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Economists say interest rate rise needed now

As the Bank of England's interest rate setters prepare to cast their votes, a shadow monetary policy committee made up of some of Britain's leading independent economists has voted in favour of a  rate rise.

 

A group of leading economists have said it is time for the Bank of England to lift interest rates to rein in rising prices.

The Institute of economic affairs' shadow monetary policy committee, a group of nine leading independent economists which meets monthly to discuss the state of the economy, voted 5-4 for a 50 basis point rate increase in the official UK bank rate to 1%.

Inflation is rising much faster than the official target of 2%, even according to official consumer price inflation data, and Bank of England governor Mervyn King recently warned that inflation could rise to 5%. Retail price inflation, which includes housing costs, is already at 4.7% and set to go even higher in the months ahead.

The five economists who said it is time to lift rates said that if the UK's official rate-setters did not move to tackle inflation then the Bank's credibility would be damaged. Economists fear that if rates are held then it could lead to spiralling inflation as workers demand higher wages, leading to higher price increases.

The economists also expressed concern about the pace of global growth and the weak pound.

Mervyn King has said that rising prices mean real incomes have been falling for six years but said that weak growth means a rate rise now would threaten the recovery.

And four of the shadow MPC members agreed the economic recovery is so anaemic that it would be de-railed by the additional business uncertainty generated by even a small increase in rates.

'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 ansd expressed concerns that the recent increase in Value Added Tax to 20% could squeeze living standards even further, depressing household consumption,' according to a press release form the shadow committee.

Minutes from the Bank of England's last rate-setting meeting in January show two of Britain's rate-setters voted for a rate rise, while many others considered voting for an increase.

But that was before the shock news that the UK economy shrank in the final quarter of 2010. Most committee watchers still believe the MPC will not vote for a rate increase on Thursday but expect it to be a close call.

Bank of England minutes

MINUTES OF THE MONETARY POLICY COMMITTEE MEETING HELD ON 12 AND 13 JANUARY 2011

Before turning to its immediate policy decision, the Committee discussed financial market developments; the international economy; money, credit, demand and output; and supply, costs and prices.

Financial markets

2 As was typical during the Christmas and new year period, the level of activity in financial markets had been relatively low. So the asset price movements that had occurred within the month were to be interpreted with some caution.

3 Over the month as a whole, expectations of the point at which Bank Rate would begin to rise had been brought forward. Information derived from overnight index swaps indicated that market participants expected that Bank Rate would increase by 25 basis points by around August. By contrast, longer-term interest rates in the United Kingdom were little changed, having increased in the month leading up to the previous MPC meeting.

4 Euro-area sovereign debt markets had remained strained, reflecting continued concerns over some countries’ fiscal positions. The difference between the yields of many peripheral euro-area countries’ sovereign bonds and those of equivalent German government bonds had increased. Credit default swap premia on both peripheral and German sovereign bonds had increased over the month.

5 Having been subdued during December, activity in bank funding markets had picked up since the start of the new year. Consistent with the movements of sovereign bond yields, market contacts had reported increased discrimination by investors across the banking sector debt of different European countries, with funding for peripheral euro-area country banks becoming more costly. Non-financial corporate bond yields had been broadly unchanged during the month.

6 Equity prices had increased by around 4% in the United Kingdom and United States during the month, and by a little less in the euro area. The FTSE All-Share index had recovered to stand around 10% below its peak in June 2007, while equity indices in the United States and euro area had remained further below their pre-crisis peaks. That may have, in part, reflected the depreciation of the sterling exchange rate. Much of the recovery of UK equity prices over the past year could be accounted for by expectations of stronger earnings and dividend growth. It may have also reflected financial market participants’ perceptions that the likelihood of a sustained period of very weak economic growth had lessened as the global recovery had progressed.

7 The sterling effective exchange rate index had been little changed over the month as a whole, despite some volatility around the turn of the year. It had ended the month modestly above its 2010 average, but sterling had remained relatively stable, moving within a small range, since the beginning of 2009.

The international economy

8 The data released during the month had remained consistent with continued firm growth in the global economy, albeit uneven across countries. And, as in previous months, there were continued signs that global demand was putting upward pressure on commodity prices.

9 There were some signs that the recovery in the United States was becoming more firmly rooted. The ISM non-manufacturing business activity index had reached 63.5 in December, its highest level since 2005, while the manufacturing PMI had remained broadly unchanged. These business surveys pointed to growth in the fourth quarter at a little above its historic average, consistent with the signal from monthly indicators of consumer and business spending. And the recently announced additional fiscal measures, as well as the resumption of large-scale asset purchases, were likely to support activity in future. Set against that, it was possible that unemployment would fall only slowly; non-farm payrolls had increased by 103,000 in December, below the pace of employment growth that would probably be necessary for a sustained fall in unemployment. And the continued weakness of the housing market would most likely remain an impediment to construction sector activity for some time.

10 In the euro area, the picture remained one of moderate growth at an aggregate level, but with considerable cross-country variation. Third-quarter GDP growth had been revised down fractionally to 0.3%, and the business surveys and other indicators remained consistent with similar or slightly stronger growth in the fourth quarter. Industrial production was estimated to have increased by 1.2% in November, following an increase of 0.7% in October. Indicators of German growth had remained strong. But demand growth in some peripheral countries was likely to be restrained over the next few years by actions to reduce fiscal deficits. Moreover, there was a risk that an intensification of concerns over fiscal sustainability could result in disruption to bank funding markets and weaker growth.

11 Indicators had remained consistent with robust growth in emerging economies, which provided almost a quarter of UK goods imports. China and some other countries had tightened monetary policy during the month, in response to heightened inflationary pressures, which could feed through to higher export prices. Unless offset by a movement in the sterling exchange rate, such heightened inflationary pressures could lead to higher UK import prices.

12 Oil prices had risen by almost 8% in sterling terms since the Committee’s previous meeting, while industrial metals prices had also risen. Since July 2010, oil and other commodity prices had risen by around a third or more. It was possible that demand and supply pressures could lead to further increases in the prices of some commodities and exert further upward pressure on UK import prices.

Money, credit, demand and output

13 Estimated GDP growth in 2010 Q3 had been revised down by 0.1 percentage points to 0.7% during the month. Within that, a downward revision to the measured contribution of net trade to growth had been offset by stronger business investment. But revisions to the data for previous quarters implied that the level of GDP in the third quarter was broadly unchanged from that implied by the previous data release.

14 On balance, business surveys had remained consistent with some slowing in the pace of growth in 2010 Q4. The impact of the snowy weather in December and the increase in the standard rate of VAT in January were likely to inject some volatility into output around the turn of the year, making the data difficult to interpret. The sharp fall in the CIPS/Markit services business activity index was consistent with some negative impact on activity from the bad weather, as it appeared to be centred in the consumer-facing service sectors; the equivalent construction activity index had also fallen. That matched reports from the Bank’s Agents.

15 Although output had evolved broadly as the Committee had anticipated, there remained downside risks looking forward. It was likely that some households had not fully adjusted their behaviour in response to the prospective fiscal consolidation. And the growth in households’ real incomes was likely to be held back by the elevated level of near-term inflation and by subdued pay growth. These factors had the potential to dampen household spending. Moreover, house prices had fallen by 0.4% in December according to the average of the Halifax and Nationwide indices, while mortgage loan approvals had remained at a low level in November.

16 Prospects were also uncertain for net trade, which had reduced GDP growth by 0.1 percentage points in 2010 Q3. There had been some encouraging news in recent quarters. The recovery of the world economy had continued. UK goods exports had increased at an average quarterly rate of almost 3% for the past five quarters, although exports of services had been considerably weaker. And there had been further strong increases in survey measures of export orders during the month. Nevertheless, in recent quarters net trade had generally reduced GDP growth in part because of the strength of import growth. The growth in imports was associated with a recovery of domestic demand, but it was disappointing that net trade had not yet improved by as much as expected given the past depreciation of sterling and the growth of world trade. And there remained a downside risk to export growth stemming from the financial tensions within the euro area, the United Kingdom’s largest trading partner.

17 The latest data indicated that broad money and credit growth had remained subdued relative to pre-crisis rates, with M4 excluding the holdings of interbank intermediaries rising by 1.4% in the year to November, and M4 lending on a similar basis falling by 0.8%. But nominal GDP was estimated to have risen by around 5% in the year to 2010 Q3, close to its historical average. And nominal domestic demand had increased by almost 7%. That pattern might have reflected a reduced reliance on the banking system during the recovery, given the tightening in bank credit conditions. This trend might persist if businesses were to rely increasingly on existing cash balances and capital markets, rather than bank lending, to finance investment in future. The relative weakness of broad money growth might also reflect banks increasing their capital bases in advance of the introduction of higher regulatory capital standards. To the extent that these factors persisted, money and credit growth could remain weaker than nominal spending growth for some while.

Supply, costs and prices

18 CPI inflation had risen to 3.3% in November from 3.2% in the previous month. In line with the usual pre-release arrangements, an advance estimate for twelve-month CPI inflation of 3.7% in December had been provided to the Governor ahead of publication. A detailed breakdown of the inflation data was not yet available, but increased food, petrol and utility prices were likely to have contributed to the increase on the month.

19 Also in line with the pre-release arrangements, the Governor informed the Committee that producer output prices had risen by 0.5% in December, causing the twelve-month inflation rate to rise to 4.2%. An estimate of producer input prices had also been provided, showing a rise of 3.4% in December, an increase materially larger than the average market expectation: the twelve-month inflation rate had risen to 12.5% from 9.2% in November. Increases in food and energy prices could account for the majority of the rise on the month.

20 Recent developments in the prices of imported commodities and other goods indicated that the most likely near-term path of CPI inflation might be higher than the Committee had thought at the time of the November Inflation Report. It appeared likely to rise above 4% in coming months. The latest reports from the Bank’s Agents suggested that it was also possible that the pass-through into consumer prices of January’s VAT increase would be greater than previously expected. These factors represented further shocks to the price level whose direct impact on inflation should dissipate over time. But they were a source of concern if imported price pressures were to remain elevated or if businesses were more able or willing to pass on cost increases than might have been expected given the shortfall of demand relative to supply capacity. They were also likely to exacerbate the risk that expectations of above-target inflation would become engrained, affecting wage and price pressures.

21 Survey measures of households’ expectations of future inflation had generally drifted up in recent months. This month, data from the Citi/YouGov survey indicated that households’ expectations of both near and longer-term inflation had increased again in December. Measures of businesses’ expectations of future inflation had appeared more stable through most of the year, although it was difficult to know how much weight to place on the limited survey information that was available. Implied measures of inflation expectations derived from financial market prices had shown no clear pattern on the month. The expectations implied from inflation swaps had been broadly stable since the middle of 2010.

22 Annual regular pay growth had increased to 2.3% in the three months to October, compared with 1.6% in the three months to July. The LFS employment measure had fallen by 33,000 in the three months to October, compared with the three months to July. But it had risen substantially over the preceding year – by almost 300,000 in the year to 2010 Q3. The Workforce Jobs measure of employment had fallen over the same period, however, making it more difficult to judge the pace of job creation and productivity growth.

23 Taken at face value, the strength of employment growth shown by the LFS data over the past year or so had been surprising. Given the large reduction in productivity relative to its pre-crisis trend that had occurred during the recession, businesses might have been expected to be able to increase output during the recovery without taking on many additional employees. If the LFS measure was accurate, then the past strength of employment growth might indicate that the degree of spare capacity in the economy was less than the Committee had assumed, or else was more unevenly spread across different businesses and sectors. The downward pressure on prices stemming from the margin of spare capacity would then be commensurately less. But in that case, consideration would also need to be given to the implications for income and spending growth. The Committee would seek to analyse this issue further in the context of the projections prepared for its February Inflation Report.

The immediate policy decision

24 Inflation had generally exceeded the Committee’s expectations in recent months. But the key consideration for monetary policy was the likely rate of inflation, and the balance of risks around it, in the medium term. The Committee discussed how the balance between the opposing key risks had altered over the past few months.

25 The first key risk was that the growth of private demand might be relatively weak, and that the margin of spare capacity would cause inflation to fall below the target in the medium term. Overall, there had been little change in this risk since the Committee’s previous meeting. The recovery in the United Kingdom and overseas had continued broadly as expected. Abstracting from the likely effects of the snow in December and the VAT rise in January, the data had remained consistent with UK growth at around its historical average in the second half of 2010 and early 2011. And, if anything, it was possible that near-term growth in the United States would be a little stronger than the Committee had previously assumed. But there remained significant downside threats to UK growth. Those stemmed primarily from: the risk of a sustained rise in the household saving rate, possibly in response to the UK fiscal consolidation; the possible impact on the United Kingdom and the international banking system of an intensification of sovereign debt concerns within the euro area; and the continuing funding challenge for UK banks.

26 The second key risk was that inflation might remain above the 2% target for long enough to cause expectations of future inflation to move up and that this would in turn lead to higher increases in future wages and prices, so making it more costly for the Committee to bring inflation back to the target further ahead. Commodity prices had risen further, and it was probable that the near-term path of inflation would be materially higher than the Committee had thought at the time of the November Inflation Report. The extent to which these developments affected inflation expectations would be hard to gauge, given the imperfect and partial nature of the available indicators. Survey measures of household inflation expectations for both the short and medium term had risen. But measures derived from financial market prices, and measures of businesses’ inflation expectations, which were likely to be more immediately relevant to the setting of wages and prices, had remained more stable. And wage growth had remained moderate, especially when compared to productivity growth.

27 Even without a generalised increase in inflation expectations, there was a risk that inflation would remain above the target in the medium term for three reasons. First, the recent increases in commodity prices might continue. Some members thought it was likely that robust growth in emerging economies would continue to put upward pressure on commodity prices, but for other members the best forecast was embodied in futures prices, which were lower. Second, more general inflationary pressures in emerging economies could lead to higher UK import prices. In the event of either of those risks crystallising, lower domestically generated inflation would be needed to hit the inflation target. Third, there was a risk that the prices of the domestically produced goods and services that competed with imports would rise further in the aftermath of sterling’s depreciation as the economy recovered.

28 The Committee considered the case for an increase in Bank Rate at this meeting. The domestic and global recovery had proceeded at least as well as expected. And the most likely prospect was for continued growth, despite the downside risks that remained. For most members, the balance of risks to medium-term inflation relative to the target had moved upwards over the past few months, reflecting the recent and prospective buoyancy of import prices and the possible impact of higher near-term inflation on public inflation expectations. That would suggest that a lower level of demand might be consistent with hitting the inflation target in the medium term, and so might argue for a withdrawal of some of the current monetary stimulus. Moreover, an increase in Bank Rate at the current juncture might lessen the risk that a larger increase became necessary at a later stage if inflation persisted above the target. Members noted that a small increase in Bank Rate at this meeting would still leave monetary policy highly accommodative, and would not preclude the Committee from increasing the policy stimulus in future if that became necessary.

29 The Committee also considered the arguments for maintaining the current level of Bank Rate. Inflation had been boosted by the past depreciation of sterling, and increases in VAT and energy prices. These effects were large and – in the view of many members – could more than account for the current deviation of inflation from the 2% target. This suggested that the margin of spare capacity had exerted downward pressure on inflation, and would continue to do so while demand growth remained insufficient to reduce that margin materially. Moreover, material downside risks to demand remained. The impact of the fiscal consolidation on spending was uncertain. And euro-area sovereign debt problems remained capable of delivering a significant jolt to UK export demand, as well as to the international banking system and confidence more generally. In addition, while Bank Rate had been reduced to an exceptionally low level, the effective stimulus had been offset by the reduced supply of credit: since the onset of the financial crisis the interest rates faced by many households and businesses had fallen by less than Bank Rate, and in some cases had increased. On this view, the balance of risks continued to suggest that inflation would fall back to around the target once the impact of the factors boosting it had dissipated.

30 Some members also noted that an increase in Bank Rate at this meeting might be misinterpreted as a signal that the Committee would attempt to bring inflation back to the target excessively rapidly, which could cause expectations of a relatively sharp tightening of monetary policy that could have a detrimental impact on confidence and activity.

31 There was a spectrum of views among Committee members about how much weight to place on the arguments for and against a change in the policy stance.

32 For most members, recent developments implied that the risks to inflation in the medium term had probably shifted upwards. For some of those members, the decision this month was finely balanced. The analysis that fed into the forthcoming February Inflation Report projections would provide an opportunity to assess fully the developments since the previous Report, and to evaluate more thoroughly the risks to inflation in the medium term. The publication of the Report would also give the Committee the opportunity to explain fully its assessment of the outlook and its policy decisions.

33 For two members, the evidence suggested that the balance of risks was already sufficiently clear to warrant an immediate increase in Bank Rate. The continued elevated rate of inflation, which was forecast to persist, posed a significant risk to inflation expectations and hence to the medium-term outlook for inflation. This made more powerful the case which had been building for some time for a gradual rise in Bank Rate.

34 For one member, the balance of risks to inflation continued to warrant an expansion of the Committee’s programme of asset purchases, financed by the issuance of central bank reserves, because it was likely that inflation would fall to below the target in the medium term. This member acknowledged that a sustained upward trend in commodity prices or in global demand prospects, or a shift in sentiment against sterling, could outweigh the domestic forces pushing down on inflation. But this member did not see this risk as yet large enough to require a policy tightening.

35 The Governor invited the Committee to vote on the proposition that:

  • Bank Rate should be maintained at 0.5%;
  • The Bank of England should maintain the stock of asset purchases financed by the issuance of central bank reserves at £200 billion.

Six members of the Committee (the Governor, Charles Bean, Paul Tucker, Spencer Dale, Paul Fisher and David Miles) voted in favour of the proposition. Three members of the Committee voted against the proposition. Andrew Sentance and Martin Weale preferred to increase Bank Rate by 25 basis points and to maintain the size of the asset purchase programme at £200 billion. Adam Posen preferred to maintain Bank Rate at 0.5% and increase the size of the asset purchase programme by £50 billion to a total of £250 billion.

36 The following members of the Committee were present:

  • Mervyn King, Governor
  • Charles Bean, Deputy Governor responsible for monetary policy
  • Paul Tucker, Deputy Governor responsible for financial stability
  • Spencer Dale
  • Paul Fisher
  • David Miles
  • Adam Posen
  • Andrew Sentance
  • Martin Weale

Dave Ramsden was present as the Treasury representative.

Shadow MPC minutes

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. 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.

8 comments so far. Why not have your say?

William Phillips

Feb 07, 2011 at 11:56

The banking system is 'so fragile' that its leading lights are about to report profit recovery worth billions and its bosses will be in line for bonuses worth millions.

But at the same time usury 'so fragile' that millions of pensioners are being starved by the virtual absence of interest-- so that rather smaller numbers of so-called homeowners can be shielded from the consequences of their improvidence, and the institutions that lent to them from the knock-on effects.

The British economy reflects not only grotesque structural imbalances but corrupt priorities. It deserves to crash, because it is riddled with immorality for which it must do penance. A 'recovery' based on fiat money and 0.5% base rate is not worth having: a mere prolongation of agony.

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John Lacy

Feb 07, 2011 at 13:32

As I have pointed out ad nauseam the causes of UK inflation are caused by international factors that are outside of the control of the Bank of England. Will an interest rate increase reduce the inflation caused by Oil, Gas or Electricity price rises? Or the effect of spiralling food prices?

No of course it won't!!! All it will do is remove yet more disposable income to be spent from the overall economy and make recovery even more difficult.

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Danny Lovey

Feb 07, 2011 at 13:54

When will some people understand that the problem with inflation at the moment is the fact that we are 'importing' it through higher commodity prices of most goods and there is nothing that the BOE can do about it! It is NOT demand led inflation - were this the case I could see the point in raising rates. We have a fiscal tightening in this country which will remain in place for several years that will ensure consumer spending remains subdued. Increasing BOE rates will do nothing to stop inflation, on the contrary it will add to costs which is counter productive to what is needed and will not help industry invest

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what do you think?

Feb 07, 2011 at 13:59

Would lifting intrest rates not make sterling stronger thus reducing the costs of imported inflation? Also give confidence to overseas investors that inflation will not erode investment? or have i got this wrong?

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Danny Lovey

Feb 07, 2011 at 14:57

What do you think - to be honest I think things like oil prices and other commodities, our economy growing + strenght of the dollar etc more of a factor in the level of sterling.

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allan c

Feb 07, 2011 at 20:44

JOHN LACY ... is right 100% all that would happen would be a massive amount taken out of the consumers pockets...they have had.. very small pay rises if at all.....???

these industrilists ..that meet to decide these things about rate rises needed run companys that if there was a rate rise ..would have there employees asking for a bigger wage increase,

there 10 people meeting of which 5 ...are turkeys voting for xmas i imagine,

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Anthony O' Grady

Feb 07, 2011 at 21:57

I agree with John Lacy. I have also long since held the view that Andrew Sentance is a moron.

Just a final word about savers, particularly the elderly. It is annoying that those who have been careful and prudent over the last few years now have to suffer because all of the jackasses who borrowed way way too much now have to be propped up. However given the current fragile state of private household finances and the UK economy generally, any interest rate rises now would be a disaster.

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Robin Linger

Feb 08, 2011 at 10:58

I sometimes wonder why analysts have such a negative view of our industrial health and economy. They follow ideas from other countries which are not necessarily successful at present, instead of from thriving examples of prosperity such as Germany with their brilliant leader, Angela Merkel. Firstly and most importantly, she was adamantly against QE and encouraged industry to retool at all times, with the certainty to protect jobs. Germany has not encouraged devaluing the Euro to make their products cheaper and more shoddy but just the opposite and now to see their trade surplus rising in a more competitive world is exemplary. We must put up interest rates and increase the value of sterling and support our industry to update and retool, cut public spending and stop the B.O.E.dithering ,which is causing uincertainty and in its wake, stagnation.

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