Download here. - Institute of Economic Affairs

SHADOW MONETARY POLICY COMMITTEE
Institute of Economic Affairs
2 Lord North Street
Attendance: Professor Philip Booth (Observer for IEA), Professor Tim Congdon,
John Greenwood, Dr Andrew Lilico, Professor Kent Matthews (Secretary), Professor
Anne Sibert, David Smith (Chair), Dr Peter Warburton.
Apologies: Professor Roger Bootle, Professor Alec Chrystal, Professor Patrick
Minford, Professor Gordon Pepper, Professor Peter Spencer.
The Economic Situation:
Before inviting Andrew Lilico to summarise the domestic and international economic
scene, David Smith commented on the recent revisions to data by the ONS and the
difficulties of assessing the state of the economy with revisions of the order of
magnitude made. In particular, it made an important difference to one’s assessment of
the current economic conjuncture if one believed that real household consumption
was 9.3% above its long-term trend in the second quarter, as shown by the old 1995
price national accounts, or the 5.4% shown by the new data. David Smith also pointed
out that, amongst other revisions, the cumulated growth in the volume of capital
investment between 1995 and 2003 Q2 was now shown as having been 44.6%
compared with the 28.3% increase shown by the old national accounts. The wider
implications of such huge and recent revisions for the monetary debate had still not
been fully digested, in his view.
World Economy – Unexciting, Domestic Economy – Superficially benign.
Andrew Lilico referred to his circulated notes (appendix). The recovery in the US was
sill too slow and world economy (OECD) could be summarised as steady but
unexciting. On the domestic economy, net borrowing had gone from a surplus of
£15.4 bn in 2000/1 to £24.5 bn in 2003/4 – a turnaround of £40 bn. Without this fiscal
injection; there would have been no growth over the past two years. The domestic
economy is superficially benign but there remain two dangers. First, if house prices
fail to rise, let alone fall, household spending could decline sharply. Second, the state
of the public finances deem that taxes would have to rise in the future which adds
further to the risk of declining household spending.
Discussion
World Economy – buoyant 2004 or disorderly adjustment?
Tim Congdon said that while we have typically concentrated our discussion of the
world economy on the OECD, we now have to look at developments in the Far East
and China in particular to get a fuller picture. Commodity prices, oil prices and freight
rates are all being affected by the growth in the Chinese economy. The OECD is not
the whole story. The US economy is below trend capacity and so has a lot more room
to grow. The result is that 2004 will see a very buoyant world economy, with possible
dangers for oil and commodity prices.
2
Andrew Lilico said that the scenario Tim envisaged for the Far East relied on the
existing currency pegs remaining, which in turn depended on not too great a
divergence in performance between the Far East and the US. But Andrew did not
expect US recovery to be sufficiently rapid for this. He also expected oil supplies to
increase and put downward pressure on oil prices.
John Greenwood added that the Asian economies have been restructuring since the
Asian crisis and export growth has been phenomenal. The current account surpluses
will eventually feed into domestic demand, which can be expected to grow even more
strongly.
Peter Warburton questioned whether the US is showing a sustained recovery. After
having boosted demand through monetary policy he suggested that what is being
witnessed in the US is an inventory cycle and not a durable commitment to capital
spending. He felt that the recovery in the US was temporary. He also felt that growth
in China could be slowed through a credit clampdown, which is the likely outcome if
the situation continues.
Anne Sibert said that the large US current account deficit has the potential for a
disorderly adjustment of foreign exchange markets with the pound sterling
appreciating rapidly in the short-term.
John Greenwood said that to have a disorderly adjustment of the dollar there has to be
a loss of credibility in the Fed or in the Bush administration’s fiscal policies -implicitly a major shift away from the dollar by the Asian central banks. In the
absence of either the dollar is likely to continue in an orderly decline. Peter Warburton
said that three-quarters of the purchases of dollar bonds in the 2nd quarter were from
the private sector and not central banks and therefore the potential for disorderly
adjustment exists.
Domestic Economy – a fog of statistics
David Smith concluded the discussion of the world background by pointing out that,
rightly or wrongly, world equity markets now appeared to have the bit between their
teeth, and were signalling quite a robust cyclical recovery. The rise in bond yields
since the start of the year suggested that deflation was now less of a market concern.
He then invited the Committee to comment on the state of the domestic economy. In
order, to get the debate rolling David Smith started by expressing three concerns.
First, he was worried about the extent of the data revisions to the macroeconomic
data. Second he remained concerned about the fiscal side and supply-side issues and
finally the proposed switch to the HICP as the inflation target variable. His view was
that real interest rates should be neutral – neither inflationary or deflationary, which
implies short-term money market rates of around 4¾%, given an assumed real rate of
around 2½% and the fact that retail price inflation ex. Mortgages and house price
depreciation was currently fluctuating around 2¼%.
Tim Congdon said that the level of output in the UK is currently at trend, whereas in
most industrial countries it is beneath trend. Because the output gap is negative in
most industrial countries (especially in the USA), above trend growth can be
reconciled for several quarters with good inflation news and perhaps even further
declines in inflation. But because the output gap in the UK is more or less nil, above
trend growth here would lead to rising inflation.
Peter Warburton said that dissecting the economy in the current fog of data is difficult.
The revised data has lifted the investment figures, removing the dip in recent quarters.
As a result, he now expects private investment to decline in the near future.
3
Policy Response
A more than usual statistical fog
Kent Matthews said that the condition of the world economy remains uncertain. The
differing views of the members of the SMPC are a reflection of this uncertainty.
While he felt that the last cut in rates by the MPC was wrong and sent out the wrong
signals, it would be inappropriate to raise rates at the moment. He voted to keep rates
on hold with a bias to raise as soon as the fog of data lifts.
John Greenwood agreed that there was more than the usual statistical fog. He said that
output growth may be close to trend but trend growth will be slower because of fiscal
policy and supply-side issues. At the same time there is not enough evidence that
monetary growth has reached dangerous levels. He voted to keep rates on hold.
Andrew Lilico said that the previous cut by the MPC was incorrect. However, if the
target for inflation switches to the HICP, inflation will be at the lower bound of the
range. He believes that the MPC may eventually have to cut rates again if it is not to
breach the lower bound of the target. However for the next three months he voted to
keep rates on hold with a bias to cut.
David Smith agreed that the supply-side was deteriorating and as a consequence
nominal private sector demand needed to be squeezed in order to make way for the
burgeoning demands for productive resources coming from government. He made the
general point that monetary policy can only operate on the private sector, since the
government is not liquidity constrained and has no demand for money. This meant
that the monetary authorities had to force ever coarser adjustments onto the private
sector – in order to plug any given GDP gap – as the government sector increased its
share of national output. He said that there was a case for a non-precipitous rise in
rates but for the moment he voted to keep rates on hold with a bias to raise.
Peter Warburton said that the only argument to raise rates would be to offset a lax
fiscal policy. He felt that examining the quarterly growth figures did not tell him the
size of the output gap. Given the fog of data he voted to keep interest rates on hold.
Anne Sibert said she was puzzled by the use of the term trend growth in the arguments
forwarded, as it is an unobservable variable. She felt that the signs of recovery were
still tentative and voted to keep rates on hold.
Date of next meeting
20 January 2004
Policy Response
1. A mixture of views on the state of the economy meant that there was no unanimity
on the policy response. On a vote of 5 to 2 the SMPC voted to keep interest rates
on hold.
2. The Committee cited the uncertainties caused by the data a major factor in their
decision.
4
Appendix
The Economic Situation
Introduction
This note provides a summary of recent international and British economic
developments as part of the background material to the 14 October 2003
meeting of the Shadow Monetary Policy Committee (SMPC). The note starts
with statistics on the international background, followed by a discussion of
British monetary conditions, UK demand and output, the UK labour market,
and UK prices. There then follows some brief comment.
The International Situation

GDP: Aggregate OECD GDP rose by 0.5% in the second quarter and grew by
1.9% in the year to 2003 Q2, having risen by a yearly 2.0% to 2002 Q1. US GDP
expanded by 2.5% in the year to 2003 Q2, and Canada and Australia grew by
1.6% and 2.0% annually, each having a soft quarter at –0.1% and 0.1% quarterly
growth, respectively. ‘Euro-zone’ GDP has grown by 0.3% over the same period,
having stagnated in both Q1 and Q2 2003, but after a few healthy quarters
growth in a row Japanese GDP was up 3.0% over the year to Q2. UK GDP
expanded by 2.0% in the year to 2003 Q2.

Inflation: OECD inflation in the year to August 2003 was 2.4%, 1.9% excluding
the high inflation economies. Annual inflation in the leading developed countries
in the year to August or September ranged from minus 0.3% in Japan, to 0.5% in
Switzerland, 1.1% in Germany, 1.9% in France, 2.0% in Canada, 2.8% in Italy,
2.1% in the Netherlands, 3.0% in Spain and 3.3% in Greece. Annual inflation in
the USA was 2.2% in August, and 2.0% in the Euro-zone inflation. Inflation was
2.9% in Britain on the RPIX measure in August and 1.4% on the HICP.

Money supply: Annual OECD broad monetary growth was 6.7% in August,
down from 10.2% in 2002 (or 6.0%, same as 2002, excluding high-inflation
countries). Annual broad monetary growth in the year to August was 8.0% in the
US, 5.3% in Canada, 11.2% in Australia, 1.1% in Japan (narrow money up
4.9%), and 7.9% in the Euro-zone.

Exchange rates: The Bank of England’s trade-weighted exchange rate indices,
based on 1990=100, show average September 2003 figures of Japanese Yen at
133.2 (down from 134.1 September 2002), sterling at 99.2 (down from 106.5) the
US dollar at 102.9 (down from 104.0) and the Euro at 89 (up from 81.6).

Commodity prices: The price of a barrel of Brent crude oil was $31.98 on 10
October, compared with $29.01 on 10 July. The weekly ‘Economist’ all-items
dollar commodity price index was 81.5 at October 7 (1995=100), up 0.6% on the
month and 9.8% on the year (n.b. the Sterling all-items index was 77.1, down
4.1% on the month and up 2.5% on the year).

Equities: The MSCI World equity index in US$ closed at 953.81 on 10 October
(the 2003 high, up from a 2003 low of 705.20). The US S&P was 1038 while
Britain’s FTSE 100 was 4311 .
5

International interest rates: The US Fed Funds rate is 1.0% (prime rate 4.0%),
the ECB Main refinancing operations minimum bid rate is 2.0% and UK base rate
is 3.5%. The US 10-year bond yield averaged 3.96% in September, while 10-year
German bonds yielded and average of 4.27%.
British Monetary Conditions

Narrow money: The seasonally-adjusted M0 monetary base rose by 0.3% in
September, giving an annual increase of 7.7% compared with 7.9% in August.
Notes and coin went up by 0.5% in September producing a yearly rise of 7.8%,
against 7.8% in August.

Broad money: M4 was unchanged in August, representing a yearly rise of 6.6%
(down fairly sharply from 8.0% in June, as discussed at the last SMPC). M4
lending rose 0.4% in August, 9.5% on the year.

Credit: Secured lending outstanding grew by £7.7 billion or 1.1% in August,
seasonally adjusted, £0.5 billion lower than the rise in July. The three-month
(annualised) growth rate rose to 14.1% from 13.8% (14.0%) in July. The twelvemonth growth rate was unchanged at 13.9%. The number of loans approved for
house purchase in August was 120,000, seasonally adjusted, compared with the
average of 105,000 in the three months to July.
Consumer credit grew by £1.6 billion or 1.0% in August, seasonally adjusted,
£0.1 billion higher than the rise in July. The three-month (annualised) growth
rate fell to 13.5% from 14.4% (14.6%) in July. The twelve-month growth fell to
13.7% from 14.2% in July. Gross advances were £17.3 billion, compared with
the average of £17.2 billion in the three months to July.
Mortgage equity withdrawal: MEW was £11.2bn in 2003 Q2, or 6.0% of posttax income, down from £11.5bn (6.2% of post-tax income) in 2003 Q1 and
£12.1bn (6.6% of post-tax income) in 2002 Q4. Figure 1 illustrates. £11.2bn is
seven times the quarterly rise in household final consumption expenditure.
Figure 1: Mortgage Equity Withdrawal
14000
9.0
8.0
12000
7.0
10000
5.0
6000
4.0
4000
3.0
2.0
2000
1.0
19
70
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
0
-2000
0.0
-1.0
-4000
-2.0
£m
as % of post-tax income
% of post-tax income
6.0
8000
£m

6

Public sector Borrowing: The cumulative figures for the first five months of
2003/4 (April to August) show a cumulated PSNCR deficit of £11.5bn, compared
with a £2.4bn deficit in the same period of 2002/3. Public sector net debt was
31.8% of GDP at the end of June, compared to the 30.5% recorded at end of
June 2002, and up from 29.7% in February 2002. The peak of recent years was
44.0% in 1997.
UK Demand and Output

Chain-linking: The UK national accounts have moved to annually weighted and
chained estimates of volume growth from September 30th.

UK Q2 real GDP: Growth in the second quarter of 2003 was 0.6% revised up
from 0.3% on the early estimates (and up from 0.2% in Q1). This acceleration in
growth is due to a recovery in the construction industry, which is now estimated
to have grown by 4.4% in the latest quarter after a fall of 1.9% in 2003 Q1. This
strength in construction in the latest quarter is most marked within housing repair
and maintenance. This appears to be a genuine re-estimate of the figures rather
than a statistical consequence of the shift to chain-linking.

Manufacturing: The Chartered Institute of Purchasing and Supply (CIPS)
manufacturing index was 52.9 in September, up from 52.2 in August. The
Engineering Employers’ Federation/RSM Robson Rhodes third quarter 2003
Engineering Outlook found that, for the first time in over two years, more
companies reported output and orders expanding rather than contracting (driven
by demand for exports — companies continued to report a decline in domestic
orders).

Retail sales: Growth in retail sales volumes is stronger than earlier in the year. In
the three months to August 2003 retail sales grew by 1.8 % compared with the
previous three months, the highest three-month rate of 2003. Three-monthly
growth rates into August increased for supermarkets and department stores and
decreased for household goods stores. Growth in the three months to August
was 4.9 % over the same period a year ago. Month-on-month, retail sales
increased by 0.2 % in August. In value terms and without seasonal adjustment,
retail sales in August were 4.7 % higher than in August 2002.

Business Investment: Business investment for 2003 Q2 is 0.7% lower than the
same period of last year and 2% higher than in Q1. This compares with a fall of
0.2% in the Q1.

UK trade: The current account deficit widened to a record £8.6 billion (or 3.2% of
GDP) in 2003 Q2. This compares with a revised deficit of £2.3 billion in Q1. The
increase was mainly due to a fall in investment income. UK oil company earnings
on direct investments abroad have fallen, while foreign earnings on direct
investments in the UK increased £1.4 billion to £7.0 billion due to higher earnings
of foreign-owned banks and insurance companies in the UK. As a result the
surplus on direct investment has fallen from £9.3 billion in the first quarter to £5.4
billion in the second. The trade in goods data now reflect the adjustments to the
trade statistics to reflect VAT Missing Trader Intra-Community fraud. There has
7
also been a large downward revision to earnings on foreign direct investment.
The revised deficit for 2002 now stands at £19.0bn, or 1.8% of GDP — little
changed from 2001.
UK Labour Market

Unemployment: Survey data for the three months ending in July showed
unemployment at 1.49m, down by 1,000; there were 9,000 fewer men but 7,000
more women unemployed compared with the previous three months. The
unemployment rate was unchanged at 5.1% (5.6% for men and 4.5% for
women). The claimant count fell by 6,900 from the revised July figure to 930,800
in August. The rate remains at 3.1%, for the twentieth consecutive month.

Employment: The employment rate for people of working age was 74.6%, up
marginally on the previous quarter. The number of people in employment rose
63,000 over the previous three months to a record 27.93m. The number of men
in employment rose 60,000 to 15.1m. The number of women in employment rose
3,000 to 12.9m.

Earnings: The annual rate of growth in average earnings for the three months to
July 2003 was 3.4%, up from 3.1%. The main contributor to the increase in pay
growth was private sector services, where pay growth including bonuses rose
from 2.6 % in June to 3.8 % in July. This was caused by some higher bonuses
and some bonuses being paid later in 2003, as well as additional overtime, in the
retail trade and repairs, and real estate and business services sectors.

Productivity: In 2003 Q2 productivity growth was 0.4%, compared with no
change in Q1. Annual productivity growth for the whole economy was 1.8%,
compared with 2.0% in Q1. (However, this annual rate difficult to interpret,
because 2002 Q2 was probably affected by the Jubilee.) Annual manufacturing
productivity growth was 5.9%, improving for the fifth consecutive quarter.

Unit wage costs: UWC for the whole economy grew annually by 1.2% in the
year to 2003 Q2. This was the lowest rate since the 0.8% growth recorded in the
first quarter of 1996. This was due to a deceleration in the growth of wages and
salaries. For similar reasons, overall manufacturing unit wage costs showed an
annual decline of 2.9%, down from 1.5% in the previous quarter.
UK Prices

Producer prices: In September, output price annual inflation remained at 1.5 per
cent, while input price annual inflation fell to 0.4 per cent. Month on month,
prices rose 0.1 per cent on August, mainly reflecting rises in petroleum and other
manufactured product prices. Input prices of UK manufacturers’ materials and
fuels rose 0.4 per cent in the year to September (compared with a 1.8 per cent
rise to August). Between August and September the input index fell 1.4 per cent,
mainly reflecting a 9.6 per cent fall in crude oil prices. In seasonally adjusted
terms the index fell 1.2 per cent between August and September. The "narrow"
output prices measure showed an annual increase of 1.3 per cent, compared
with a 1.1 per cent rise to August. Seasonally adjusted prices rose 0.1 per cent
between August and September
8

Retail prices: RPI inflation over the year to September was 2.8%, down from
2.9% in August. RPIX inflation was likewise 2.8% down from 2.9%. The annual
change HICP was 1.4%, unchanged from August.
The largest downward effect on the RPI inflation rate came from clothing and
footwear, particularly women's outerwear, where price rises associated with the
introduction of the new season's stock were less than last year. Another
downward influence came from a specific index for airfares, and the associated
seasonal decrease in fares, being included for the first time this year. A small
downward effect came from leisure services, with the cost of foreign holidays
falling in contrast with rises a year ago. Other downward effects came from
changes in the prices of domestic heating oil, fees and subscriptions, and
tobacco.
The main upward influence came from seasonal food, particularly fresh
vegetables, where prices rose by more than a year ago following adverse hot
and dry growing conditions. In addition, non-seasonal food contributed a small
upward effect.

House prices: The latest figures from the Office of the Deputy Prime Minister
showed that the annual rate of house price growth stood at 14% in August, down
from 14.6% in July. The relationship between monthly mortgage payments and
monthly average earnings on new purchases has now overtaken their 1998
relationship at the previous peak of mortgage interest rates.
Table 1: House prices and Earnings (Halifax index)
House Prices
Mortgage
Rates (%)
Monthly
Mortgage
Payments (at
100% LTV)
Monthly
Earnings
Monthly
Mortgage as % of
Monthly
Earnings
Sep-98
£
72,885
8.87
£ 611.84
£
1,846
33.1%
Dec-02
£
119,943
5.64
£ 755.35
£
2,310
32.7%
Jan-03
£
120,137
5.64
£ 756.57
£
2,280
33.2%
Feb-03
£
123,686
5.63
£ 778.17
£
2,363
32.9%
Mar-03
£
125,933
5.49
£ 781.59
£
2,425
32.2%
Apr-03
£
128,280
5.51
£ 797.71
£
2,283
34.9%
May-03
£
130,642
5.50
£ 811.61
£
2,283
35.5%
Jun-03
£
132,426
5.49
£ 821.89
£
2,308
35.6%
Jul-03
£
133,815
5.49
£ 830.51
£
2,322
35.8%
9
Latest MPC Meetings

The October MPC meeting held interest rates steady at 3.5%.

The minutes of the September meeting showed the committee voting
unanimously in favour of holding rates then. For most members this was clearcut, though others felt that the argument for holding was finely balanced against
the argument for raising rates. All members agreed that it was difficult to assess
the state of the economy accurately because of statistical uncertainties.

The committee felt that the key policy-relevant judgements were: the durability of
the US recovery (noting especially the weak labour market) and its implications
for world recovery and hence UK demand; the prospects for UK domestic
demand, given the unexpected resilience of consumption growth and the
continued rapid accumulation of debt by households; and the extent of the passthrough to RPIX inflation of sterling’s depreciation since last autumn.
Comment

The 1990s could be characterised as a period in which the UK economy was
fundamentally very strong, so that although it was challenged by occasional
shocks (such as the Asian crisis) its fundamental strength and balance sustained
its growth. Now I believe that that situation has reversed. We are now in a
period in which the UK economic situation is superficially benign (though
unexciting) with steady growth and inflation and very low unemployment.
However, behind this façade I believe there are two significant domestic threats.

The first threat is related to the housing market. The economy has become ever
more housing-driven. Consumption is sustained by mortgage equity withdrawal.
Inflation is held above target by housing depreciation. Even our statistical
revisions are now housing-driven with the Q2 revision of construction figures
alone adding 0.3% to GDP. House prices cannot continue to rise at anything
close to current rates for much longer, and may be very close to their peak. But
if house prices stop rising (even if they were not to fall) then the opportunity to
withdraw mortgage equity will disappear (and with it consumption growth), RPIX
will start coming in below target, and people will become more aware of the
burden of their debts.
The second threat is the public finances. Total managed expenditure will have risen
from 38.1% of GDP in 2000/1 to 41.1% of GDP in 2003/4 — if it is held within the
government’s projections — an 8% proportionate rise in only three years. Net
borrowing will have gone from a surplus of £15.4bn in 2000/1 to £24.5bn in 2003/4
— again if the government holds matters within its own projections, which in this case
seems unlikely given the problems with the tax haul — a turnaround of £40bn (or
3.8% of GDP) in only three years. Without these massive fiscal injections it seems
clear that there would have been almost no growth in the past two years. But
injections on this scale cannot be sustained. In fact, although there is no public
sector debt problem in the short term, it seems likely that taxes will rise soon after the
next general election, and hence 2006 may be a focal year. If households have not yet
fully incorporated expectations of such tax rises into consumption behaviour, their
doing so could be another danger for domestic demand over the next year.