown of GDP showed that, in line with the modest recovery in retail sales, consumer spending rose by 0.5% in 2011 Q4. This was the strongest quarterly increase since the second quarter of 2010. The improvement was driven by aggressive discounting and unusually mild weather conditions. Although retail sales in January also posted a sharp increase, it is doubtful whether this pace of improvement can be sustained – given the tightness of credit conditions, the fragility of the labour market and the ongoing contraction of household real incomes. Government spending was also surprisingly firm, rising by 1% on the third quarter. Again, it is questionable how long this can last against the backdrop of increasing government cutbacks, the bulk of which have yet to take place.

More encouragingly, net exports posted a sharp improvement in end quarter of last year, driven higher by a 2.3% rise in exports – its strongest quarterly increase since 2011 Q1. That exports managed to post such a firm bounce-back amid the turmoil in the euro area – the UK’s largest trading region – is clearly encouraging. It provides further, albeit still tentative, support for the view that the UK is undergoing a rebalancing of sorts. Offsetting this, however, business investment fell by 5.6% in the quarter. The decline occurred despite the fact that companies are sitting on record financial surpluses. On the face of it, the continued scaling back in spending on plant and capital equipment does not bode well for future jobs or productivity growth. One should be cautious, however, against reading too much into this. On closer inspection, much of the decline appears to have been driven by the utility sub-sector and therefore may be idiosyncratic rather than cyclical. Manufacturing output has also staged something of a recovery in recent months and looks as if it is returning to growth rates seen in the first half of 2011, before the tsunami, earthquake and nuclear meltdown in Japan. Exports are up and order books look healthy.

However, and before getting carried away, we have to look at the monetary and fiscal background facing the UK economy. Money supply growth is weak and falling, driven by de-leveraging by households and business. Hence, the pressure on balance sheets remains a real issue for the pace of the recovery. Furthermore, growth in our key Continental European export market remains weak. UK economic growth this year will be only just positive, in a likely range of around the ½% to 1% level through this year. Fiscal policy will remain on its tightening path, despite some better than expected numbers in the last two months. With this in mind Bank Rate should be kept on hold and QE maintained at £325billion, with a further £75bn held back to counter the effects of any future downward pressure on the money supply.

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

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

Chairman’s Comment

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

UK Economic Situation

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

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

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

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

World Economy

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

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

Discussion

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

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

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

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

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

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

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

Comment by Roger Bootle

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

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

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

Comment by Jamie Dannhauser

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

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

Comment by Anthony Evans

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

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

Comment by Andrew Lilico

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

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

Comment by Kent Matthews

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

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

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

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

Comment by David B Smith

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

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

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

Comment by Akos Valentinyi

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

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

Comment by Peter Warburton

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

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

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

Comment by Trevor Williams

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

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

Policy response

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

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

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

Date of next meeting Tuesday, 17th April 2012.

What is the SMPC?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

The SMPC itself is a group of economists who have gathered quarterly at the Institute of Economic Affairs (IEA) since July 1997. That it was the first such group in Britain, and that it gathers regularly to debate the deeper issues involved, distinguishes the SMPC from the similar exercises carried out by a number of publications. Because the committee casts exactly nine votes each month, it carries a pool of ‘spare’ members since it is impractical for every member to vote every time. This can lead to changes in the aggregate vote, depending on who contributed to a particular poll. As a consequence, the nine independent SMPC analyses should be regarded as being more significant than the precise vote. The latter is not intended as a forecast of what the Bank of England will do but a declaration of what the shadow committee believes it should do. The next quarterly SMPC gathering will take place on Monday 16th January and its minutes will be published on Sunday 5th February. The next two SMPC e-mail polls will be released on the Sundays of 4th March and 1st April, respectively.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Appendix: ‘E-mail from America’

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

Minutes of the Meeting of 17th October 2011

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

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

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

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

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

The Monetary Situation
The International Situation

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

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

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

The UK Economy

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

Discussion
Supply-side uncertainties cramp monetary options

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

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

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

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

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

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

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

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

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

Votes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Policy response

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

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

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

Date of next meeting

Monday 16th January, 2012.

Appendix: ‘E-Mail from America’

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

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

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

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

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

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

What is the SMPC?

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

SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

Minutes of the Meeting of 18th July 2011

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

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

Chairman’s comments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Policy response

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

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

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

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

Date of next meeting

Monday 17th October.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What is the SMPC?

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

Current SMPC membership

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

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

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

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

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

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

Minutes of the Meeting of 13th April 2011
Attendance:

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

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

Chairman’s comments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Further Comments by non-voting participants

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

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

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

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

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

Policy response

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

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

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

Date of next meeting

Monday 18th July 2011.

What is the SMPC?

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

SMPC membership

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Note to Editors

What is the SMPC?

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

Current SMPC membership

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

Forthcoming membership changes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Further Comment by David H Smith (Sunday Times)

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

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

Policy response

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

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

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

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

Date of next meeting

Wednesday 13th April 2011.

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

SMPC membership

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

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

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

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

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

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

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

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

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

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

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

As far as the UK is concerned, Mervyn King – the governor of the Bank of England – made statements in 2010 which suggested that he had bought into a monetarist view of the world, where th